Options trading: Questions welcome

I received the following message via e-mail and reproduced an abbreviated version here:

Hi Mark,

In your part 2 article of "Can You Beat the Market?", you stated the
exact reason I started learning about options recently: "…I'm looking
for an investment strategy that increases my earnings at the same time
that it reduces risk".  I'm not shying away from them, but want to
learn, as by my initial learnings they can help reduce the risk and
generate extra income/reduce cost basis. 

Over the years, I've started
dealing more w/ ETFs because of my frustration of owning stocks that
tanked or whipsawed through stop losses and then took off right afterward. 
The ETFs are generally less volatile and since it's hard enough to pick
the individual stocks that will outperform, I've settled on these for
significantly lower risk on a downside gap vs stocks (stocks can gap
20-50% or so, but not the SPY or QQQQ).  I'm looking forward to your next articles as, yes, covered calls
generates income and lowers the stock cost basis.  Those alone don't
offer the downside protection that puts would provide…  I don't know if there's a way
to combine all these or how to time the strategies, but that's what I'm
trying to learn

I've been reading "Sure Thing Options Trading" by Angell to learn some
basics.  If you have any common-sense advice from here, I'd appreciate
your tutelage.  Should I just watch for more articles by you on this
topic?

 
As I have further questions going forward, do you mind answering them? 
I wouldn't overdo the privilege.

 
Regards,

Don

***

Hello Don,

1) I am unfamiliar with Angell's book. Take a look at a sampler version of my recent book by clicking here.

2) Yes, options were designed to reduce risk.  When used that way, most of the time the probability of earning a profit is increased – but those profits are limited.

3) Using ETFs or indexes is an excellent method for diversifying your stock holdings.  As you state, one of the benefits is the extreme unlikelihood of a large gap opening.  Such a gap is not impossible, but it's far less likely to occur than with individual stocks.  That's one good method for reducing risk.

4) I always say there is no 'best' strategy, but for what you are looking to do: protect assets from losses, increase profitability, and find a way to combine the good parts of various option techniques, I believe the collar fits the bill.

I've discussed the collar several times in the past, and will no doubt do so again.  Click here for a detailed example of a collar trade.

5) When I continue the series on 'beating the market: searching for answers,' the collar is the next strategy to be discussed.  One of the complaints that most people have about the collar is that it's costly – and using that strategy makes it almost impossible to beat the market. 

I'll take an up-to-the-minute look at collars and how difficult it is to make money using them.

6) Don – please send questions (and suggested topics for a blog post) and I'll do my best to provide a good answer.  It's not a problem.  That same request goes out to all readers of this blog.  If you have a question that's just too personal to post, send it by e-mail.

456

13 Responses to Options trading: Questions welcome

  1. Dave 09/22/2009 at 10:31 AM #

    Hi Mark,
    Is there a certain time of the day that theta is calculated? For example, I assume sometime late Fridays opening theta on Monday is established… Is is last hour? Minute by minute all day? Or?
    Thank you,
    -Dave

  2. Dave 09/22/2009 at 10:34 AM #

    I’m reading that question not liking it. Lets try: Is there generally a time of day that theta values of the next trading day come into play? Thanks!

  3. Mark Wolfinger 09/22/2009 at 10:59 AM #

    Dave,
    Theta is calculated and adjusted continuously. The computers that are used by the market makers to determine their bid/ask quotes always use current time.
    The theta formula requires that the number of time units remaining until expiration arrives be inserted into the equation. For LEAPS, a day makes little difference, so it’s reasonable to use the number of days in the formula.
    But, to be have more accurate calculations, one can use the number of minutes remaining until the options expire. As the minutes pass, the option’s theta is essentially unaffected – until we get closer and closer to expiration.
    To be even more precise, it’s okay to use the number of seconds to expiration – but that’s overkill. Some may use it during expiration week – but I have no idea.
    The answer to your question is that there is no such trigger point that moves the clock forward. Time is continuous. Of course, if the computer is programed in days (which I doubt is still used), then the time unit changes overnight.
    When you use a calculator, I have no clue how it’s programmed.

  4. Dave 09/22/2009 at 12:01 PM #

    So then is a purchase/ sell Friday afternoon a delta bet, or are prices “adjusted” for Monday via vega or..?

  5. Mark Wolfinger 09/22/2009 at 12:48 PM #

    Prices are adjusted if the market makers set their computers to accelerate the clock on Friday. Perhaps it runs at triple or quadruple speed on Fridays. I do not know. I am not involved with floor trading and have not been for 9 years. Much changed during that time.
    My guess is that there is no set algorithm. Everyone uses whatever his/her trading company deems appropriate. I truly have no insight.
    But selling options Friday afternoon with the intention of buying them back Monday morning and collecting the ‘free theta’ is not viable.
    My best answer to your question is that they are NOT adjusted for Monday, but they are set to a time later than Friday afternoon. How much later? Dunno.
    All naked buys and sells are a delta bet, and Friday afternoon is no different.

  6. NG 09/22/2009 at 1:08 PM #

    Hi Mark
    I always appreciate your simple and clear explanations on OPTION trading.
    Please help me out in this question:
    STOCK-CME-Price on 4 Sep 09 =$270.00
    CME Today=$310. A Gain of $40.00.
    OPTION-CMJ C JAN 190:
    Price on 4 Sep = $77.9
    Price Today=$122.00
    A Gain of $45.00
    As Per IVOLATITLITY.COM
    DELTA=.97
    VEGA=.14
    IV=54%
    PLease expalin the OPTUION price move.
    I expected the ITM OPTION to move $39.00,
    but it moved more then that.
    I am just wondering what role did the other two GREEKS played in this OPTION .
    I have not yet invested but am interested in buying may be TWO contracts.
    Thanks
    NG

  7. Mark Wolfinger 09/22/2009 at 2:03 PM #

    NG,
    I find this question to be so disturbing that I am devoting a whole post to the discussion. It covers important ground.
    The bottom line answer for now is that the other Greeks played no role and the prices you are using for the option are bad – inaccurate – prices.
    Your source, ivolatility.com is not a good source for option prices if these are the numbers you got from the,
    The full reply be published as quickly as I can get to it. But not before Thursday.

  8. NG 09/22/2009 at 10:10 PM #

    Hi Mark
    I will look forward to your reply.
    The OPTION prices are from TD Waterhouse where I have my account.
    IVOLATILITY.COM is where I got the GREEKS from.
    Please tell me what is a reliable sourrce for GREEKS.
    I noticed that TD Waterhouse OPTION chain , which also gives GREEK values don NOT agree with IVOLATILITY values.
    I hope you will touch on this issue of which GREEK values to follow AND USE.
    OPTION values are correct, bacause I prinT them every day so that I can do the type of analysis that I did and ask you this question.
    I am hoping to be educated where I have gone wrong.
    Thanks
    NG

  9. rluser 09/22/2009 at 10:13 PM #

    From my broker’s data it appears that on Sep 4 someone traded 12 of those calls at shorty before 10:13 a.m. EDT for 77.9. At that time the price of the underlying dropped from about 263 to 262.60. A few minutes before, 3 traded at 77.10. I don’t see that any other trades of that contract have been made in the past month. I just thought I’d throw that out there as food for thought (and I was interested in the data).

  10. Mark Wolfinger 09/22/2009 at 10:33 PM #

    NG:
    Right now, scheduled for Thursday, 9/24
    ivolatility.com is good for Greeks – but your broker is the best source. Why? Because they will show you the Greeks of your positions allowing you to measure risk.
    Greeks are not magic. Their purpose is to measure risk. That allows you to take steps to reduce that risk – but only if you want to do so.
    Greeks will differ when the volatility estimate used to make the calculations changes. I have no idea which source is using a ‘better’ volatility estimate and cannot tell you where to get good Greek numbers. Are the differences you so so large that it makes a difference in what you ant to do? Are you worried about a difference between 15.4 and 15.6?
    I cannot really tell you where to find more accurate Greeks because – when doing the calculations, you must estimate the future volatility of the stock, and I have no idea who makes the better estimate.
    If your data source uses the current implied volatility as the volatility value in the Black-Scholes equation, that’s probably best. You will have to ask your broker how they make the volatility estimate. I don’t know how they do it.
    The OPTION VALUES are NOT correct. Those values you gave me were BAD values. They were inaccurate. Guaranteed. That’s the entire reason why you had a problem.
    I’ll provide answers that I hope will help, but I took a harsh tone with you. I apologize in advance. I do not mean to offend you. But I am very disappointed.
    Take another look at that options value of 77.9 and see if you can figure out for yourself why that is NOT a valid value for the option – I don’t care what Ameritrade said.

  11. Mark Wolfinger 09/22/2009 at 10:37 PM #

    Ok,
    But the last trade is NEVER a good value to use when quoting the price of an option. It may be the price at which you can buy or sell the option, but that would be a random outcome.
    Please notice that NG gave the price of the option as 77.9 and the price of the stock as 270. That’s the problem.

  12. NG 09/23/2009 at 8:15 AM #

    Mark
    Thanks for your explanation.
    I can only tell you what I found.
    TD Waterhouse data for OPTIONS are my only source OPTION data.
    TD Waterhouse says the THOMPSON REUTER is the data source.
    I have noticed that some of the OTM- DELTA values varies by 80% between what TDW says and what IVOLATILITY.COM says.
    For CME – C OCT 360 -DELTA values are as follows
    TDW=.28, IVOLATILITY.COM=.09.
    I asked my broker about this discrepancy and they said that
    they cannot comment on IVOLATILITY.COM.
    They feel that TDW values are correct. The front line guy
    said that these values are calculated by complex formula and has no idea why these two sources differ so much.
    I am trying to learn from experts like you how best to adjust
    the RISK/ REWARD in CALL buy ,when I feel that stock may go up.
    I am looking forward to your indepth discussion
    of effect of IV and VEGA in option pricing.
    At the moment I just look at DELTA and IV to determine
    how much ITM CALL option to buy.
    I learnt that from you a while back, but still not quite sure
    how to use IV in my BUY decision.
    I remember you said earlier that HIGH IV is a risky situation
    and OTM CALL or PUT can misbehave i.e. go opposite to stock price movement.
    I am trying to use ITM option strategy.
    I will look forward to your sage advice in RISK /REWARD
    of ITM CALL/PUT buying.
    Thanks again.
    NG

  13. Mark Wolfinger 09/23/2009 at 8:52 AM #

    1) If you are buying calls with the intention of being naked long, there is nothing to adjust. You just own the calls in a manner equivalent to buying shres of stock. You can ignore the delta because buying very deep ITM alls is just like buing stock, but uses less cash and has less risk if the stock really tumbles. But if you want to own two of these calls, you don’t cae about delta.
    So my question is why so much emphasis on delta?
    2) If you want a hedged position, such as a call spread, that’s a different story and you never indicated that this was a consideration.
    I cannot devote this much time to replying to your questions in this space – where few people see it. It must be part of a main blog post. Thus, I am adding these questions to my original reply to you – and that will appear tomorrow morning.
    3) Just because there are sometimes complications when using OTM options DOES NOT MEAN that it’s a good idea to buy deep ITM options instead. That is not a valid conclusion.
    4) You want my sage advice on ITM PUT/CALL buying: Don’t do it. Only exception: if you want to own shares or sell them short.
    More tomorrow in a blog post. I hope you can understand why replying here – at the bottom of a string of comments – is not a fair use of my time.