Options Q&A

[BlueHorseshoe 10]

Hello,

 

I’m interested in learning more about options, with a view to incorporating them into my current trading approach.

 

I can no doubt wade through countless books and find out all the information I need to know to decide if and how to do this, but I’m very busy (or, if you prefer, lazy). I’m looking for someone who is knowledgeable about options and is prepared to discuss them with me. I’m not interested in learning about options strategies; instead, this would simply be a case of providing me with the answers to a set of specific questions, mostly relating to pricing.

 

As I know relatively little about options, my questions will be very naïve and basic, so the discussion may be beneficial to others on here starting out in this area.

 

Look forward to hopefully hearing back from someone . . .

 

Cheers,

 

BlueHorseshoe

[MadMarketScientist 11]

Hi,

 

I've been trading options the last year so maybe I could help - definitely with the 'basics' as you've described. Noticed you are not interested in discussing options strategies, not sure why, but that's how you implement them! I'm sure you've seen the set of articles we have?

 

 

MMS

[BlueHorseshoe 10]

Hi,

 

I've been trading options the last year so maybe I could help - definitely with the 'basics' as you've described. Noticed you are not interested in discussing options strategies, not sure why, but that's how you implement them! I'm sure you've seen the set of articles we have?

 

 

MMS

 

Hi MMS,

 

That sounds good to me, thanks.

 

When I say I am not interested in strategies, I mean options-specific approaches such as butterflies and strangles. I already have a trading approach that I am comfortable with, so really I'm more interested in whether using options to implement this could improve profitability.

 

So, on to some questions then . . . Apologies if these are very basic questions, but I don't want to assume that I know anything when I don't . . .

 

My trading approach is to buy/sell pullbacks in long term up/down trends in the ES.

 

The biggest difficulty with this is that if my entry timing is not very accurate, many positions suffer adverse excursion before they can be closed out for a profit. As such, introducing a stop-loss can result in many positions being stopped out before they can return a profit. The alternative, trading without a stop-loss, is never psychologically comfortable, makes the quantification of risk difficult for money management purposes, and results in occassional runaway losses.

 

I detailed a recent entry and exit in the 'Volume' thread, and have attached a chart image below.

 

Following the entry, the market moved against me significantly, before it eventually reverted and I was able to exit for a profit.

 

1. Am I correct in thinking that I could have purchased a PUT option on the index at the time of my entry to benefit from a declining price?
    
   
2. To most closely mimic my futures position, would I have purchased an 'in the money', 'out of the money', or 'at the money' PUT option?
    
   
3. Am I correct in thinking that after my purchase, my maximum exposure on the position is limited to the cost of purchasing the option (ie the premium plus commissions)?
    
   
4. Am I correct in thinking that I would be able, at any time before the option's expiration, to close out my position if the market traded to a lower price than the strike price, and profit from the difference, net of premium and commission?
    
   
5. How can I know, or estimate, what the cost in premium would have been to do this?
   

 

If my questions are unclear, then please let me know.

 

Thanks,

 

BlueHorseshoe

Edited June 24, 2012 by BlueHorseshoe

[alwaysastudent 10]

1. Am I correct in thinking that I could have purchased a PUT option on the index at the time of my entry to benefit from a declining price?
    
   
2. To most closely mimic my futures position, would I have purchased an 'in the money', 'out of the money', or 'at the money' PUT option?
    
   
3. Am I correct in thinking that after my purchase, my maximum exposure on the position is limited to the cost of purchasing the option (ie the premium plus commissions)?
    
   
4. Am I correct in thinking that I would be able, at any time before the option's expiration, to close out my position if the market traded to a lower price than the strike price, and profit from the difference, net of premium and commission?
    
   
5. How can I know, or estimate, what the cost in premium would have been to do this?
   

 

Assuming you are long the index.

 

Yes, purchasing a PUT i.e. long a PUT, would benefit you when price declines. The purchase of a PUT in this manner, called a Protective Put, is to have the PUT substitute a stop loss.

 

Since the PUT is a sub for a stop loss it makes little sense to purchase it in the money or at the money. Typically you would purchase an out of money PUT with a strike price as close to your stop loss as possible.

 

How much time to purchase is related to how long you intend to be in the trade. Options lose value rapidly in the 3-4 weeks before expiration and very rapidly on the final week of expiration. Unless you are in the trade only for a few days going next month or even 2 months out would be prudent.

 

Yes, your maximum exposure is the purchase cost of the option.

 

Yes, at any time before the option's expiration you can close your position.

 

The easiest way to estimate premium is to use a Risk Graph. This is available in most options trading platforms including, ThinkOrSwim, OptionsXpress etc. There are freely available Excel spreadsheets that estimate premiums.

[bradhouser 10]

Hi MMS,

 

That sounds good to me, thanks.

 

When I say I am not interested in strategies, I mean options-specific approaches such as butterflies and strangles. I already have a trading approach that I am comfortable with, so really I'm more interested in whether using options to implement this could improve profitability.

 

So, on to some questions then . . . Apologies if these are very basic questions, but I don't want to assume that I know anything when I don't . . .

 

My trading approach is to buy pullbacks in trends in the ES.

 

The biggest difficulty with this is that if my entry timing is not very accurate, many positions suffer adverse excursion before they can be closed out for a profit. As such, introducing a stop-loss can result in many positions being stopped out before they can return a profit. The alternative, trading without a stop-loss, is never psychologically comfortable, makes the quantification of risk difficult for money management purposes, and results in occassional runaway losses.

 

I detailed a recent entry and exit in the 'Volume' thread. Unfortunately I can't post a chart image as all the images I attach end up tiny, regardless of their original size.

 

Following the entry, the market moved against me significantly, before it eventually reverted and I was able to exit for a profit.

 

 

1. Am I correct in thinking that I could have purchased a PUT option on the index at the time of my entry to benefit from a declining price?

 

Yes. Puts go up in value as the underlying goes down.

 

2. To most closely mimic my futures position, would I have purchased an 'in the money', 'out of the money', or 'at the money' PUT option?

 

Every strike price has an implied rate of return. When the Delta is 1.00 (deep in the money) you get $1 for each $1 the underlying drops. Divide $1 by the cost of the put and that is your rate of return. Looking at this there may be multiple strike prices where the delta is 1 so you would want the lowest cost one. If you take this further, you could calculate delta divided by cost for all the other strikes to see which has the highest ratio.

 

You would then need to determine how many contracts you would need to buy to compare apples with apples for a given investment amount (e.g. $1000) and include commissions.

 

Lower deltas will give higher returns, but you will need to buy more contracts, and the net return will drop due to higher commision costs.

 

You also need to consider the spread, as you may only be able to buy at the ask and sell on the bid due to low open interest and liquidity.

 

Using SPY options is safer than SPX, do to the low spread, but you need to buy more contracts than with SPX options.

 

3. Am I correct in thinking that after my purchase, my maximum exposure on the position is limited to the cost of purchasing the option (ie the premium plus commissions)?

 

Yes.

 

4. Am I correct in thinking that I would be able, at any time before the option's expiration, to close out my position if the market traded to a lower price than the strike price, and profit from the difference, net of premium and commission?

 

Sort of. The extrinsic value of the option drops every day by Theta, so the amount the underlying has to move increases in order to get the same profit. The stock could go down and you can still lose money if you hold it too long.

 

5. How can I know, or estimate, what the cost in premium would have been to do this?

 

If your platform graphs Profit/Loss vs. Underlying Price you can see not only the values at expiration (Max loss, breakeven, profit as a function of price) but also estimate the premium at various dates up to expiration. On Thinkorswim this is done in the Analyze tab.

 

As you can see there is no simple answer. When buying Puts and Calls, you are making a direction and timing call. You have to be right on both.

[SIUYA 11]

1. Am I correct in thinking that I could have purchased a PUT option on the index at the time of my entry to benefit from a declining price?
   

 
yes.
 

To most closely mimic my futures position, would I have purchased an 'in the money', 'out of the money', or 'at the money' PUT option?

 
The higher the delta of the option the closer to replicating the underlying you will get.
So ITM options have a higher delta than OTM options
A lot will decide on how you wish to manage the options. Do you wish to just get an equivalent exposure at the time. (if so then you modify the number of options purchased depending on the delta), or do you want to risk a certain amount of premium in absolute $ amounts, or do you wish to get enough exposure so that if the market collapses then your exposure is a certain amount?
 

Am I correct in thinking that after my purchase, my maximum exposure on the position is limited to the cost of purchasing the option (ie the premium plus commissions)?

 
yes. Selling is very different. Also an option price can be separated up further.
Premium = intrinsic value + its time value + implied volatility value
Understanding some basic option relationship values makes understanding options a bit simpler and tells you really where some costs actually lie.
 

Am I correct in thinking that I would be able, at any time before the option's expiration, to close out my position if the market traded to a lower price than the strike price, and profit from the difference, net of premium and commission?

 
yes and no.
As options are priced (see above) with a volatility and time component, then usually yes.
Sometimes no as it depends on , how long it takes to occur, and what the implied volatilities do between purchase and sale.
Also its does not have anything to do with trading below the strike price. As per the earlier question which strike to purchase ITM, ATM, or OTM may vary, as such the delta is how much change in the option price you can expect from a change in the underlying.
eg; with a ten tick down move in the underlying, you should expect to see a 5 tick up move in a put that has a delta 50 (or 0.5 = 50%), a 3 tick up move in the delta 30 put.
Now also remember that as an option becomes more ITM the delta increases. So as an underlying decreases the put delta might increase from delta 40 to delta 46 say.
 
 

How can I know, or estimate, what the cost in premium would have been to do this?

 

All depends on the components of the option formula, the strike, and the series (which month).

These can be roughly worked out. the black and scholes and binomial formulas etc; pretty much work out the implied volatility component - the rest can easily be worked out.

and this is important to remember ----Option fair values are theoretical only, and are priced relative to other options trading at the time.

That is to say - if implied volatilites go down because there are lots of sellers then just because you have a fair value, does not mean everyone else has the same fair value.

[karoshiman 10]

Hi BHS,

 

I am wondering what your intentions are in the first place.

 

If I understand you correctly, you try to use options for your current directional trading strategy in order to reduce adverse excursions.

 

From my point of view, this can only be achieved by using out of money options (long put with your example) as they have no intrinsic value and don't fluctuate so much together with the underlying instrument.

 

However, this comes with a price... they do not much move either, when the underlying instrument moves to your favor. So, you have to expect a very strong move to be able to benefit from it.

 

The other possibility would be a sell call. But if that option is in the money, you have the same problem with the adverse excursion. If it is out of money, then you have the same problem as with the long put.

 

Also, you have to consider that you add a further layer of complexity to your trading, which comes from the option pricing itself. Siuya mentioned the different elements of options prices. Depending on which expiration date you choose, the respective option could be relatively illiquid leaving room for manipulation.

 

There is a reason why option strategies exist... because options are mostly used for very specific trading purposes other than pure directional trading, which can be done with futures as well and with a lot less complexity.

 

I am not a big fan of sim trading. But in this case, I highly recommend to sim trade options for a while parallel to your current trading and see how prices react and get a feel for it.

 

[BlueHorseshoe 10]

Hi SIUYA,

 

Thanks for the detailed reply.

 

This quickly starts to get complicated, and Karoshiman makes a good point below - Options generally have their own strategies because they are not useful for simple directional trading. But I'd like to keep working through this until I fully understand why.

 

A lot will decide on how you wish to manage the options. Do you wish to just get an equivalent exposure at the time. (if so then you modify the number of options purchased depending on the delta), or do you want to risk a certain amount of premium in absolute $ amounts, or do you wish to get enough exposure so that if the market collapses then your exposure is a certain amount?

 

I suppose I want to replicate what I can do with futures, but with a known and limited risk at the time of entry and thereafter. In other words, I want a method of limiting risk without the possibility of being stopped out. I fully realise that this may be ludicrously idealistic expectation of what can be done with options, however!

 

Can we try to work through a specific example (though it needn't be in a precise fashion) so that I can see how this can or can't be done?

 

In the case of my chart above, the daily position summary was roughly as follows:

 

15/06/12 - Sell short on close @1337.5

18/06/12 - Market closed @ 1341 - Unrealised P/L = -$175

19/06/12 - Market closed @ 1350 - Unrealised P/L = -$625

20/06/12 - Market closed @ 1351 - Unrealised P/L = -$675

21/06/12 - Buy to cover on close @ 1319.00 - Realised P/L = +$925

 

This is obviously based on a contract trading at $50 per point.

 

How could I best have gone about replicating the above position with options to achieve the same dollar outcome?

 

What might my costs have been, and how would I have been able to calculate these? To make a profit equivalent to $50 per point in the underlying, would my premium be $5, $50, $500?

 

If on 20th June, had the ES closed at 1300, how could I calculate what my profit would have been with the same options scenario at that time?

 

eg; with a ten tick down move in the underlying, you should expect to see a 5 tick up move in a put that has a delta 50 (or 0.5 = 50%), a 3 tick up move in the delta 30 put.

 

So to replicate the price movement of a futures position precisely, I would need to purchase a Delta 100 Put? Does such a thing exist? When you compare ticks above, does a tick in the option price have the same value as a tick in the underlying (ie does a single ES option move in $12.50 tick increments the same as the ES)?

 

As options are priced (see above) with a volatility and time component, then usually yes.

Sometimes no as it depends on , how long it takes to occur, and what the implied volatilities do between purchase and sale.

 

I understand this, but I don't understand how it can be managed in such a way as to make the option tradeable in any quantifiable manner. This surely adds in a host of additional conditions that must be met in order to be profitable - "not only must the market trade in the direction you predict, but also within a certain amount of time, and in a certain way"? It seems that I could make what with a futures contract would be a profitable trade, but the profit I would be likely to achieve with futures would be totally indeterminate?

 

Thank you for your patience!

 

BlueHorseshoe

[BlueHorseshoe 10]

Hi Karoshiman,

 

Thanks for your reply.

 

I was very unclear of what my intentions were in my first post (I think I mentioned improving profitability, which is completely wrong!). My intention is to find a way of managing and quantifying risk that does not entail the disadvantages of using a hard stop in the underlying.

 

I am not usually the beneficiary of large moves in my trading - when I am it is normally by 'fluke'. My trades are typically held for three to five days and take advantage of whatever movement takes place within that time period - in the ES this is generally about 15-20 points. From what you are saying, it seems that an Out of the Money option would not be sufficiently responsive.

 

At what point does an option become fully responsive to movement in the underlying - ie at what point does it move totally in tandem with the underlying?

 

There is a reason why option strategies exist... because options are mostly used for very specific trading purposes other than pure directional trading, which can be done with futures as well and with a lot less complexity.

 

I have no doubt that this is probably true, and that I am hoping for something that cannot actually be achieved with options. I'd like to be at least reasonably clear about why, however, before abandoning this line investigation.

 

I am not a big fan of sim trading. But in this case, I highly recommend to sim trade options for a while parallel to your current trading and see how prices react and get a feel for it.

 

This sounds like it might be a good idea, as it I think it is this practical understanding that is lacking (I have already read about the theory of options pricing), and obviously I can't afford to gain this experience with real money. Any suggestions on where to start with a sim account, given that I typically only trade one or two times per month?

 

Many thanks,

 

BlueHorseshoe

[bradhouser 10]

Hi SIUYA,

 

 

In the case of my chart above, the daily position summary was roughly as follows:

 

15/06/12 - Sell short on close @1337.5

18/06/12 - Market closed @ 1341 - Unrealised P/L = -$175

19/06/12 - Market closed @ 1350 - Unrealised P/L = -$625

20/06/12 - Market closed @ 1351 - Unrealised P/L = -$675

21/06/12 - Buy to cover on close @ 1319.00 - Realised P/L = +$925

 

This is obviously based on a contract trading at $50 per point.

 

How could I best have gone about replicating the above position with options to achieve the same dollar outcome?

 

 

What might my costs have been, and how would I have been able to calculate these? To make a profit equivalent to $50 per point in the underlying, would my premium be $5, $50, $500?

 

If on 20th June, had the ES closed at 1300, how could I calculate what my profit would have been with the same options scenario at that time?

 

To get at least a $925 profit with options one way would be with a Put with a delta of -1.00 On 6/15 the July monthly SPX 1445 Puts with a delta of -1 were asking 104.30. The same contracts were bid at 120.30 on 6/21, a difference of $16. If you bought one contract, if would cost $10,430, and you would sell it at $12,030, a $1600 profit. Lower strike prices would come closer to $925, 1380 would be close.

 

If you are using options as a proxy for futures, you would want to minimize theta decay, the part of the option that reduces the extrinsic value over time. Deeper in the money puts or further out in time will do that, but the price of the investment goes up as does the spread.

[SIUYA 11]

Options generally have their own strategies because they are not useful for simple directional trading. But I'd like to keep working through this until I fully understand why.

 

Mainly because of cost, spread and brokerage, and liquidity. Plus they can be used, your risk profile may change a lot, and they are ideally best used to replicate an idea....sometimes this can be dont effectively othertimes not.

 

I suppose I want to replicate what I can do with futures, but with a known and limited risk at the time of entry and thereafter. In other words, I want a method of limiting risk without the possibility of being stopped out. I fully realise that this may be ludicrously idealistic expectation of what can be done with options, however!

 

The holy grail! Sometimes it happens, most often not. Ideally options do give you this with the increased leverage of when you get it right....the offset is time decay....and as per most trading, waiting until all the ducks line up is the hard part. 100 ideas, 15 great ideas able to be put on, 10 trade entered, 1 winner.

You can replicate anything, but it might come at a cost.

 

In trying to answer the scenario......

Brokerage costs - these should be easy for you to work out....at a guess options brokerage is higher than your futures.

 

A lot will depend on what is happening in the options prices at the time. You really only have a few choices at a simple level (to minimise risk and hence only buy puts) and this is based on which strike and hence which delta to replicate

either an equivalent amount of deep ITM puts....margin should be less, but risk is limited (not much difference really)

twice as many (or delta equivalent) ATM or OTM puts....eg; delta 25 means you need to buy 4 times as many.....hence if it collapses you make a killing....but when it comes to jobbing them, then the price should ideally move the same as the underlying move as you have 4 times as many.

 

To run through these scenarios as to what things may or may not have been you really need to be able to replicate them in a system that can show it to you.....those payoff diagrams you often see are for expiry only generally.

Also at best unless watching what happens in the actual option market, the rest is theoretical.

 

If on 20th June, had the ES closed at 1300, how could I calculate what my profit would have been with the same options scenario at that time?

 

eg; with a ten tick down move in the underlying, you should expect to see a 5 tick up move in a put that has a delta 50 (or 0.5 = 50%), a 3 tick up move in the delta 30 put.

 

yes.....and dont forget the delta 50 may now have a delta 51. The delta changes as the underlying price changes....the more ITM, the more it tend towards delta 100 (or 1). This also becomes much more sensitive as the option decays. eg; on expiry day the delta can move from 0 to 1 as it moves through the strike in a few ticks., whereas 3 months before hand its less sensitive.

 

So to replicate the price movement of a futures position precisely, I would need to purchase a Delta 100 Put? Does such a thing exist? When you compare ticks above, does a tick in the option price have the same value as a tick in the underlying (ie does a single ES option move in $12.50 tick increments the same as the ES)?

 

As options are priced (see above) with a volatility and time component, then usually yes.

Sometimes no as it depends on , how long it takes to occur, and what the implied volatilities do between purchase and sale.

 

I understand this, but I don't understand how it can be managed in such a way as to make the option tradeable in any quantifiable manner. This surely adds in a host of additional conditions that must be met in order to be profitable - "not only must the market trade in the direction you predict, but also within a certain amount of time, and in a certain way"? It seems that I could make what with a futures contract would be a profitable trade, but the profit I would be likely to achieve with futures would be totally indeterminate?

 

yep...you got it.

Often the future is the better instrument.

Simple....Options are often best seen as a method of insurance to protect, or as a measure of extra leverage (when opportunities really rarely pop up) or as part of a portfolio strategy in which you write that insurance.

They can be used to replicate positions using combinations eg; bull bear collars, where by the risk profile changes, DEPENDENT on what happens.....maybe the best way to think about it is as way to look at varying scenarios and varying payoffs......but its still not a risk less, or risk free trade....you will still get stopped out.

[karoshiman 10]

 

...

 

I am not a big fan of sim trading. But in this case, I highly recommend to sim trade options for a while parallel to your current trading and see how prices react and get a feel for it.

 

This sounds like it might be a good idea, as it I think it is this practical understanding that is lacking (I have already read about the theory of options pricing), and obviously I can't afford to gain this experience with real money. Any suggestions on where to start with a sim account, given that I typically only trade one or two times per month?

 

...

 

 

Hi BHS,

 

I trade with Tradestation. They have a sim account, but I am not sure whether you can access this without a real money account. Check it out. However, it should be possible to trade also options at their sim accounts as Tradestation offers options trading for real money accounts.

 

Regarding info on options, did you check this site?

 

Options Trading Explained - Free Online Guide to Trading Options

 

They have a lot of info about options in a very compact form.

 

There I've found also this link where you can calculate the required margins:

 

CBOE Margin Calculator

 

Regards,

k

[karoshiman 10]

To get at least a $925 profit with options one way would be with a Put with a delta of -1.00 On 6/15 the July monthly SPX 1445 Puts with a delta of -1 were asking 104.30. The same contracts were bid at 120.30 on 6/21, a difference of $16. If you bought one contract, if would cost $10,430, and you would sell it at $12,030, a $1600 profit. Lower strike prices would come closer to $925, 1380 would be close.

 

If you are using options as a proxy for futures, you would want to minimize theta decay, the part of the option that reduces the extrinsic value over time. Deeper in the money puts or further out in time will do that, but the price of the investment goes up as does the spread.

 

 

Hi Bradhouser,

 

Interesting info. Where did you get the bid/ask info from?

 

I use Tradestation and as far as I understand I can only see the actually traded prices for the past. The put you mentioned was traded only with 3 contracts in June (if I've found the one you are talking about).

 

It would be interesting to see the lowest bid of that put during that time period BHS mentions (probably on June 20th), as he is interested in reducing his drawdown (and I am now interested, too ).

 

Thanks in advance.

 

Regards,

k

[BlueHorseshoe 10]

Thanks to everyone for their replies in this thread. It has been extremely helpful to me and is exactly the sort of reason that TL is so worthwhile. Hopefully my posts are ocassionally equally helpful to others here.

 

Options clearly aren't the answer to the problem I was trying to solve here (indeed, there may be no answer - limited risk and unlimited upside is doubtless an expectation that borders on the unrealistic). They seem unsuited to directional strategies, and the element of uncertainty in their pricing seems no less severe than the element of uncertainty in the directional behaviour of the futures position whose risk I was seeking to modify.

 

Cheers,

 

BlueHorseshoe

[bradhouser 10]

Hi Bradhouser,

 

Interesting info. Where did you get the bid/ask info from?

 

I use Tradestation and as far as I understand I can only see the actually traded prices for the past. The put you mentioned was traded only with 3 contracts in June (if I've found the one you are talking about).

 

It would be interesting to see the lowest bid of that put during that time period BHS mentions (probably on June 20th), as he is interested in reducing his drawdown (and I am now interested, too ).

 

Thanks in advance.

 

Regards,

k

 

I used Thinkorswim's Thinkback feature. It shows closing quotes for dates going back some period of time. THe open interest was 2 for the 1445 SPX puts on 6/15.

[ntrader 10]

Hello,

 

I’m interested in learning more about options, with a view to incorporating them into my current trading approach.

 

I can no doubt wade through countless books and find out all the information I need to know to decide if and how to do this, but I’m very busy (or, if you prefer, lazy). I’m looking for someone who is knowledgeable about options and is prepared to discuss them with me. I’m not interested in learning about options strategies; instead, this would simply be a case of providing me with the answers to a set of specific questions, mostly relating to pricing.

 

As I know relatively little about options, my questions will be very naïve and basic, so the discussion may be beneficial to others on here starting out in this area.

 

Look forward to hopefully hearing back from someone . . .

 

Cheers,

 

BlueHorseshoe

 

Hi BlueHorseshoe,

I have just started a new thread aboyt the advantages and disadvantages of stock options i think it will help you check: http://www.traderslaboratory.com/forums/options-trading-laboratory/15289-advantages-disadvantages-stock-options-trading.html