Buying Options

Mark,

I see a lot of chatter on boards for the most part concerning short
sided (premium selling) neutral plays but don't come across nearly as much on directional
type trading. In theory, I understand because this is often considered a
"riskier" play.


I have found I have the best success trading on 4 -5 stocks (and 2
indexes) over and over again, as I seem to learn their movements and
ranges pretty well.
The stocks specifically have medium to low IV and trade pretty decently
within a range for the most part.   That helps me identify
when they are outside their top and bottom levels and probably due for a
reversal of some sort at some time.

Based on this I have been paper trading some long plays thru slightly
OTM calls or puts when stocks hit a high or low level.  This has turned out
quite well over the last few months. Much better return than my short
sided plays.

I'm going to take 10% of my capital and start placing real
funds in the game.


My question is this. I'm sure you've had much experience on the buying
side
. Any particular recommendations you may have on this strategy?
Better to be ATM, OTM, etc? (I'm using slightly OTM as in 1 strike away)


How many months out have you found best? (I'm going 2 months out
currently).

Any particular technical indicators or other analysis tools
you find to be helpful? (I currently am just basing when price swings
outside the normal range).

Not really sure exactly what questions I'm wanting to ask but more or
less get your "been there done that" feedback as to what has worked for
you in the past. Thanks.

Jason

***

Hello Jason,

You see most comments about premium selling because most traders understand that is the more profitable side over the longer term – IF, AND ONLY IF, ONE EXERCISES PRUDENT RISK MANAGEMENT.

Your 'style' is unusual.  Most traders who use technical analysis believe that when a stock is trading at a new high, it's right to buy, not get short.  Similarly, a new low is a signal
to sell. 


To your questions:

I have almost never bought options as a directional play, and I've been trading options since 1975.

I do buy options to add positive gamma to a position, but the purpose is to adjust another position – not to make a directional play.

However, I do have opinions:

1) Unless you are playing for either a very quick move or a substantial move, buying OTM options is a losing strategy

2) Is your total trading history for directional plays that 'few months' of paper trading?  I ask because when buying options you must have a proven ability to get the direction and timing right.  I note you are not so sure about timing.  'At some time' is not quite good enough for trading options.  Especially OTM options.

A few months experience is not nearly enough.  Maybe you had several good years picking stocks before you moved on to options?  But I do encourage you to go ahead with your 10% plan and see if you can make money on your idea.

Please go in with the understanding that the odds of success are very much against you – track record or no track record.  Just look at the mutual funds as one example.  They hire expensive professional traders, and those guys/gals cannot outperform the market averages.

Why do you believe you can do it?  If it were me, I'd want solid proof that I had the elusive talent to consistently get it right when picking stocks – before attempting to make money by buying OTM options.   

2) If cash is not an issue, I'd prefer to buy (one-strike) ITM options.  These don't lose much to time decay and immediately gain the major portion of the move (due to high delta).

If your plan is to use leverage and buy a 'bunch' of options, looking for a big win, then that requires you to buy options with a lower delta.  But I loathe that idea for myself.  It may work for you – if you have the talent mentioned previously.

3) I like the idea of two-month options, but to be honest, when making a forecast – and especially when buying options – being accurate on timing is essential.  That's why you should KNOW, and not ask, which option to buy based on timing of the move.

Lacking that timing instinct, you are just taking a chance, no matter which option expiration is chosen.

4) Going one step farther and being even more helpful (smile), I use zero technical indicators.  I know FOR A FACT that my stock market prognostications are not good, and I do not make directional plays.

5) I have never been 'there' and I have never done 'that.'  But I hope this reply is helpful

736

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11 Responses to Buying Options

  1. Rick Forno 07/09/2010 at 6:50 AM #

    As Mark and I were talking yesterday elsewhere, I went long a bunch of 6, 9, or 12-month spreads on some bearish index/ETF positions back this spring when options were ‘cheap’ and volatility low. They noodled around +/- 5% for a while, but really took off in recent weeks obviously.
    Apropos to Mark’s Point #2 above, those spreads were the first time I’d bought ITM (well, ATM) options as opposed to OTM. Yes, I was very confident of an OTM play being successful, but for some reason I decided to do it “the way I’ve seen others whom I respect” enter such trades. I’m glad I did that, and it’s how I’ll be doing similar trades down the road. 🙂
    Yes, earlier this summer, I did enter a few OTM spreads on those as well as “higher-reward, lower-probability” trades, but at the time, the price seemed right for what I saw as a speculative trade (OTM vs ITM).
    I do use 2 indicators in my e-mini and stock/options trading, but with respect, I prefer not to discuss how I use them and thus let each trader find out what works for them individually….after all, what ‘works’ for me may not ‘work’ for you based on personality, capabilities, goals, or risk tolerances. (They only ‘work’ for me because I spent several years seeing them in action in the markets in real-time and developed a working ‘sense’ of how to interpret them.)
    Still, regardless of what *any* indicator might “say” I let my own judgment of market conditions, macro environment, and broader situation determine whether to put a trade on or not — after all, the Market can be irrational far longer than any of us can remain solvent. I’ve ignored more indicator “signals” than I’ve “taken” — and more often than not, I’m doing the right thing. 🙂
    Good luck!

  2. Don 07/09/2010 at 7:38 AM #

    Hi Mark,
    I am always interested in your experience as a market maker and your experience “on the floor.” I am curious about gathering indirect information and any correlation that you have noticed. For example, I sometimes see very large (50,000) lots traded in certain options with a bullish or bearish direction. This is a huge amount of money and I am aware that there may be hedging going on etc…but I wondered if they ever prove to be a pre-indicator of a price movement. Along those lines, occasionally you can see in individual stocks a huge upsurge in volume or IV and I wondered if on the floor these were indicators of upcoming price movement more often than not- nothing scientific, just wondering what you noticed, if anything.
    Thanks, Don

  3. Gordon 07/09/2010 at 7:54 AM #

    Hi Mark,
    Interesting column as always. Thinking about Jason’s question, since his goal is profit through directional moves, why not buy calls that are deep in the money, with a delta between 90 and 100 that are two to three months to expiration? They’d move nearly dollar for dollar in the direction of the stock, wouldn’t be as subject to the erosion of time value, and would give Jason more leverage than buying the stock long. Unless there is a collapse in the stock price, he should be able to get out prior to expiration with a gain or loss similar to the underlying stock. I’m not sure I’d have the confidence in my forecasting ability to try this, but it seems like the safest way for Jason to accomplish his goal. Am I missing something, or do you think this might work for him?
    Thanks, Gordon

  4. Mark Wolfinger 07/09/2010 at 8:06 AM #

    Rick,
    Thanks.

  5. Mark Wolfinger 07/09/2010 at 8:12 AM #

    Don,
    When I was on the floor (remember, it was last century!), I ever had access to any information that did not occur in my trading pit.
    Thus, large trades in other pits and volatility spikes were unknown to me.
    The bottom line is that I have no idea whether large blocks are indicative of anything. As you note, it can be a hedge against an old (or new) position and there is just no way to know.
    However, I’m sure someone, somewhere has tracked this type of information. But it’s probably proprietary.
    Regards

  6. Mark Wolfinger 07/09/2010 at 9:19 AM #

    Gordon,
    Thank you.
    Yes that can work very well for him (and others). However, as you warned: ‘unless there is a collapse in the stock price.’
    I recommend paying some time premium to own an option that is less deep in the money – just to reduce losses if the trader is wrong (or the market collapses). To me, a delta of 75 to 80 is a good compromise.
    However, this is a difference in investing style and confidence in one’s picks. Your idea is sound – for the right trader. It’s absolutely better than buying stock (non-dividend). Not for everyone.
    Regards

  7. Jason 07/09/2010 at 11:18 AM #

    Glad to get feedback on this. To be honest I enjoy the challenge of this approach and used it in only 2 scenerios … one, when volatility was low in April and I straddled a few 2 month contracts which paid off and the other trades were on 3 stocks that I’ve followed for a while and feel like I know their trading pattern somewhat. When one reaches what I feel to be a high outside the normal range after a few successive days of buying I have bought a few ATM and one strike OTM puts and vice versa on the down side with calls. Usually hold these a day or so at the most and basically just play the bounces.
    If it doesnt immediately follow the direction I thought I hold until it comes around which it mostly has … so far.
    I like the ITM idea and will look into that more.
    And agree with Rick on the indicators. I do like the technicals but often use them as suggestions more than anything and end up relying on my own judgement.

  8. Steve 07/09/2010 at 11:27 AM #

    Hi Mark.
    I am interested in your comment about traders realizing selling is the most profitable side. Is that because you can still capture the big moves up (profit) but get the added bonus of the premium paid to you as well? I understand risk management is key because your risk is more than just the premium you pay.
    I will admit that when first starting, I was in the must buy to open a position and sell to close a position mode. That didn’t work out so well. One thing I heard that made sense to me was that you buy low and sell high, but not necessarily in that order. I have enjoyed being the seller of the options in my paper money.

  9. Mark Wolfinger 07/09/2010 at 11:34 AM #

    Steve,
    1) The first point you mention would be true only for covered call writing.
    2) I was saying that considering all strategies, a carefully managed program of selling options tends to be more rewarding than buying options
    3) Some argue this is impossible becasue they think options is a zero sum game (a discussion for another time)
    4) On average, over the years, options have been overpriced by a small amount.
    Translation: Realized market volatility turned out to be a little less than anticipated by the prices of options. In other words, option prices (and thus, implied volatility) was higher than the final result says it should have been.
    5) When selling premium, I believe in selling spreads and not naked options. [Sole exception: It’s okay to sell naked puts ONLY when you WANT to accumulate shares of stock]

  10. Don 07/09/2010 at 12:05 PM #

    Mark, if an investor is interested in accumulation of stock by selling puts could an investor further lower the cost of acquisition by selling calls at the same time (or call spreads for additonal safety. For example VZ is at 26.30 you could sell the 22.50 puts and sell a call spread to further reduce cost of ownership? Do you think it would be necessary to sell a call spread vs. a straight call sale on a stock with this capitilization?
    Thanks again, DOn

  11. Mark Wolfinger 07/09/2010 at 12:21 PM #

    Don,
    I don’t like this idea as an initial trade. If a trader is interested in accumulating shares, it must be assumed that the trader has a bullish bias. There is no point in losing money on a rally.
    However, once investor owns shares – as a result of being assigned on some puts – then it becomes a good idea. I’d suggest that selling calls (not spreads), converting the position to a covered call, is a worthwhile strategy. It is an income-producing strategy and not a trade looking to earn a significant profit on a rally.
    Regards