Let's talk about options

[TinGull 10]

I've been asked to start a topic on options and trading them effectively and woould love to open things up for discussion. I've been trading options for a little over a year now and have gained some significant insight into that world as I am very active in a large options community, Investools, and also with ThinkorSwim and RedOption.

 

I'm not sure where to start, so hopefully some folks will ask questions and I can help and this can be a beneficial discussion.

 

For great info on options trading, check out redoption.com .

 

I'll start in the morning discussing basic option strategies, as its getting late and I'm super tired from travelling today.

 

Till then...

[torero 10]

Got a question for you: how does black-scholes model fit into trading options? Or is it useful anymore? Which type of options are you trading: index? stock?

 

Thanks.

[TinGull 10]

Hey Torero,

 

The Black Scholes model is used to figure out if your option is fairly priced. Say you have the strike you're looking at, the share price of the underlying, the time till expiry and the volatility of the option. Then, with the results, you can see if the option is overpriced, or fairly priced. It's very helpful, but I think a lof of softwares should have a "theoretical price" built in so you can see it without having to do the calculations yourself. So, yes, it's absolutely useful and essential to know if you're overpaying for an option. Now...if you're selling the option, which is what I usually do, then you want it to be overpriced.

 

For what I trade, index options only. They're treated like commodities by the tax man, which gives me some nice tax benefits, plus I don't have to worry about huge fluctuations because of earnings or scandal.

 

There are also volatility models that can help you figure out the probability percentage of an option expiring in the money or not. Those are somewhat useful, in that the market *usually* has a fairly normal pattern to things. October was a HUGE exception and I know a lot of options traders (myself included) who had their worst month ever selling options as we expected Oct to be a flat to down month, not the roaring month it was. So...probability analysis can work....most of the time.

[testaclese 10]

Hello all.

 

Just found this forum a couple days ago. I've been reading so much my eyes are "buggin". I have only recently ( 4 months) been demo trading e-minis so that is pretty new to me. But I have been in the option market for some time. Like all new endeavors there was a very steep learning curve for me with options. Timing wasn't right for me on so many things. However, persistence has paid off and I can say that I am fairly comfortable with the strategy that I finally locked onto.

 

I now usually only sell credit spreads on the indexes with an occasional spread on really strong trending stocks. My experience has been since most options expire worthless for the one who owns them, the logical side to be on is the opposite one. And with credit spreads I only have to monitor my positions. The reasoning for positions on indexes is primarily less risk. Most indexes spend most of their time in trading ranges which work perfectly for credit spreads. When they are in these ranges, many months I am able to open spread positions on both sides of the index and capture two premiums. With the right broker only one maintenance will have to be provided. For a conservative trader credit spreads offer a fairly decent return monthly. They aren't the most exciting plays in the book, but they are very consistent.

 

Anyway, I would be glad to engage in this conversation as I believe it would be as stimulating as the rest of this forum seems to be.

 

Testaclese

[torero 10]

Hi testa and welcome to the forum!

 

So does one approach making an option position? Starting with determining if there is an established range already and determine that this area has a probablity of not breaking out right?

[TinGull 10]

Welcome Testa! That was my main strategy as well for options...until october. Had a few iron condors and some bear call spreads and was rocked by that uptrend on SPX and RUT!! Took me for a good ride, and then decided to trade the eminis so I didn't have to have a bias that remained in place for a month or two at a time.

 

Credit spreads were good to me up until then, though, and I think that overall spreads are a good place to trade. Hopefully we'll be able to open up some discussions on this forum

 

Torero, as far as how one approaches putting on a position...this is how I look at it. First, see if we're trending...if so, sell a position to benefit you in that trend. Uptrend...sell a put spread. Downtrend...sell a call spread. If we're kind of in a range (which I would suspect we're starting to see happen now after that mega uptrend since July) Iron Condors are great in that kind of market. There, you're picking two areas to sell both a call and a put spread. For instance...look at a chart of the SPX... selling a 1350/1340 put spread and a 1420/1430 call spread would prove to be a nice way to go.

 

Why? You've got 3 areas of support and a 50Day MA to break through before you'd be taken out on the downside and start to lose money. Now, if we're at 1341 on expiry, you're getting the full credit. I will close my positions between 4-10 days prior cause the vega exposure is too great. That means that the delta is moving so fast as it comes on to expiry it can either really help your position, or really kill it. 4-10 days gives you good time.

 

For the call spread in the IC, that area is a bit above where we're at now...and it looks like a top is forming. We've been seeing some real rocky trading lately, and the trend is seemingly sideways for the time being, and then I'd love to see a nice correction down to the bottom of the IC. At that point, it's gonna take some time to get back up to around that 1400-1420 level, and by then you could have exited that call spread with profit and if we're around 1400 or higher by expiry (january)...then let that one expire worthless.

 

There are a few volatility models to show you expected percentages of probailities, and one that I use is in my ThinkorSwim platform. It'll basically say that based on past performance, this option has xx% chance of expiring worthless, which is what we want when selling spreads.

 

Hope that helps a little bit....

Chris

[isoroi 10]

New here as well.

 

I read that you do mostly buy-writes. When determining a stock to do a buy-write, what importance do you place on implied volatility?

[torero 10]

I read from another forum that there's a trader doing really well doing European style writing options for FTSE. I understand it's much safer than the American style option writing.

[TinGull 10]

I'm not aware of the differences in writing them...just aware of the differences between Euro style and american style as far as expirations and things go. isoroi, as far as implied volatility...thats the name of the game when you're selling options. If you sell something that has no volatility...then there's nothing to decay, really. You want something that has the premium pumped up SO much that there's little else for it to do other than dwindle away.

 

Say you sold a spread with very little IV, you could actually lose money on the options even if the underlying was to go in your favor. Thats because the IV is getting pumped into your options, making you lose money on the ones you sold, while you gain a minor amount in the ones you bought against the sold ones.

 

I hope that makes sense....let me know if you've got other questions.

[willd 10]

The attached article is one I wrote for a blog site about six months ago on TradingMarkets.com. This past week I took the time to update the data and the article to include all of 2006.

 

I was not sure as to where I should post this. However, it is about the effect option expiration week has on the SP500. Anyone trading intraday during this week may find this data to be useful.

Option Week Effect Article NEW.doc

[torero 10]

willd, you can post it in the Articles category http://www.traderslaboratory.com/forums/f43/

 

It would be a great read for everyone, including me.

[RhodyTrader 10]

It's threads like this that scare most people competely away from trading options. It is made to sound like it is incredibly complicated. While that certainly can be the case, it doesn't have to be at all.

 

A while back I completely shifted away from actually trading stocks themselves to using a very simple and straight forward option strategy to position trade stocks. No spreads. No worrying about B-S and getting all tied up in Greeks (and yes, I am very familiar with option pricing models and methods). The options give me a fixed downside and don't use up nearly as much of my capital as holding the stock would.

[TinGull 10]

It's threads like this that scare most people competely away from trading options. It is made to sound like it is incredibly complicated. While that certainly can be the case, it doesn't have to be at all.

 

A while back I completely shifted away from actually trading stocks themselves to using a very simple and straight forward option strategy to position trade stocks. No spreads. No worrying about B-S and getting all tied up in Greeks (and yes, I am very familiar with option pricing models and methods). The options give me a fixed downside and don't use up nearly as much of my capital as holding the stock would.

 

Hi Rhody,

 

I do agree that it can be made to be very easy. As for fixed downside, how are you fixing that? What strategies are you using?

 

For example of easiness, I had just bought a few calls of CROX right after Christmas and recently it had broken out to new highs and I sold the calls after making 44% on them. Not bad for a few weeks of holding.

 

Buying calls can work good, but you have to understand volatility and how it's going to play into that option youre buying. If not, you could buy into a winning stock, but the option could hardly move compared to the underlying if the volatility is just getting sucked out of it.

[wsam29 10]

your net delta is pretty important as well.

 

There is no sense having a position on if your net delta is less than +50 if you are long spread or -50 if you are short spread.

 

For those that do not understand the greeks, just think of delta as how much your options will change in price relative to the stock it derives its price on.

 

example.

 

ABC bull call spread, long at 1.00, delta +30

 

ABC stock goes up 1.00, your bull call spread would be at 1.30 now because the +30 delta. Mind you the greeks change in value depending on how close to the money they are. Once they get In-The-Money (ITM) your delta changes even faster, but that all depends on the Gamma, which is the rate of change of the Delta.

 

That is why and where people get confused.

 

There are just too many variables that need to be factored in.

 

Not to mention the underlying market conidtions will be a major factor to your spread.

[RhodyTrader 10]

Hi Rhody,

 

I do agree that it can be made to be very easy. As for fixed downside, how are you fixing that? What strategies are you using?

 

You fixed downside is the cost of your options, plus commissions of course. That assumes you are long the options. If you were short, and unhedged you would have an unlimited upside risk. I stick to just buying calls as proxies for long trades in the underlying stocks.

[RhodyTrader 10]

ABC stock goes up 1.00, your bull call spread would be at 1.30 now because the +30 delta. Mind you the greeks change in value depending on how close to the money they are. Once they get In-The-Money (ITM) your delta changes even faster, but that all depends on the Gamma, which is the rate of change of the Delta.

 

That is why and where people get confused.

 

There are just too many variables that need to be factored in.

 

Not to mention the underlying market conidtions will be a major factor to your spread.

 

Here's a very simple way to determine whether an option is too pricey, meaning there is too much volatility built in to the price. Figure out what the intrinsic value of the option would be if the price of the underlying stock were to move by 10%. Compare that to the current price of the option. If it's not at least 50% higher, the option is too pricey.

 

Let me break that down a bit.

 

XYZ stock is trading at 51. The 50 Call is currently at 3.50. A 10% increase in the price of XYZ would put the stock at a bit over 56. The intrinsic value of the option - which is stock price minus strike price - would be 6. That would represent an increase in the 50 Calls by 2.50, which is more than 50%. By my personal trading rule, that makes it worth buying. If the option were at something like 5, though, it would be too expensive.

 

To provide parameters for my option trading I don't hold options into their final month and I always trade at-the-money strikes.

 

Naturally, the 50% measure is just a guide. And yes, I realize that the option would actually be worth considerably more than the intrinsic value if the market were to rise 10%. I just use this rule of thumb as a very conservative method of identify option trades with real potential.

[Save_trader 10]

Hi

 

Nice little option thread. By the way, are there any options on future traders here or are you all pure stock options traders ?

 

If so, the questions remains the same : What about starting a trade by selling an option and making a stop loss with the share or future ?

 

Doe's any one trade that way and how are his experience with that ?

 

Save_trader

[SIUYA 11]

first learn this relationship....and all other derivations of it..... there are quite a few.

 

Long Call + short put = Long underlying

 

Once you start hedging with the underlying, you are generally just creating another synthetic option. If you are short volatility and selling options..... then you may not be reducing your risk with a hedge....you have not stopped the loss. All you have done is change the risk profile and created a new option. There is a lot more to options trading than just buying and selling.

Personally I have always been a long vol option trader - a buyer. The guys I know who have been short vol - sellers of options have all either blown up or changed their ways over many years. (unless they are institutionalised)

[Save_trader 10]

Hi SIUYA

 

Thanks for your clear thoughts and explanations.

 

I then would have some questions on the long buy part of options.

 

SL would be done % on the amount of money I have in my options account. Example : 10'000.-- and I choose 1 %. So my SL money would be 100.--

 

Or is it better to decide on any particular options buy, means ; I choose my SL on the price I have to pay for that particular option. Example : I have to pay 5000.-- I will choose 1%. So my SL money would be 50 and I would have to sell the option with 4950.--

 

Or as a last idea : Is it best to decide the SL on the underlying of the option ? If the underlying is by spot 9000 and I choose 1 %, I then would sell my option when the underlying is by 8910.

 

What is your opinion on that ?

 

Take care

 

Save_trader

[MadMarketScientist 11]

Thanks for reinvigorating this thread.

 

There needs to be a lot more discussion of options on TL. It's such a popular area and there's so many potential advantages to options in particular for the smaller trader who might have an issue to control 100 shares of stocks like Apple and Google, etc...

 

Also, nice report that's available on TL here:

 

IB Options Report

[SIUYA 11]

 

I then would have some questions on the long buy part of options.

 

SL would be done % on the amount of money I have in my options account. Example : 10'000.-- and I choose 1 %. So my SL money would be 100.--

 

Or is it better to decide on any particular options buy, means ; I choose my SL on the price I have to pay for that particular option. Example : I have to pay 5000.-- I will choose 1%. So my SL money would be 50 and I would have to sell the option with 4950.--

 

Or as a last idea : Is it best to decide the SL on the underlying of the option ? If the underlying is by spot 9000 and I choose 1 %, I then would sell my option when the underlying is by 8910.

 

What is your opinion on that ?

 

Take care

 

Save_trader

 

First this is a very different proposition/question to the attributes or buying v selling an option and then the re-hedging. This is more money management and how/what to trade.

 

Honestly I think trading options requires much more thought, more money and more planning than just straight directional trading. As there are many more possibilities, and scenarios to cover. As a result trying to apply the same money management ideas of % of equity and where to set stop losses...... does not necessarily work when it comes to options trading. (not to say it cant be done....but in my estimation its like trying to approach building a house with the wrong tools..... hard work)

 

When it comes to options and buying them..... you have time decay AS WELL AS directional profit or loss, plus market maker spreads to contend with. So you can actually be right, but still loose or not make much.

 

You can do many possibilities..... eg; buy a call as you are bullish.

When you are right or wrong, you can exit the call, you can hedge the call in the underlying, you can hedge the call using other calls, or other puts.

 

Your last choice to me makes the most sense. You have decided that the underlying is not doing what it should and hence you have exited the trade. From this work out what the options will be when you enter the trade, what they are likely to be when you may exit the trade, and from this determine how much you are willing to loose on the trade, and from this work out how many options to actually trade. (you may find this will not allow you to trade many options)

 

Remember as well that options give increased leverage with potentially less exposure, and yet......its very easy to get carried away. (hence why I think trading options with a small amount of money can be very dangerous).

Just this week I bought 10 calls at 21 cents in something that I think may go up. This gives me the effective exposure to 10,000 shares (in Australia each contract covers 1000 shares). For me this is a $2100 bet.... and my plan on this bet is that if i loose the lot so be it. Now I could have bought many more options and decided to cut it if I lost the $2100. But this is different to how I wanted to play this. This does not form a fixed % of my equity....its just a view. its just an amount I am willing to risk. If I thought the stock was no longer going up.....I could sell out the options, OR I could short the stock effectively making it a put. But I choose to trade less options, and choose to say its a binary bet - I am right or wrong.

As mentioned - options open up many mnay more choices other than just buy or sell.

[Save_trader 10]

Hi SIUYA

 

Again, THANK you very, very much for your detailed answers. It helps me a lot to clarify my thoughts about the subject.

 

I have a lot of option theory behind me. In the last few months, I improved my knowledge about different option strategies. I do have little practical experience in the market. Had some rough trades in the past by experimenting with strategies. Was also never really sure if I should implement a strategy leg by leg or by giving the broker already an order as one spread, for example a call back spread. After all reading I would say, that leg in is may the better choice. Any thought on that ?

 

I feel now again to be at the point, where I could implement trades in the market. It is like standing on the beach just before jumping in the water. To do so, I want and need to be prepared. At the moment I am in the water, I have to have clear thoughts about any move I am doing, in case a sudden storm comes up and I am no more near the beach.

 

Have a nice Sunday evening.

 

Save_trader

[SIUYA 11]

i would say if you are wanting to put a spread on as a trade,..... then give it to the broker in its entirety.....mainly as legging it on can be tough and you are crossing two spreads to a market maker, whereas a spread may have a smaller bid offer differential, than legging it on.

This is very different to taking an existing position and turning it into a spread.

 

First and foremost if using options to trade direction, have the direction part already mapped out. If trading volatility, then its less an issue (but this is more for market makers, or more active participants)

[MadMarketScientist 11]

I'll throw in a few comments....

 

I would favor starting just directional -- straight calls and puts when you feel you have a direction in mind for the underlying stock that is well established. Where you feel the odds are good based on your system of that move carrying forward. In particular a move you expect can take place in 1 day to 2 weeks.

 

From there you can buy the call or put, allowing 2+ weeks until expiration if possible, though you can always roll to the next month if you're still holding and things are going well.

 

I would try to buy something that is slightly in the money if possible -- a delta if you can get it of 0.50 or greater.

 

And, I'd let the underlying stock drive everything -- I wouldn't be charting the options contract or trying to take trade signals off an options technicals. The underlying stock should drive everything.

 

Finally, I wouldn't take the trade unless you knew exactly what your profit target and protective stop was of the underlying and use that to determine when you exit your option.

 

MMS

[Save_trader 10]

Hi MadMarketScientist

 

Like your throwing ins. Thanks a lot as it has cleared some other mess on my table.

 

May I ask you, what you think about the mathematical approach in option trading. Some talk about the wings, which should be placed on a standard deviation point. They use also the bell curve in there explanations.

 

The idea behind that, is to enter a trade on such Stdv levels by placing limit orders there and wait until they are hit.

 

Any comments on that way of entering an option trade ?

 

Save_trader