Thursday, May 27, 2010

How to find the best option for your price and time strategy? (Guest post by chaugner)

Tonight's post is a complement of

chaugner  (looking good, huh???)

and too keep an eye on future misdeeds visit blog







Before I start, let me ask two simple questions.

“How often have you bought a put contract just to see it loose 50% of its value even though you are still at the same price you bought it a week earlier?”

“How often have you bought a call at what you thought was the bottom just to see it down in your account while the market has rallied the next day?”


We have all been there trust me. When I first started with options it was not pretty, I had some lucky ones but when time, price and volatility are against you – boy can you end up with a bad trade. I clearly remember that one trade that forced me to read up on options because I obviously was missing something. I did a straddle (buying put and call on same expiration and same strike price) on AA just before earnings thinking of a big move, nothing happened overnight and price stayed exactly the same at the open – thinking to myself “oh well, no money on this trade” it turned 9:30 and all of the sudden both positions were down 50%. I am sure many had similar experiences so it is extremely important to understand what option traders call the “greeks”. The Greeks are often overlooked by many traders that tend to just buy straight “naked” puts or calls. As part of this post we will be focusing on trying to get a better understanding on those Greeks and also do an exercise to find the best option for a specific market outlook you have. As I am covering many different areas you will need some basic knowledge of options first.

  • What is a naked option, put or call?
  • What is a spread?
  • In the money option
  • At the Money option
  • Out of the money option
  • Bearish Put Spread
So before you continue, read up on those above points above in case you do not know what they mean. To make it easier the focus of this post will be on bearish put spreads (debit put spread). There are many other option strategies out there for different market outlooks so let’s keep it simple in this first exercise for us here. When it comes to options, especially longer term ones (lets say 2-3 months out) I use two mechanisms to try to find the best option package for me:
  • TradeStation OptionStation Search
  • ThinkOrSwim Trade Analysis
Please sign up for demo accounts for both of those platforms if you do not have access. So for now let’s use the exercise of trying to find the best put spread for SPX at 880 in August with an increase of volatility of 30%. The beginner’s way for this is generally finding an option with the expiration close to the date you are looking for. In this case a beginner would usually buy a “SPY August 88 PUT” (out of the money) or a “SPY August 107 Put” (at the money assuming that SPY is trading at 107). So let’s go to trade station first and use their wizard based option search. Entry window for Tradestation OptionStation Search. I am using SPY here with 10 expiration dates out and 10 strike prices from current price. Current Price is SPX close @ 1074.03. Tradestation offers you many options either by selecting the strategy directly or doing it based on market outlooks. We are selecting debit put spread. We are assuming we want to close this position out in Aug 17th (because we believe we will have reached SPX 880 by that day). I just picked this date randomly, make your plan and put in whatever date you want here. We are assuming SPY to be 15% below current price (you have other options but lets keep it simple). We are risking $5K on this trade. We are assuming VIX is 30% higher compared to today. There are two other screens after this, just select next until you get to your final window. Lets take the top position that tradestation came up with here. It’s telling us the following:
  • Buy 63 SPY Aug 101 Puts @ 4.14
  • Sell 63 SPY Aug 98 Puts @ 3.35
(Keep in mind we are buying a total of 126 option contracts here). So now that we have the position, let’s switch to ThinkOrSwim where the real fun starts. Most people here use TOS so I assume you know how to put in your positions for analysis. After you put in your positions on the analyze tab (or go to add simulated trades) you should see a standard graph. Before we continue go to the top right section (red rectangle) and change it to the values that I put there. “+4 @ Day Step” and put something higher then 15 on the step. This will give us more visibility of where the position will be on different time scales. I also have a green rectangle around the Greeks (Delta, Gamma, Theta, Vega) – again we talk about this later. Your TOS should looks like this now: Now that your position is in the platform and you have your time slices properly mapped, you can drag the red-dotted line to different price points. So as an exercise lets take a look at our position when SPY is 108, double click on the graph around the 108 SPY price point. At this price point you can see your PL in the price slice window for today, but you can also see how much you would be down if we were to reach this price on different time scales (white rectangle left bottom). Next exercise is moving the red dotted line to 88 on SPY. Again the price slice window shows your PL and the bottom left side would show you how much you would be up if SPY 88 will be reached in different time windows. Final exercise, uncheck your spy short put position (left bottom) and change the quantity on the Long Put to 12 because that is how many naked puts you could buy with a $5K at risk (remember we only want to risk $5k on this trade so we assume that those 12 puts will go to zero). Now the graph here is drastically different, and heavily weighted against you. Take the example of SPY 100. If you had a spread you would be in the money on this position at any time until expiration, however, on the straight put you can see that if time works against you – not so nice. You may have heard this before in relation to options “you are racing against the clock”. This is a perfect example to show how time will affect your “naked” option. Ok, what next? Well first, play around with the following and see how the graph changes. After each change go back to your red-dotted line and move them to price slices where the trade went against you, slightly for you, and when you have reached your price target.
  • Quantities (add more long puts, add more short puts)
  • Option Cost (change price on your long put to something smaller, meaning you were able to buy them lets say at $3.00 each instead of $4.14)
  • Change Strike Prices – maybe a 105 put on the long side
  • Expiration Dates – change expiration dates to move them closer, or further out
  • Change the time step (at the top where it currently says 21)
  • Remove the short put and just use the long put with quantity of 12 and move left and right on the price via the red dotted line
Every option change you make, make sure to change the quantities to match the risk profile we are using. In this case $5000. For example changing the strike price will increase/decrease the cost of the option so you have to adjust the quantity accordingly. Cool stuff right? Now before you continue, go read up on the greeks, Delta, Gamma, Theta, Vega, just some casual 10 minute reading via google (focus on the delta and theta for now). After this go back to TOS and see how the greeks change based on the above changes I had asked you to do. Now go back and read that same information on the greeks again (oh yeah I am not making fun here). This is just an intro and if you guys and girls like it, I can go into a lot more details to be able to figure out how to get positioned, scale in and out and how to change your portfolio outlook on a dime by adding positions to your current holdings. As I am going into a lot of detail here it may also be helpful to do a “beginners guide” here first in case some of this is a bit over your head (don’t be afraid to ask, its your money, trust me, the more you know when it comes to options the better). The beauty with options is the usage of greeks. You have to make them work for you, not against you. If you can make the greeks work for you, you can create amazing option strategies that allow you to manage any type of outlook you may have. We may be bearish long term, but what if something where to happen on the short term that may change your outlook to short term bullish? Yes you can close out positions but sometimes you can add to your existing positions to change your portfolio behavior. Heard of delta-neutral, delta-negative or delta-positive before? Yeap its those same greeks and we can make some amazing short term changes to those core holdings to squeeze every last penny out of this market without exposing your hard earned cash to more risk. One final exercise to take just to show you one more way of how greeks affect your positions. Create 2 new positions:
  • 10 x SPY JUNE 107 PUTS @ 2.00 (something you may have purchased a few days ago)
  • 10 x SPY JUNE 107 CALL @ 2.50 (something you may have purchased today)
Lets take a look at that graph. The only thing missing from this TOS platform here is an option to give your money directly to the Market makers and forget about trading. That is what this graph is telling you. Until next time and be careful out there !!!



[Posted by DavidDT on behalf of chaugner ]

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