Options Seminar
Saturday, April 17, 2004
Larry McMillan
Don't view options as lottery tickets, taking advantage of leverage.
The shorter term your horizon, the higher the delta of the option should be.
So day-traders really should not be using options because the bid-ask spread is too wide.
Even OEX options when liquid didn't have consistently narrow enough spreads.
Recommends in-the-money options with a .8 delta or greater, perhaps 1-2 strikes in-the-money, front-end month, e.g., May if today is April.
LEAPS have very high delta so even slightly out-of-the-money deltas have a LEAP > .5.
EG XYZ = 115 in July
Sep 130 call 8 bid 9 asked, delta = .46
- stock must move nearly 2.25 to overcome the bid-asked spread because of the delta of .46;
- so avoid this trade;
- in an OEX option, you may be able to get in between the bid-asked spread, but with this probably no.
If XYZ rises 4 points, your bid may be only 8 1/4 if eg the implied volatility drops 10% (from 95% to 85% in this case).
So pay attention to veta (d option price/ d implied volatility).
- in-the-money options have very small vegas generally;
Risk management
Risk a fixed percent of your account on each trade (3% eg). (Optimal f is perhaps the best book on risk management.)
- winning increases the size of your bet;
- if losing, you automatically ¯'s the size of your bet.
Eg if a stock is at 100 with sell stop at 95 and $100k account, buy 600 shares = $100,000 * .03 / 100
With calls, however, you have to use a model, so you may be able to buy many more than 6 calls because a fall to 95 would not mean you would lose as much per contract. So we could buy 10 calls, not 3.
In poker, a big mistake is not trading a good hand to the maximum.
Using options as a predictor of the underlying.
Direct indicator: takeover rumors, earnings announcements, earnings warnings, momentum trades.
- market makers if taking very aggressive orders, will turn around and buy everything else on the books.
Momentum Trading
Up down volume: sum of volume on up days / sum on volume on down days over past 50 days
1 neutral
2 very strong
3 extremely strong
- good for confirmation of breakouts;
Volatility
Important Bullish Signal:
- if a market is collapsing rapidly AND implied volatility is RISING rapidly;
- watch for volatility to peak, usually on a spike peak, then this is a buy signal.
- can buy outright or sell an index put capitalizing on rich premium;
When VIX makes a low reading, the market is going to explode probably in the direction of the major trend.
- low VIX is not nearly as predictive as high VIX;
VIX remains relatively low.
Ticker = ^vxo.
Merrill study: if you are long 90% S&P 500 and 10% volatility outperforms S&P 500 with lower volatility.
- 6 months standard deviation was 10.9% 1993- 1Q 2004
- covered call writing reduces volatility to 7.2%.
- hedging and covered call writing drops it to 5.7%.
- note this strategy will protect you much better than puts, because a dramatic decline in an index will lead to a spike in volatility that will offset many losses.
The CBOE will have options on these futures, BXM index.
Put-call ratios
- ratio is volume of puts / volume of calls traded;
- high ratio means the masses are bearish, which is bullish;
Currently put-call ratio is making what may be a short-term or intermediate term peak - ? buy signal.
Dollar volume = option price x option volume;
Ratio = sum of dollar volume of puts / sume of dollar volume calls
Covered Calls
3 approaches to covered calls
Rolling for Credit
- you own a block of stock that isn't producing a lot of income so
- you'd like to write calls on it
- but you don’t want to sell at price level;
- decide on a price at which you wouldn't mind getting called away;
- eg 10k XYZ @ 70, willing to sell at 100
- sell 20 of the June 70s
- if XYZ at 80 roll up to Sep 30's (buy Jun 70s, sell Sep 30's);
- if XYZ then climbs to 90, roll up to 60 Sep 90's;
- each is done for a credit;
Easier to predict volatility than stock price direction.
When to buy options:
- implied volatility in lowest 10th percentile or lower;
- has nothing to do with the volatility of the stock;
eg XYX @ 50 buy july 50 calls at 5 buy the july 50 put at 4
- could lose the whole 9 but not too likely.
- straddle - limited risk, unlimited profit potential;
- nice when options are cheap;
- if profits went to 50th percentile, a not unreasonable assumption, profit would return to breakeven or better;
- tends not to buy straddles unless this is a positive number;
- follow-up: if profitable, then uses trailing moving average as a stop
- eg GM @ 65, buy straddle for 5, 60 - 70 profit area; if blows through 60
- does not use targets, uses 20 day moving average; sells if closes below this moving average;
- futures tend to trend more than stocks;
- very hard to keep your hands off these positions;
- if parabolic, will roll up, selling an atm option, taking most of the money out of the position;
Criteria for buying straddles:
1. Implied volatility <>th percentile
2. Probability Calculations a Must - uses
- will use lower of 3 numbers; probability that one of breakeven points will be hit any time between now and expiration - 96% eg; - wants at least an 80% chance of hitting the
3. Verify that Historical Movement is reasonable (visual inspection)
a. actual movement
Enter symbol: TRW
Enter straddle price: 7.0
Enter underlying price: 43.13
Enter number of trading days to expiration: 106
- how often was it able to move 16%? => 95% of the time
- has to be > 80% of the time;
b. check the news
4. Tries to use options 4-6 months out as the best time frame;
Volatility skew: options on the same stock have different implied volatilities.
Eg stock @ 41
Sep 40 call implied volatility = 60%
Dec 40 call implied volatility = 49%
Could buy Dec 40 calls @ 49% and sell Sep 40 calls for a calendar spread
- but test to insure no news on the stock;
- make sure that the options are in a low percentile of implied volatility; don't do if all options are implied volatility;
- calendar spreads have positive veta, meaning that if volatility 's, option prices do well;
Linear skews - different strikes have different skews
Sep Nov Jan Feb
55 49 40 37 35
60 41
65 35
70 32 31 31 30
So could buy Feb 70 @ 30 sell Sep 55 @ 49 - try to keep it delta neutral
Do not sell credit spreads - not worth it because you are selling an expensive option, then buying an expensive option.
Instead, sell naked options, then monitor.
Only sell naked puts on indexes, not stocks.
- If you are profitable 8 months in a row, the probability is high that you will lose money the next trade.
- If you sell a naked put and it becomes at-the-money, roll down and out, e.g., if May 1100 put, buy back and sell June 1095 put.
Option Trading Philosophy
- Always use a model
- Trade all markets
- futures tend to trend more;
- Use follow-up strategies.
- limit risk to start with = most important rule;
- roll down if in naked option position if have strikes to roll to;
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