Trading With Options

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An overview of trading with options By Arthur J. Schwartz .
Draft Outline of talk to be given 6/16/2011

What is an option?
• Call= the right but not the obligation to buy XYZ at a price of A (called the strike price) up until an expiration date. If you are long the call, and XYZ goes up, the value of the call will generally increase (subject to changes in time decay and volatility).

What is an option?
• Put= the right but not the obligation to sell XYZ at a price of A (called the strike price) up until an expiration date. If you are long the put, and XYZ goes down, the value of the put will generally increase (subject to changes in time decay and volatility.

• A simple mnemonic= call me up; put me down. (However this mnemonic is only true for long options. Don’t forget that you can be short a call or put. Then the short call gains value as XYZ stays the same in price or drops, while the short put gains as XYZ stays the same in price or increases.)

What are advantages of trading options versus the underlying?
• The most important advantage is that it’s possible to overcome the EMH (efficient market hypothesis) even in the “strong form” (example) • The second important advantage is the opportunity to adjust option positions to capture profit or reduce risk. (We could spend days on this one topic; I will give a single example on NFLX to offer a glimpse of what is possible).

Disadvantages of trading options versus the underlying?
• The most important disadvantage is that there is a steep learning curve to understand the strategies, and align them with a trading philosophy (directional, volatility, or arbitrage). It can take several years to really understand option strategies. I recommend budgeting time and money towards reading books and taking courses.

How options trading differs from stocks, futures, or currencies
• One: options life is limited • Two: options value is dramatically affected by time decay and volatility • Three: it’s possible to make profits without being exactly right on direction. • Four: option positions can be adjusted. Why: to lock in profits while remaining open for additional profits or to reduce risk • Five: options can be arbitraged against the underlying or against other options

Three broad types of options trading
• Directional, volatility, and arbitrage trading • Directional trading: intended primarily to make money from a direction in the underlying. • Volatility trading: intended primarily to make money from a change in volatility

Arbitrage trading
• Classical arbitrage: intended to make money from capturing differences in prices of the underlying trading in different markets (example gold in New York versus London); from mergers or acquisitions; or from options. • In today’s market, options arbitrage positions have to be entered dynamically, over time, rather than simultaneously. Note that the time element exposes the options’ arbitrage trader to significant risk.

Synthetic relationships
• Any two of these three can synthetically create the third: underlying, call, put • Example: long stock is the same as long call and short put. Would you rather buy IBM at about 170 per share or buy a one year 170 call and short the 170 put? Check the prices! • Why is this important? • Because we can often create or adjust a position using synthetics far more cheaply. Less cost means the worst you can do is lose less; less cost also means your return on a smaller investment can be greater

Volatility trading
Calendar spreads Straddles or strangles ATM flys or other wingspreads Ratio forward spreads or back spreads

My trading
• Directional, however I will often adjust a position into an arbitrage position to preserve profits and open up possibilities for additional profits. Example: NFLX below

Arbitrage positions: conversions, reversals, boxes, & time boxes.
• Conversion: long underlying; long put at strike of Y, short call at same strike • Reversal: short underlying; short put at strike of Y, long call at same strike • Box: Long a vertical at two strikes in calls; long the opposite strikes in puts. • Time box: also called a “jelly roll”. Same as box except the two verticals are in different months

Example of my trading
• NFLX. Vertical adjusted into a box to keep profit then additional vertical sold against one leg of the box to increase profits. Rational: with the market looking weak in recent weeks, this stock seemed headed higher. Original position: long the July 265 call at 15.16, short the 270 call at 12.73 for a net debit of 2.43.

Capturing profit on vertical
• NFLX moved up and the vertical was worth about 2.90 for a gain of about 0.47 in just a day. Instead of selling, I bought the July 270 puts at 12.20, sold the 265 puts 10.10 for a net debit of 2.10. Thus I owned the 265 270 box which would be worth the difference in strikes or 5.00 at expiration, no matter what the stock did, for a net cost of 2.43 plus 2.10 or 4.53, preserving a 0.47 profit.

Gaining additional profit on vertical
• When NFLX sold off, I then sold the June 300 calls at 0.83, bought the 305 calls at 0.50, for a net credit of 0.33, with the rationale that this vertical would likely expire worthless. This was similar to a covered call write as I was selling a short term vertical against a back month vertical. There was no additional margin required as this vertical was covered by the July 265 270 long debit call vertical.

Selling again in July
• Thus net profit of 0.47 on cost of 2.43 was increased to 0.80 (almost doubling the profit) --- and if the 300 305 vertical expires worthless tomorrow (as seems likely) there are additional opportunities to sell another vertical in the July expiration against my original position which can increase profits further – perhaps to a triple.

For the examples that follow…..
• For all examples, I will suppose a stock trading at 50; volatility of 35%; no dividends; time to expiration of sixty days. • All prices from the calculator within “The Options Tool box” a free download from www.cboe.com

Directional strategies that I use
• • • • • Call or put. ATM vertical. OTM vertical or DITM vertical. Synthetic long or short. OTM fly or broken wing fly

Types of option strategies (long or short)
• • • • • • • Call or put Vertical Wingspreads (fly, condor, broken wing fly) Straddles or strangles Time spreads Ratio verticals (forward and back spreads) Any of these can be ratio-ed or calendarized

Call or put, long or short
• Long call or put; short call or put • Advantages> simple; makes the most if right on direction • Disadvantages> exposed to significant changes from volatility or time decay. If short, unlimited losses. • Example: XYZ at 50; buy call at 50. Cost: 3.03

ATM vertical
• Advantages: less cost than long call or put; less exposure to time decay or drops in volatility • Disadvantages: less profit potential if right on direction • Example: XYZ at 50, buy the 50 call at 3.03, sell the 55 call at 1.23 for a net debit of 1.80

OTM vertical spread =DITM vertical
• Advantages: can overcome the EMH because you do not have to be exactly right on direction. In fact you can wrong on direction -- to some extent --- and still make money! • Disadvantages: as with any vertical, you give up some profit potential • Example: XYZ at 50. Direction appears up. Sell the 45 put and buy the 40 put for a net credit of 0.68.

More on the OTM credit vertical or DITM debit vertical
• Advantages> As Warren Buffet has said, “I’d rather be roughly right than precisely wrong”. You do not have to exactly right on price. Also, the vertical minimizes effects of time decay and changes in volatility since these affect both options at once • Disadvantages> profits are limited if you are right.

Synthetic long or short
• Advantages: same profit as long or shoirt the underlying • Disadvantages: if wrong, you’ll get hammered on both options! • Example: XYZ at 50, long 50 call at 3.03, short 50 put at 2.65 for a net debit of 0.38

OTM fly, condor, or broken wing fly
• Advantages> similar to OTM vertical except that cost is dramatically less; so less movement required for profits. Easy to adjust into vertical ratio spread if wrong on direction. • Disadvantages> More legs to the spread means more commissions putting position on and taking off. Commissions and slippage in putting on or taking off a leg can eat up your profits. • Example> with XYZ at 50, buy the 50 55 60 call fly. Long the 50 strike, short two calls at 55, long one call at 60. Cost 0.98.

OTM wingspreads
• A key advantage is that the reward to risk ratio can be very good. It’s not uncommon to have a five to one reward to risk ratio • Another advantage that’s often overlooked by novice options traders is the lack of exposure to changes in volatility

Comparing directional strategies on cost alone
• • • • • • Call = 3.03 debit Synthetic long= 0.38 debit ATM vertical= 1.80 debit OTM vertical= 0.68 credit OTM fly= 0.98 debit OTM broken wing fly= 2.32 debit

Which strategy is the best?
• Answer: They are all right! Each has its place in the tool box! Just as a master carpenter selects the right tool for the job, the master options trader has to balance some of these factors in selecting the strategy: • Strength of trend (if trading directionally) • Expected time in position. • Cost of position

Selecting the strategy (continued)
• Risk of position (not necessarily the same as the cost). How much can I lose? • Exposure of position to time decay or changes in volatility • Using options software we can model the effect of changes in price, time decay, and increases or decreases in volatility on a proposed option strategy

General advice
• Set a price stop and a time stop. Meaning: close position if it does not move in your favor in a certain time or by a certain dollar amount • Do not be so eager to put on a position that you receive too low a credit, pay too large a debit, or take unwarranted risk. • Selling naked options may be attractive, but when you are wrong, it can cost you plenty 

Recommended reading or courses
• • • • • • • • • Books Options as a Strategic Investment, Larry Macmillan The Volatility Edge in Options Trading, Jeff Augen Trading Options in Turbulent Markets, Larry Shover Options the Hidden reality, Charles Cottle Seminars or mentoring OASIS seminar, Optionetics Dan Sheridan, Sheridan mentoring program in options

Recommended software
• The Options Toolbox, a free download from www.cboe.com • Think or Swim’s Analyze page allows you to visually see the effect of changes in price, time, and volatility

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