Options Give you more Options Options Give you more Choices Options Give you the World
This Website is about Creating Better Options in the Financial Markets. Successful implementation of various investment strategies dictates a sound knowledge of options. The following is a road map to profitable workings of options on Stocks, Commodities, Futures or Indecies.
Options Basics
An option is an investment vehicle which offers the option buyer the right, but not the obligation, to buy or sell a particular asset at a given price for a specific period of time for a market premium. Options are identified by an Underlying Asset, an Option Type, Strike Price, and Expiration Date. The underlying asset is the specific stock or commodity that the option conveys to the purchaser when the option is exercised.
There are two distinct types of options: Calls and Puts, and you can buy or sell them: A Call gives the holder the right to buy an asset at a fixed strike price. A Put gives the holder the right to sell an asset at a fixed strike price.
Strike Price and Expiration Date
The Strike Price or Exercise Price is the stated price at which a buyer of a call has the right to buy a specific contract, or the price at which a buyer of a put has the right to sell a specific contract. The Expiration Date is the last day an option can be either exercised or liquidated. The Strike Prices and expiration dates are established by the various exchanges.
Option Pricing and Time Value
The price of an option "premium" is the tangible result of the economic interplay between supply and demand. It is what a buyer pays a seller for the right to take a position at a strike price by a limit time.
Options can be In The Money(ITM), At The Money(ATM), or Out of The Money(OTM). A Call option is In The Money if its strike price is lower than the underlying market price. A Put option is In The Money if its strike price is higher than the underlying market price. Out of The Money(OTM) options cost less than In The Money(ITM) options. Options with more time cost more than options with less time till expiration.
Option Value is composed of two parts: intrinsic value and time value.
Intrinsic Value: is the amount by which an option is in the money.
Time Value: is the part of an option premium that exceeds intrinsic value.
There are four major factors that determine the price of an option:
the Price of the underlying.
the Volatility of the underlying.
the Strike price of the Option.
the time remaining until the Option expire.
There are two less important factors that also affect the price of an option: the current risk free interest rate and the dividend rate of the underlying stock.
Knowing Volatility
Volatility often plays the most important role in trading Options. Volatility is a measure of asset price fluctuation. Knowing Volatility can help you:
Choose and implement the appropriate option strategy.
Improve market timing in entering or exiting positions.
Identify overpriced and underpriced options.
Options Trading
The three most important factors in option trading are market movement, option volatility, and time decay. Their proper use can result in a trading edge. We have the ability to measure the true value of an option through scientific means. There are pricing models that determine what the market price of an option should be. Many of the established formulas for pricing options provide a good estimate of the true worth of an option. Options, being highly leveraged, exaggerate the emotional optimism or pessimism of the market, causing prices to vary widely from their true worth.
There are two risks in trading options. Price movement in the underlying market, and changes in volatility. The Price risk can be managed through the initiation and maintenance of neutral positions. This leaves you open to isolate your market exposure to volatility--that is, changes in time value--buying volatility when you anticipate market volatility to increase and selling volatility when you anticipate market volatility to fall. Also, buying undervalued options and selling overvalued options by using an option pricing model. The secret to successful options trading is to buy options that are underpriced and sell options that are overpriced.
Understanding Volatility
Volatility is a measure of the amount by which an asset price fluctuates in a given time. Mathematically, volatility is the annualized standard deviation of the asset daily price changes.
There are two types of Volatility: Statistical Volatility and Implied Volatility. Statistical Volatility-a measure of actual asset price changes over a specific period of time. Implied Volatility-a measure of how much the "market place" expects asset price to move, for an option price. That is, the volatility that the market itself is implying.
Volatility Based Trading
Volatility Based Trading presents a wealth of opportunities. Volatility always reverts back to its'mean. You need to put the "trading edge" on your side. There are five steps for using volatility to your advantage:
Understanding Volatility, the key to trading success.
Measuring Implied Volatility, that is being implied by the actual marketplace.
Trading options based on volatility and volatility skew for consistent profits.
Balancing the probability of profit on each trade with its potential Risk/Reward.
Managing through the maintenance of neutral positions.
The Delta Factor
The first risk measurement that concerns options is Delta. Delta is the rate of change of the price of an option relative to the change in the price of the underlying security (stocks or futures). Delta is a measure of how much an option price changes given a unit change in the asset price. Every futures contract or share of stock or option has a delta. All fixed markets have a delta of 1.0, this means that a market move of 1 pt changes the price of a stock or futures by 1 point. Long futures are expressed as having positive deltas (+1.0) and short futures are expressed as having negative deltas (-1.0). For an option, Delta is a number that ranges between 0.0 and 1.0 for Long Calls, and between -1.0 and 0.0 for Long Puts. This depends on how far it is In or Out of The Money. The absolute value of the delta increases as the option goes further In-The-Money and decreases as the option goes Out-of-The-Money. At The Money Long call or Short put options have a delta of .50, and Long Put or Short Call options have a delta of -.50. Out of The Money options have smaller fractions deltas, tending towards 0.0 as options become Way Out of The Money.
Delta Neutral Trading
The term "Delta Neutral" refers to any strategy where the sum of deltas is equal to zero. The principle behind delta neutral is based upon the way an option's delta changes as the opotion moves further into or out of the money. Keeping that in mind, we can construct profitable delta neutral trades. Knowing an option's Delta can help the trader:
Estimate the change of the options price relative to the change in the underlying.
Determine the number of options needed to equal one asset contract.
Determine the probability the option will expire in the money.
Manage position Risk, so it is always Balanced.
Balanced Trading Methodolgy
Balanced Trading is Probability Based Trading. In creating low risk trades we combine stocks, futures, and options on stocks or futures , in such a way that the deltas are balanced. Thus we create a cumulative delta position which is controlled. The key to being successful is managing the position so you are always delta neutral. A delta neutral position is one in which the sum of the projected price changes of the long options in the spread is essentially offset by the projected price changes of the short options in the same spread. The key to delta neutral trading is to enter a combination which will create a delta neutral position, and make adjustments to the position as it becomes out of line. An adjustment is the process of buying or selling options to bring total positional deltas to delta neutral. The objective of the Balanced Trader is to collect money every time the market moves by adjusting and protecting against time decay, and using time decay to his advantage. The basic objective of a balanced trader is to use volatility to establish positions that are delta neutral and to later adjust them back to neutral if they become unbalanced.
Basic Option Positions
It's your option..know your options..visualize your options..explore your options.
If you anticipate prices rising or falling, you can take the simple approach of buying or selling a call or a put.
The basic option positions are:
Long Call: Waisting asset as time passes, value of position eroodes. If volatility increases, erosion slows, position increases.
Long Put: Waisting asset as time passes, value of position eroodes. If volatility increases, erosion slows, position increases.
Short Call: Growing asset as time passes. If volatility increases, value of option increases, position declines.
Short Put: Growing asset as time passes. If volatility increases, value of option increases, position declines.
Ongoing Option Spreads
Spread Trading involves taking position in two or more options on the same underlying asset and expiration date, but with different strike prices. Spreads are constructed by being both long an option and short another option on the same underlying, where both options are call or both options are puts. Spreads are designed to limit risk, and they often limit profit potential as well. A spread is a vertical spread if both options have the same expiration date, but they have different striking prices. There are two main types of vertical spreads, the bull spread and the bear spread. Either one may be constructed with calls or with puts.
You can utilize a more balanced approach --Spread Trading. Always enter multiple positions around a single asset. These Combinations enable you to take advantage of under/over pricing, premium disparity, and time decay. Combinations combine more than one option to create a flexible position.
The 8 most common Combination strategies are:
Long Straddle
Short Straddle
Long Strangle
Short Strangle
Call Ratio Spread
Put Ratio Spread
Call Ratio Backspread
Put Ratio Backspread
Volatility Trading Strategies
Here we consider the underlying volatility first, then the market outlook. We always visualize our options at different points in time. These are the selected Options Strategies Combinations that provide a Trading Edge:
When Volatility level is very High and a Fall in implied volatility is expected: (premium selling opportunity) Call or Put Ratio Spreads. Short Straddles, or Short Strangles.
When Volatility level is very Low and a Rise in implied volatility is expected: (premium buying opportunity) Call or Put Ratio Backspreads. Long Straddles, or Long Strangles.
Rules for Trading Options
Following trading rules is paramount to achieving success. Profitable trading takes work, and straighforward written rules. When current implied volatility is at the low end of its historical range, we focus on strategies which "buy premium" such as buying calls and puts, buying straddles or backspreads. When current implied volatility is "relatively" high, we focus on strategies which "sell premium", such as selling straddles or strangles, selling credit spreads or buying ratio spreads. To succeed, you must narrow your focus and zero-in on a limited number of variables. You shoud have written rules for the three phases of trading options:
Exercise self management and adhere to the method--Discipline.
Formulate detailed Rules that incorporate Risk Management.
Think in terms of Probabilities
Let's say you have developed two strategies. With the first one you can make $2000, but you can also lose $200. With the second one, you can make $50 ,but you can also lose $200. Which is the better strategy to choose? Obviously most people will say the first strategy is far better, but experienced traders will not immediately jump to this conclusion. They will first ask this key question: "What are the probabilities?" Professional traders will most often base their judgement solely on the probabilities. So, think in terms of probabilities !
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