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OPTION STRATEGIES |
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OPTION STRATEGIES |
This is a safe and reliable strategy that provides a very relaxing (and profitable) way to trade. It can be used by almost anyone, and is especially well suited for small traders who wish to become large traders!
This technique works best on "Markets With Undervalued Options" (Usually a market that has had little movement one way or the other, causing speculators to feel comfortable that nothing is going to happen. This is one event that causes option prices to become under valued).
When that happens:
* Buy an at-the-money straddle (a put and a call option at the same strike price).
* The options you buy should have at least 30-60 days remaining before expiration. Remember that time decay accelerates as the option's expiration date approaches, so if you allow more time, you minimize the time decay.
* If the market doesn't go anywhere in a month, close out the position. As will be explained below, you can usually do this for a small loss or no loss at all.
* If the market does make a move, even a moderate one, you should make a nice profit.
* You don't care which direction the market moves. It doesn't matter. You just want the market to move, up or down.
* As the implied volatility increases, it offsets some of the time decay. So, even if the market doesn't go anywhere, you can get out of the trade with a very minimal loss or possibly no loss at all.
* If the market does make a move, even just a moderate one, the combination of that movement along with the increasing implied volatility will increase the value of your straddle, and you make a nice profit.
When you think you know where the price of your commodity is headed, you can buy underpriced options to give yourself a statistical edge.
Find options where the current market price of the option is less than its computed fair value (theoretical price). These are underpriced options. They don't stay that way for long. (Work with your broker to find underpriced options.)
Primarily look to buy options that don't expire for at least 30 to 60 days, or more. You can often find underpriced options when they have more time remaining. As an option approaches expiration, its premium almost always falls in line with its computed fair value. This is especially true during the last 2-3 weeks before expiration.
For this reason, it is difficult to find underpriced options which expire within 30 days. So, make sure that the options have at least 30 days remaining, or more.
Note: Practice good money management. For instance, If you are wrong about the direction, you might want to sell your options if they lose half of their value.
It shifts the probabilities in your favor. When an option's premium is equal to the fair value, no one has an advantage. But when you buy an option with a premium that is less than the fair value, you have a slight "house advantage", just like a casino.
It reduces time decay (because you are paying for less time value).
It limits your risk and reduces losses when you are wrong about the direction. Since the option is already underpriced, if there is an adverse price move, the option will lose less value than it would otherwise.
It increases your profits when you're right about the direction. As the option's premium moves back in line with the fair value, this helps your position.
So, if you insist on predicting price direction, at least make sure that you buy underpriced options to give yourself an advantage.
If you own any stocks or mutual funds, this is an excellent way to protect your holdings against a major stock market correction.
* First, look for underpriced, out-of-the-money put options on the futures you own. Recall from #2, an option is underpriced when its option premium is less than the computed fair value.
* Buy these underpriced put options. If the futures market drops off a cliff, these cheap put options will dramatically increase in price. Your profit on these options will help to offset the loss on your futures. This is a low cost form of portfolio insurance.
* It is a good idea to buy under priced put options that have more than 30 days remaining. This will further minimize time decay, making your insurance even less expensive.
With these kinds of positions, you make money regardless of price direction. The only way to lose, is if the price of the underlying moves too far in either direction. But as you will see, you can structure these trades so you have a very wide profit zone, with a high probability the price will stay in the profit zone. In addition, you can make adjustments, if necessary, to manipulate the profit zone.
To enter into a neutral options position, all you have to do is sell one or more out-of-the-money call options and at the same time, sell one or more out-of-the-money put options. For example, if June T-bond futures are trading at 110, you might sell the 116 call and the 104 put.
If the price of June T-bond futures is anywhere between 104 and 116 when the futures contract expires, you get to keep all of the premium you collected from the options you sold. So you can see, this strategy provides a wide profit zone.
Anytime the market is in a trading range (even a wide trading range is ok). Since most markets are in trading ranges 65% of the time (or more), you will get a lot of use out of this strategy.
* Make sure you have at least an 80% probability of success. What this means is, based on the statistical volatility of the underlying asset, there is an 80% or better probability that the price of the underlying asset will stay within the profit zone.
* To obtain this high probability, you must sell options that are far enough out-of-the-money. Also, make sure that the premium you collect for selling the options is worth your while.
* Don't put on this trade when statistical volatility is close to its 2 year low, because as stated earlier in #1, that is usually right before the market makes a big move.
* Conversely, when statistical volatility is close to its 2 year high, often times the market will go into a trading range (after having been in a trend). Also, implied volatility will usually be high at this time (and along with it, high premiums). So, the combination of a market entering a trading range and having high implied volatility as well, would be a great time to use this strategy.
Let's continue with the our example:. T-bond futures are trading at 110 and you sold the 104 put and the 116 call options. If the price of T-bond futures starts to move one way or another, you can adjust your position as follows:
If the market is rising:
* If T-bond futures moves from 110 up to 112, you could sell an additional put option at one strike price higher than before. So in this case, you could sell one 106 put option and continue to hold your short position with the 104 put and the 116 call. This would have the effect of shifting the profit zone up a little higher.
* If the market continues to rise, you could then sell the 108 puts and so on.
* If the price of T-bond futures gets up to around 114, you would buy back the 116 call option, because you don't want to take a chance that it might go in-the-money.
If the market is falling:
* If T-bond futures moves from 110 down to 108, you could sell an additional call option at one strike price lower than before. So in this case, you could sell one 114 call option and again, continue to hold your short position. This would have the effect of shifting the profit zone down a little lower.
* If the market continues to fall, you could then sell the 112 calls and so on.
* If the price of T-bond futures drops to around 106, you would buy back the 104 put option.
By making these kinds of adjustments, you can effectively shift the profit zone up or down as desired, allowing time decay to eat away at the options you sold (so you can keep the premium you collected).
This is another nice strategy that often provides a wide profit zone. When a market makes a big up move, relatively quickly, the general public rushes in and buys out-of-the-money call options. This causes those options to be overpriced in relation to the at-the-money call options.
Look at price charts and find a market that has just made a fast up move and is now slowing down or even topping out. This often happens when there is a weather scare which affects markets such as soybeans, coffee, etc. But it can occur in almost any market.*
* Once you find a market like this, look at all of the options for the given underlying asset.
* If you notice the out-of-the-money call options have a significantly higher implied volatility than call options which are closer to the money, you can capitalize on this pricing disparity by setting up a call ratio spread as follows:
· Buy one or more options and at the same, sell a larger number of options further out-of-the-money. So for example, you might buy 1 call option at-the-money and sell 2 call options out-of-the-money (which you have identified as being overpriced).
· Another variation is to buy 1 call option out-of-the-money and sell 2 call options that are further out-of-the-money.
· You can also use a different ratio other than 1 to 2. For instance, you might buy two options at-the-money and sell 3 options out-of-the-money.
· You normally want do this trade only if you receive a credit because this will give you a very large profit zone that stretches from zero all the way up to a price which exceeds your upper strike price.
Market price of S&P 500 futures ...................... 651.50
Buy 1 June S&P 500 670 Call option @ ............ 15.00
Sell 2 June S&P 500 690 Call options @ ............. 9.00
Net credit = (9.00 x 2) - 15.00 = 3.00 points x $500/point = $1500
Profit zone ........................................................... 0.00 .to 713.00
Profit within the profit zone ................................. $1500 to $11,500
Probability of profit .............................................. 91%
Margin Required ................................................ $8500
Note:.. The profit zone is the range of values which the underlying must fall within when the options expire, for the strategy to be profitable.
· If you do it for a net credit, your profit zone can be quite wide. This gives you a high probability of making a profit.
· The potential profit can also be quite large.
It also has a potential problem to watch out for. If the price of the underlying asset rises up to the strike price of the options you sold, they will go in-the-money. At that point, you should consider closing out the position, to play it safe.
This is a good strategy to use when you anticipate a large price move in a market. This strategy is the exact opposite of Call ratio spreads. When you open a backspread position, you sell one or more options and at the same time you buy a larger number of options on the same underlying asset that are further out-of-the-money (and less expensive).
If you feel the direction of the move will be upward, you might sell one at-the-money call option and buy two out-of-the-money call options. So, you might for instance, sell one 100 call option and buy two 110 call options.*
* Conversely, if you feel the direction of the move will be downward, you might sell one at-the-money put option and buy two out-of-the-money put options.
* You can use other ratios as well. For instance, you might sell two and buy three, etc.
* Usually, you will want to do this trade for a credit, that is, the premium you collect for selling the option(s) will be more than the cost of the options you purchase.
* If you can't do it for a credit, try to get in for no cost or a very minimal cost.
* If a large move occurs in the direction you anticipated, you can make a good profit because you are long more options than you are short.
* The only way you can lose with this position is if the price of the underlying asset is between your two strike prices when the options expire. In that case, the option(s) you sold would be in-the-money while the options you purchased would expire worthless.
* When you are in a backspread, if the price of the underlying asset moves between your two strike prices and stays there, close out the trade before the options expire.
Buying in-the-money options. With this strategy, you buy an in-the-money option and you sell another option to help pay for it.
If you think the price is going up, you can buy an in-the-money call option and sell an out-of-the-money call option.*
* On the other hand, if you think the price is going down, you can buy an in-the-money put option and sell an out-of-the-money put option.
* So, for instance, if a particular market is trading at 100, you might buy a 90 call and sell a 110 call. Or, you might buy a 110 put and sell a 90 put.
* The main benefit of this strategy is that the time premium of the option you sell (out-of-the-money options consist entirely of time premium) offsets the time premium of the option you buy, so your position is not subject to time decay. Which means, you get the leverage without having to worry about any time decay at all. So, if the price doesn't go anywhere, you won't lose anything.
* If the price moves against you, you get out with a small loss, as long as you practice good money management.
* If it moves the way you want it to, you can make a profit all the way up to the strike price of the option you sold.
When an option has several months remaining before expiration, time decay is relatively slow. As time goes by, the rate of time decay (the option's theta) increases. When the option has less than 30 days remaining, time decay goes into high gear. Calendar (time) spreads take advantage of this characteristic.
In a typical horizontal calendar spread, you sell an option and at the same time you buy another option of the same type (call or put) on the same underlying asset and at the same strike price, but with a further out expiration.
Price of Underlying: 50.00 |
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| Premium | Days Remaining | Implied Volatility | |
| Sell .-1 ..June 50 Call | 1.96 | 30 | 32.6% |
| Buy ..1 ..July .50 Call | 2.53 | 58 | 29.4% |
| Net cost of spread -0.57 | |||
The June 50 call will lose premium faster than the July 50 call, causing the spread to widen (the value of the spread will increase).*
* The ideal situation would be for the underlying to be trading at 50 when the June 50 call expires. It would expire worthless, while the July 50 call, now with 28 days remaining (instead of 58), would still have time premium. If the market continued to price the July 50 call at the same implied volatility (29.4%), it would have a premium of 1.72. This is summarized below:
Price of Underlying 30 days later: 50.00 |
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| Premium | Days Remaining | Implied Volatility | |
| June 50 Call | 0.00 | 0 | |
| July .50 Call | 1.72 | 28 | 29.4% |
* So, the calendar spread which cost you 0.57 would now be worth 1.72, for a profit of 1.15. That's a 200% return in only 30 days. Of course, there would be commissions and bid/ask slippage, but you get the idea how this strategy works.
* The market should be in a trading range, the narrower, the better. Any big moves up or down will hurt this position and may result in a loss.
* The options you sell should be overvalued relative to the options you buy. This will help to stack the odds in your favor.
* It helps if implied volatility is increasing. This will increase the time value premium of the options you purchase (which have more time remaining than the options you sell in a calendar spread).
* You will recall that the vega of an option indicates how much the price of an option will change for each percent change in volatility. Vega decreases as an option's expiration date approaches.
* In a calendar spread, the options you buy have more time remaining and hense a larger vega than the options you sell. Which means that an increase in implied volatility will cause the price of the options you bought to increase more than the options you sold. This helps your position.
* And of course, if you stay in the calendar spread until the options you sold expire, they will expire without any time value, whereas the options you bought will still have time value remaining.
* When you find a candidate for a calendar spread, make sure you identify the profit zone, that is, the price range which the underlying has to stay within for this strategy to be profitable. Also, look at what would happen to your position if implied volatility changes, and so on. This will help you to make sure you get into the best trades (and avoid the bad ones).
This strategy combines the best features of #3 (buying underpriced options to protect your position), and #10 (covered call writing). With this strategy, you buy out-of-the-money put options to protect your position against a market crash. In addition, you sell out-of-the-money calls to pay for the puts.
Consider the following:
Suppose you own one OJ contract that is trading at 75. You like this market because you feel it has good upside potential. However, you are nervous about the possibility that the market might undergo a large correction. You would feel much more relaxed and confident if you could protect your holdings against this type of risk.
Look for underpriced out-of-the-money OJ put options (the option premium will be less than the fair value). If you can't find any that are underpriced, it doesn't matter, just pick a put option that is one or two strikes out-of-the-money.*
* Next, look for overpriced out-of-the-money OJ call options (the option premium will be more than the fair value). If you can't find any that are overpriced, again it doesn't matter, just pick a call option that is one or two strikes out-of-the money.
* Continuing with our example above, you own one OJ futures that is currently trading at around 75. So, here's what you do: Buy one 70 put option and sell one 80 call option. In essence, you are buying insurance (puts) and writing covered calls to pay for it. This gives you free insurance that will protect your position in the event of another large market correction against your standing futures position.
* If the price of your futures
moves up above 80 and the call option you sold is exercised, then you have to
be willing to sell your OJ at that price. But, as mentioned in Strategy #10
(covered call writing), if this happens, it means you have a small but tidy
little profit. In addition, you can always buy the futures back again on a
pullback.
But the main benefit here is,
if the market crashes, you won't get burned. Delta Neutral Options Strategy The delta of an option is the
rate of change in an option's price relative to a one unit change in the price
of the underlying asset. So, for example, if a call option has a delta of 0.35
and the price increases by one dollar, the option's price should increase by 35
cents. In the example above, the
option has a delta of 0.35. Traders and brokers refer to that as "35 deltas."
Simply multiply the delta by 100 to make it a percentage. Please be aware of
that common convention. However, make sure you understand that "35 deltas"
really means 0.35. For the purpose of our
discussion , whenever we mention the delta of an option, we are referring to the
actual decimal value because that is what's actually used in all mathematical
models. What exactly is Delta Neutral? The term "Delta Neutral"
refers to any strategy where the sum of your deltas is equal to zero. So, for
instance, if you buy 10 call options, each having a delta of 0.60 and you also
buy 20 put options, each having a delta of -0.30 you have the following: ........(10 .x .0.60) .+ .(20 .x .-0.30) .=
.6.00 .+ .-6.00 .= .0 Your position delta (total
delta) is zero, which means you are delta neutral. The technique you are about to
learn, is just one application of delta neutral. It is a general trading
approach that is used by some of the largest and most successful trading firms.
It allows you to make money without having to forecast the direction of the
market. You can use it on any market (stocks, futures, whatever), just as long
as options are available and .... the market is moving. It doesn't matter
whether or not the market is trending, but it won't work if the market is really
flat. The principle behind delta
neutral is based upon the way an option's delta changes as the option moves
further into or out of the money. Consider the following example: You will notice the following characteristics of an
option's delta: *
Statistical Volatility
25.00%
90 day Tbill rate
05.00%
Option Strike Price
100
Days remaining
30
Price
Call
Put
Delta
of
option
option
of
underlying
delta
delta
underlying
.
.
.
.
80
0.0013
-0.9987
1.0000
85
0.0148
-0.9852
1.0000
90
0.0843
-0.9157
1.0000
95
0.2668
-0.7332
1.0000
100
0.5371
-0.4629
1.0000
105
0.7805
-0.2195
1.0000
110
0.9226
-0.0774
1.0000
115
0.9795
-0.0205
1.0000
120
0.9958
-0.0042
1.0000
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 call and put options have a delta that is right around 0.50 and -0.50 respectively.
* Put options have a negative delta, which means if the price of an asset goes up, the price of a put option on that asset goes down.
* Deep in-the-money call options have a delta that approaches +1.00. Conversely, deep in-the-money put options have a delta that approaches -1.00.
* Deep out-of-the-money calls and puts have deltas that approach zero.
* The delta of the underlying asset itself always remains constant at 1.00.
* All of the deltas mentioned above assume that you are buying the options or the underlying asset, that is, you have a long position. If instead, you sold the options or the asset, establishing a short position, all of the deltas would be reversed. So, in the example above, if you sold a call option with a strike price of 100, and the price of the underlying asset was 110, the delta would be .0.9226 .x .-1 .= .-0.9226.
* If you short the underlying,
the delta would be -1.0 instead of +1.0.
..........Buy 2 Tbond futures at 110 If Tbond futures increase from 110
up to 112:
Keeping all of this in
mind, we can construct the following delta neutral trade:
Tbond futures price
110
Statistical Volatility
8.00%
90 day Tbill rate
5.00%
Option Strike Price
110
Days remaining
30
Price
Option
Option
of
theoretical
delta
underlying
price
.
.
.
.
108
2.14
-0.73
109
1.43
-0.58
110
0.91
-0.42
111
0.53
-0.28
112
0.28
-0.16
..........Buy 5 Tbond futures put options (110 strike
price) at 0.91 each
Delta of Tbond futures
2 .x .1.00
= .-2.00
Delta of put options
5 .x .-0.42
= .-2.10
Total position delta
2.00 .+ .-2.10
= .-0.10
How it works:
Profit on Tbonds .= .2 .x .2.00 .= .4.00·
· The put options will decrease from 0.91 down to 0.28 (each)
· Loss on put options .= .5 .x .(0.91 .- .0.28) .= .5 .x .0.63 .= .3.15
· Net profit .= .4.00 .- .3.15 .= .0.85
If Tbond futures decrease from 110 down to 108:· Loss on Tbonds .= .2 .x .2.00 .= .4.00
· The put options will increase from 0.91 up to 2.14 (each)
· Profit on put options .= .5 .x .(2.14 .- .0.91) .= .5 .x .1.23 .= .6.15
· Net profit .= .6.15 .- .4.00 .= .2.15
If you buy the underlying and buy put options so your position is delta neutral:
When the market goes up, you have a profit on the underlying and you have a smaller loss on the options (because their delta decreased), so you wind up with a net profit.*
* When the market goes down,
you have a loss on the underlying but you have a bigger profit on the
options (because their delta increased), so again you have a net profit.
If you sell (short) the underlying
and buy call options so your position is delta neutral:
* When the market goes up, you have a loss on the underlying but again you have a bigger profit on the options (their delta increased), so you have a net profit.
* When the market goes down, you have a profit on the underlying but once again, you have a smaller loss on the options (their delta decreased), so you still have a net profit.
* Always initiate the position with a total position delta of zero or as close to zero as possible. So, your starting position is "delta neutral."
* When the market moves enough so your total position delta has increased or decreased by at least +1.00 or -1.00 delta (or more), you make an "adjustment" by buying or selling more of the underlying asset to get your position back to delta neutral. You can also sell off some of your options to get back to delta neutral. But the point is, you make profits consistently by making these adjustments.
* If the price of the underlying asset doesn't move around much, close out the entire position. You need some price action for this approach to work. If the market just sits there, time decay will eat away at this position.
* Keep an eye on the implied volatility of the options you're using. If it moves toward the high end of its 2 year range, stay away from this position for a while. Otherwise, you might have excessive time decay in your options when the implied volatility starts to drop.
* The options you buy should have at least 30-60 days remaining before expiration. Remember that time decay accelerates as the option's expiration date approaches, so if you allow more time, you minimize the time decay.
* As you have seen, these trade positions benefit by price movement in the underlying asset. It puts you in the enviable position of being able to take full advantage of big price moves, in any direction. In fact, when the Dow dropped 171 points recently, delta neutral positions in the S&P 500 did extremely well.
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