Stock Trader Moving into Options

Hi Mark,

I am a longtime stock trader, but over the past couple months, I have taken a real liking to the options game. Your blog has been a huge help in understanding many of the aspects I've been reading about.

So I was wondering a couple things:

1. I notice you trade RUT. What it is about this index that draws you to it? And a more general question is, what do you look for in a stock or index for IC/credit spread trades?

2. What are your thoughts on a strangle comprised of an out-of-the-money call spread and an out-of-the-money put spread, both bought in large lots at low delta, say .20-.25 per spread, both puts and calls? 

[See reply for comment on the word 'delta'.  It should be 'cost']

As long as I am confident of movement in the life of the options, one of the spreads will pay for the other, especially if one moves ITM… If the stock tends to swing, both sides can be closed for a nice profit.

Today's (Jul 16, 2010) hammering of the financial sector and the market in general, has made this very tempting, especially ahead of earnings.

I also own a 25 lot, low delta Jan 11 VXX call spread to hedge my portfolio, and it seems to be working okay as the spread moved from .70 to .85-.90. Is there anything I'm overlooking with this strategy?

I have not seen much advice online about using debit spreads to put on a strangle position, so I get the impression it is not used by many traders.

[Once again, 'strangle' is not the term you want to use]

My thought process is that buying a spread with ~ 25 delta and selling for $0.40 or .50 is like buying a $25 stock (albeit one that expires) and having it rally to $40 or $50, even though the underlying stock is only moving a dollar or two.

3. I am currently long PG Oct 60 calls. I paid ~ 2.50 on a market dip and when PG rallied three points, I sold Aug 60 calls for ~ 2.50 and plan to take advantage of time decay and exit both as a calendar spread. I may get a chance to buy to close the Aug 60 calls for a song, and still be long my Oct 60 calls.

Good move or is there something I'm overlooking? I am slightly worried that someone will exercise the August calls for the upcoming dividend, and am tempted to take my profit on the spread if there is a high risk of that.

Any advice or critiques would be most welcome. At this stage, my comfort zone is being long either naked options (giving me the option to leg into an instantly profitable debit spread, or sell to close) or debit spreads.

Andy

 
***

Welcome to the options world Andy. 

1) Regarding RUT: I prefer to trade European style options because they settle in cash.  I'd prefer SPX options, but trading those is inefficient for me.  

I don't trade stocks.  My requirement would be 'plenty of strikes' – and that eliminates all mid-priced stocks

 

2) I must
correct an error in terminology.  We must speak the same
language to communicate.

You are writing about low cost spreads, not low delta spreads. [Delta is the rate at which an option's price changes when the underlying stock moves one point].  Spreads can have 'low delta' but I see from your continuation that you are referring to spreads that are low priced.

Correct: If you get a big enough move and if you get it quickly enough, you can earn a nice profit.
To get a profit from both sides, you need a pretty good-sized swing. Plus, you must have a good knack for exiting one side at an opportune time. Double profit is a rare bonus.  Don't think about it. The game is to win on one side.

I have nothing against that strategy in principle. However, I take exactly the opposite position in my trading.

I sell those credit spreads (that's an iron condor position, not a strangle) and hope to profit from lack of movement, time passage, or shrinkage in implied volatility. In reality we can both win when taking opposite sides of the same trade – depending on how adjustments are handled and on our timing of trades.  However, I obviously prefer my side to yours – but I am NOT suggesting that you change.  You are okay preferring your side.  Our results depend on how well we handle position risk.

I am not paying enough attention to VIX and VXX to give a good answer and don't want to say the wrong thing. But VXX is much better to trade than VIX. In addition, you have it right. A down market should result in an increase in the implied volatility of the options, and that moves VXX higher.  When VXX is higher, your spread should gain value.

You have not seen much advice online about 'using debit spreads to put on a strangle.' That's because you have the terminology wrong (no big deal).

A strangle consists of naked options (long or short), not spreads. The position you are describing is the iron condor, and not a strangle. The iron condor is VERY popular.



Buying a spread @ $0.25 and selling @ $0.40 is similar to trading penny stocks and paying 25 cents and selling at 40 cents.  It's not like a $25 stock and a $40 stock.


3. Your PG plan is viable.

But you must know this: calendar spreads get narrower (lose money) when the stock runs away from the strike price in either direction.

In my opinion, it's easier to take your profit by selling the Oct option, but selling the August call does give you a position with the opportunity (that's all it is) to earn extra profit.


I suggest you consider an alternative when you own a profitable trade.

First, do you still want to remain long this option at the current price level for the stock? If no, sell the option, take your larger profit and move on. If yes, then it's okay to do as you suggest and find a hedge.

But know this: You are not locking in an instant profit. This is a common misconception.

You are taking your own personal money, the profit you already earned, and reinvesting it into the call spread – when you could have sold and kept the entire profit. When you exit, the cash belongs to no one but you (and the IRS).

When you hedge the trade – even at a wonderful price – you do not have an INSTANT PROFIT.  You earned that profit.  So decide:

  • Sell and take the money
  • Reinvest part of it into a a new, hedged trade

In other words, do as you suggest – ONLY when you believe the new position (in this case a calendar spread) is the place to invest your cash.

Enjoy your options.

744

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10 Responses to Stock Trader Moving into Options

  1. Logan 07/20/2010 at 3:54 PM #

    Ive always done front month trades. Havent done too bad. I wait for extended swings before placing positions which causes me to sit out more often but fits my comfort zone better.
    Ive been thinking about ways to reduce potential risk further and looking into going longer terms. Ive noticed you prefer 3 month out and often end up closing down earlier.
    What are your thoughts about using 20 or even 30 point spreads rather than 10 in this type of situation? Would allow an even lower delta and I would think could be considered a more conservative approach? Good idea or no?

  2. Mark Wolfinger 07/20/2010 at 6:26 PM #

    Logan,
    A very good idea.
    Think of a 30-point IC as three connected 10-point iron condors.
    In other words, it is a 10-pointer, then another with less delta and less cash credit and then a third with even less.
    It is more conservative, unless you do as many 30-pointers as you would do 10-pointers.
    Certain premium levels (too low) may dictate that 20-points is all you can do and that 30-wide is not a good choice. But that will vary over time.
    It is a very good idea for people who understand position size and risk.

  3. Andy 07/20/2010 at 8:08 PM #

    Hi Mark,
    I’m actually using the blog this time. 🙂
    I thought about it and closed out the PG spread. It made more sense to just take profit and then if it swings down again, to simply buy the lows.
    I have trouble thinking in terms of $.25, since the multiplier for options is usually times 100 (I have told my broker to bid $25 instead of 25 cents MANY times so far). But yeah, can be like trading penny stocks (except the stocks are actually GOOD ones and/or ones I actually want to trade! lol).
    I do not like the premiums as far as buying VIX calls, even for vertical spreads (the puts are surprisingly cheap…I guess that will change when the VIX goes up, when they will be far more attractive?). I actually added to my portfolio hedge for the above VXX spread today when I was able to get a 10-lot for $.60 on a large dip, figuring it can act as an additional hedge if volatility shoots up or quick profit if VXX stalls around 28-29. I am wondering though, for this type of vertical play (where it is more a volatility swing trade than a hedge), would the September VXX 29/32 or similar bull call spread be better to use, due to the higher theta on the outer calls? As long as I’m bullish of a rise in volatility in the near future (and I am), I would think that the spread would benefit from both the time decay and the rise in volatility. With the Jan spread, there is more time for the rise to happen, but almost no theta benefit. I opted for the Jan spread because I’m not yet comfortable holding a near-term out of the money debit spread.
    Last question: Is it wise to sell credit spreads ahead of earnings? From what I’ve gathered, options have a tendency to increase in value before a large event, then experience a sudden drop. I saw this with some Citigroup calls I own (watched them gain and then shed about 10 points with little price movement…when it dropped after earnings announcement, it went down farther than I thought they would).
    Best regards and thanks for the replies.
    Andy

  4. Logan 07/20/2010 at 8:48 PM #

    Mark,
    Thanks for your reply and confirmation.
    I think since I’ve always been a front month guy I’m having trouble getting my head around the ideal longer term trade.
    For example. If I wanted to trade a 30 point put spread on Rut right now at say 530 I could collect around a buck 60 at a 5% delta. If I went out to Oct I could collect around $3.30 at a 15 Delta.
    Heres where I get cloudy with my thinking. My initial thought is to go as far out as possible (strike) on the longer term and then my rational thought tells me to stay in normal range, collect higher premium with idea that adjustment will take place when market retracts prior to expire. So based on this I shouldnt be looking as if I am holding 3 months out.
    Second issue is thinking 3 months out at same strike level should be 3 times front month credit not 2 times although I know this wont be.
    What factors do you consider when you determine your strike? Do you look at is as though you will be adjusting/closing much earlier and play assumed ranges, consider delta, or something else?

  5. Logan 07/20/2010 at 10:29 PM #

    Last question: Forgot to add.
    I’ve always legged in each side on the front months based on market movement. But thought I read somewhere that this can actually work against you on 90 days and out IC trades and better to place call and put side together. Have you found this to be true?

  6. Mark Wolfinger 07/21/2010 at 10:20 AM #

    Andy,
    VIX puts are a wager that VIX levels will decrease. That happens when the market rallies or when investors get complacent.
    Thus, buying VIX puts is a bullish play. VIX can be very confusing. The main problem – the underlying is not spot VIX. It is VIX futures.
    I recommend avoiding VIX options – unless you take the time to truly know what you are trading.
    You are wrong about VIX calls. They increase in price when a higher volatility environment is anticipated. VIX calls move higher in down markets. These calls will not become more attractive to buy when VIX moves higher.
    VXX is a better vehicle to trade. But please be careful. These products may not be what you think they are.
    VXX calls are a ‘hedge’ when you own a portfolio that loses money in a market decline. That decline should be accompanied by an increase in VXX, but this type of hedge is not guaranteed to work.
    You have the earnings picture correct. Options prices climb prior to the news and then deflate after the news. However – you miss one point: News is released. If that news is a surprise, the stock can make a big move. That means you can take a large loss in the credit spread, despite the fact that you sold it when IV was high and get to cover when IV is lower. The move can be substantial. That’s why the options are priced high.
    You can play ‘earnings’ this way, just keep size reduced because risk and reward are increased. Size: that’s your key risk management tool.

  7. Mark Wolfinger 07/21/2010 at 10:30 AM #

    Logan,
    There is no reason to believe you can do better by legging.
    This is crucial: The longer-term options have wider bid/ask spreads, making it far more efficient to enter spread orders than single orders.
    Even when you get the direction right, it may do you no good. Longer term options change price more slowly than near-term.
    When you leg by buying a call, a rising market will reduce IV, making it very difficult to get a good price for the call you want to sell. Obviously, legging by buying a put first does not have this problem.
    In general, legging into spreads with options that have wide bid ask spreads is a nightmare. You have to be very right to make a small amount of extra money and I believe risk/reward precludes trying this.

  8. Mark Wolfinger 07/21/2010 at 10:45 AM #

    Logan,
    1) I share what I do. I NEVER encourage anyone to trade that way. I am more comfortable with longer-term options. That does not mean it’s a good idea for you or any other readers.
    Front-month is okay. Higher risk and higher reward is a viable way to play, when it suits your style.
    2) Option premium is proportional to the square root of time. Thus, you can expect a four month (week) option to have twice the time premium as a one month(week) option.
    3) Again, my methods suit me. I mention them as something for readers to consider – not to blindly adopt. When choosing the strike, I look at the delta and must be comfortable with that level. Low teens works for me, but single digits would be better.
    I look at premium. I sell as far OTM as possible to collect that premium. For me, it’s about $300 for a 3-month iron condor. Sure, I’ll take less. And if the delta makes me uncomfortable, I move farther OTM and take even less.
    If I don’t like the 3-month premium, I open a 2-month iron condor, looking to collect ~$220.
    I do not trade knowing I will close early. I hope to do so because it greatly reduces risk (and reward). Exiting three weeks early makes my delta less that the option’s true delta (because expiration arrives sooner).
    I assume no ranges and adjust as necessary. At times I own insurance and make few or no adjustments.
    I know this is not a scientific plan. Traders can do better with greater effort and a willingness to devote lots of time practicing trading, perhaps studying charts, carefully going over details trade records from your trading journal. That’s all good for the professional trader. It’s all part of the job.
    Most of my readers are not professionals and are looking for ways to manage risk. I try to speak to that audience.

  9. Logan 07/21/2010 at 11:05 AM #

    Thanks for info. Very interesting. It seems a greater influence is level of volatility at time of trade rather than level of market.
    Just to clarify. I may have used wrong terminology. By legging in I meant putting on the call spread and put spread at different times, not legging into the buy and sell side of the spread itself. So for instance placing the call spread when the market has run up a bit and waiting on the put spread until market sells off a bit.
    Is this approach advantageous or no on a 3 month plus? Thanks again

  10. Mark Wolfinger 07/21/2010 at 11:16 AM #

    Logan,
    My mistake. I should have realized what you meant by legging.
    Sill, legging into puts first – anticipating a rally often get you very little extra cash. Call spreads just do not increase in value as anticipated. That’s because IV decreases.
    For three-month iron condors, IMHO it is not worthwhile.
    Too little to gain. Unless you are VERY GOOD at market timing.
    Regards