Option Education

 

General rules

I usually trades options that expire in greater than 2 weeks, which is often the “front month” (the closest month of expiration).  Monthly options expire the 3rd Friday of every month, but  there are weekly options for many listed securities also.  I normally do not trade weekly options, as they are more volatile and there is  not enough time for the trade to work for you.  If there is a high probability trade, sometimes I will make an exception to that rule.

I normally trade options that are 1-3% in the money.   What does that mean?

That means if a stock is selling for $500, I would look at the strikes that are $5-$15 (1-3%) below the market price of the stock.   In this case, that would be the 495,490 or 485 strikes.   I would now be looking at March contracts, as the February options expire this Friday(3rd Friday this month).    Usually a 3% in the money(ITM) strike will  give me a .70 delta .  What is that? Delta  is the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative.  This means the option should move 70% of the move of the underlying stock.   The more ITM the options are, the higher the delta.

Example:  A stock is trading for 500, and you buy ITM calls by 3% (485 strike) at $18/contract and the stock gains +10 (to 510).   Your 485 calls should move .70 x 10 , or $7 (to $25 or +38%)     So, using this example if your stop was 490 (10 stop in the stock), you would place your stop in the option at .70 x 10=7 below the entry price.  So, if you bought those calls for $18, then your stop would be 18-7=$11.00 ( -38% loss)  This was just an example of the huge risk, and huge reward in options.   That is why I scale out a portion of my position relatively fast(after the option has moved 3-5% in my favor), to reduce risk.   If you scale out of 1/2 the position, you reduce risk  and are still involved with the trade (your runner).

Also, there is time decay with every option.  This will affect the price of the option with the  fluctuation of  the underlying security.  This is referred to as Theta.   Theta is a measure of the rate of decline in the value of an option due to the passage of time.  The Delta will change based on the time expiration of your options.  So, if you go out past the front month expiration, the 3% ITM options will have a lower Delta than .70(depending on how far you go out).

The above scenario was just an example.  It is very important to understand trading options is very risky.

 

 

 

14 thoughts on “Option Education”

  1. Fully agree with your above statement in both description and method of selecting options,normally that is my selection process.
    Lately with some stocks (i.e. JPM, XLE,etc…) and the market in the 9th inning, I’ve been buying very near At-The-Money front month options because the delta has been approximately 50. So I’d buy 10 or 20 contracts and for every 2 cent move in the stock price it essentially equals to a 1 cent move in the option price. After the option moves approximately 20% to 25% I will sell 3/4 postion (7 or 15 contracts) and keep the 1/4 position (3 or 5 contracts) as a runner. And given the 50 delta I can withstand these most recent violent shakeouts / pullbacks.
    Keep up with the great picks.

  2. When you say 3% ITM options, is it oversimplifying to just look for options in the ~.70 delta range? Or is that 3% number a defined part of your trading/money mgmt strategy, which dictates then which option to actually choose? Or…do both those roads lead to the same place?

  3. 3% in the money, is the general rule…This does vary, buy I usually try to get the .70 Delta. The 3% is not a defined part of my trading methodology or strategy. Taking the entries from the charts with defined risk involves my methodology, along with the 5 Essentials to Trading Success.

  4. When premiums of options are high I will use spreads. Also, sometimes I will sell OTM call against my ITM call(long) after the trades starts working in my favor.(reduces risk and gives me more time to be right on runner) Since March contracts expire in 5 weeks(lots of premium), you might want to consider spreads (2-3%)ITM long and (2-3%) OTM short

  5. What happens if you set your stop and the market trades right thru it, and never trades at your stop price? Ie: stop at 10, trades at 10.05 and 9.95, but not 10. Your stop isn’t activated. Have you ever encountered that? Happened to me on more than one occasion. Thanks!

  6. Craig,

    You need to place “stop market” orders. (not stop limit orders). This will get stopped with a stop market.

  7. Can you provide some more information on options that are not liquid? What is the best calculation to use to know if a option is overpriced. I have had some situations where the premium has deflated after I bought in leaving me stuck.

  8. If the options are not liquid (7-10% bid/ask spreads…or…..i.e 9.10/10 bid/ask), I would avoid.
    Stick with ITM with around .70 delta, and if the spreads are wide, use the equity.

  9. David, after being here a couple of days, I’ve seen you scale out of some positions rather quickly (sometimes a matter of min’s). The only time I have attempted doing this in the past, I get these scary warning messages from my broker about day trading, so I’ve cancelled the order(s). What are the rules about day trading that allow these short lived buy & then sell transactions?

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