Some Basic Rules for Options Trading - Part Two

Four Mistakes to Avoid

1)  Not paying attention to implied volatility

You need to determine if implied volatility is high or low and then pick a strategy accordingly. 

For example, low volatility is optimal for a put buying strategy – so, if volatility is low, buying a put would be optimal. 

Here’s a table for picking a strategy based on volatility levels:

 

Strategy

Profit Potential

Risk

1

2

3

4

5

6

7

8

9

10

Buy Straddles

Unlimited

Limited

x

x

Buy Naked Options

Unlimited

Limited

x

x

x

Backspreads

Unlimited

Limited

x

x

x

x

x

Buy Verticals

Limited

Limited

x

x

x

x

x

Calendar Spreads

Limited

Limited

x

x

x

x

x

Sell Verticals

Limited

Limited

x

x

x

x

x

Sell Double Verticals

Limited

Limited

x

x

x

x

Buy Ratio Spreads

Limited

Unlimited

x

x

x

Sell Naked Options

Limited

Unlimited

x

x

Sell Straddles

Limited

Unlimited

x

x

Hedging Strategy

Profit Potential

Risk

1

2

3

4

5

6

7

8

9

10

Buy Underlying/ Buy Put

Unlimited

Limited

x

x

x

Short Underlying/ Buy Call

Limited

Limited

x

x

x

Buy Underlying/ Sell Call/Buy Put

Limited

Limited

x

x

x

x

Short Underlying/ Sell Put/Buy Call

Limited

Limited

x

x

x

x

Buy Underlying/ Sell Call

Limited

Limited

x

x

x

Short Underlying/ Sell Put

Limited

Limited

x

x

x

Now, how to find the volatility level:

1)      Find the highest and lowest readings in implied volatility for a given security’s options over the last two years.

2)      Find the difference between these two.

3)      Break this number up into deciles or units of 10.

4)      Find the stock’s current implied volatility. 

5)      Where does it fall on the deciles scale found in step 3? 1 = low, 10 = high.

6)      Use the preceding table accordingly.

2) Buying Only Cheap Out of the Money Options

You need to pay attention to Delta in order to avoid this one.  Delta can be loosely defined as the likelihood an option will finish in the money.  Thus:

Solution: Buy Options with a Delta of ~ 70 or more

3) Using Strategies that are Too Complex

You need to know how to adjust your position throughout its life-cycle.  Thus, you need to be familiar with the Greeks:

Vega – expected change in price for an option given a one point change in implied volatility.  For example, a Vega of .06 implies that if implied volatility were to rise from 30 to 40, this option would gain .60 in value.

Theta – the amount of an option price that is lost in a day as a result of time decay.  For example, an option with a theta value of .015 will be a cent and a half of time premium on the current trading day.  Theta increases as expiration draws near and time decay accelerates.

Delta – again, this can be viewed as the likelihood an option will finish in the money.  A Delta of 70 means there is a 70% chance the option will finish in the money.  This is also the expected change for an option given a one point change in the price of the underlying security.

Example:  A delta of 52 implies that if the underlying stock increases in value by $1.00, this option will gain $.52 in value.

Gamma – this is the expected change in the delta for an option value given a one point change in the price of the underlying security. 

Example:  If delta is 52 with a gamma of 9, this implies that if the underlying stock gains $1.00 in value this option will increase in delta from 52 to 61.

How to Avoid Number Three:

You should id:

1)      When is your trading becoming too complex?

2)      What is your objective for entering into this trade?

3)      What is your max profit potential and the probability (delta) of achieving it?

4)      What is your maximum risk and probability of experiencing that?

5)      Will you need to adjust the position?

6)      If so, at what point will you need to adjust and what type of adjustment?  Should you lock in profits and if so, at what point and how much?

7)      Can you keep close track of this trade to avoid potential disasters?

As a side note to this, you need to factor in commissions and slippage when you sell for premium (covered call option).  Commission is what you pay your broker slippage is the difference between the quoted ask price and what you actually pay between the time the order is placed and when it is actually filled.  You can prevent slippage by using a limit order to protect yourself.  You can limit how much you are willing to pay for the option.

 

4) Casting Too Wide a Net

It seems everyone’s first instinct is to pilfer through thousands of options in order to screen down to a select few.  If not done right, this can be a huge waste of time.

How to Avoid:

Spot exceptional trading opportunities using for example, the implied volatility strategy detailed in Mistake Number One.  Also, you must have trading volume for someone to pick up the stick on the other end of your trade.  Make sure to narrow the focus.

 

Summary Table
Mistake	Why This Causes Failure	How To Avoid
1) Relying Solely on Market Timing	Ignores implied volatility - can lead to paying too much to purchase options	Carefully analyze which options are best suited to achieve your objections.  Look at implied volatility and if it fits your strategy.
2) Buying Only Out of the Money Options	Ignores probability an option will finish in the money.  Leads to buying options with little chance of profiting.	Consider the likelihood of making money on a given trade before getting in.  What are the chances the trade will finish in the money - look at Delta.
3) Using Strategies that you don't Fully Understand	Leads to unfavorable risk/reward scenarios.	Determine your objective and make certain the trade you are going to make can achieve this objective without more risk than you can handle.
4) Casting Too Wide a Net	Too much time wasted looking randomly for opportunities.	Narrow the focus of the strategies you will consider and the securities you will trade.