Chapter 9: Options

"An option can get bigger than its original size if all goes well for the trader. It can also melt with predictability." Phantom of the Pits

Options trading presents many more possibilities to vary your trading plan than do just futures, bonds or stocks. There are as many ways to trade a position or scenario as there are ideas, it seems. Phantom uses options for various reasons, as do most traders who understand them.

The purpose of this chapter is to give insight to all traders and not to narrow the insight just to the experts. There is much to be learned about trading options, and good research is needed to become properly prepared in trading them. Keep an open mind as to what the market can present on both sides of the ledger.

Art Simpson (ALS): Phantom, I know you don't see or do as most traders when it comes to options trading. How can we better understand the proper trading of options?

Phantom of the Pits (POP): Most traders know what options are and how they work. I view them as ice cubes, which can either melt or get larger when the water around them also freezes. When water freezes, it will take up more volume than the water did in the original state. An option can get bigger than its original size if all goes well for the trader. It can also melt with predictability.

I like to weigh each of my option positions against a futures contract. By this, I mean that each position or combination of positions has a weight. To impress upon you my view, let us use a balancing scale. You know the kind I mean -- one that has a platform on each side of a balance indicator. Put an ice cube in the glass of water, and I consider the weight of the ice cube as a call that has been purchased. I consider the weight of the water as a put that has been sold.

Regardless of how large the ice cube (long call) or how much water is left (short put), the total weight of that glass will remain the same. The ice cube can become larger when the temperature drops below 32 degrees, and the water becomes reduced liquid.

It is the same with the call and the put. They can and will change size. I call the size of each ice cube the delta and also the amount of water a delta. Any time you add the long call delta and the short put delta at the same strike price you will get 100 in theory, excluding the interest rate factor, volatility and time element.

Using this as a rule of thumb for our understanding, we will assume positive 100% delta in this case. You can consider the opposite as negative 100% delta -- the ice cube as a call sold and the glass of water as a put bought.

On the other side of the balancing scale you will have an equal futures position of some size and bias that will equal the option side and balances the scales. Your glass of water with an ice cube (long call, short put at same strike) is equal to short one contract of the futures you are trading. You will remain balanced and have no risk as long as this position is in place. We call this a conversion. The option side of the scale is the synthetic future. You would be either long or short a synthetic future, which can be offset with an opposite futures contract.

Pretty simple at this point. You start to throw variables in, and it changes dramatically. Each glass is going to be a different size, depending on the strike price. In other words, even though the delta of our initial position will be 100%, regardless of strike price, the size of the glass will be different. I consider the size of the glass as the value of the water and ice cube added together. It will be different at different strike prices. The delta remains at100%.

You may be getting into this description and even a little ahead of me. If you have had geometry, you can have some good fun with this approach.

We can now think of throwing out the futures contract but still wanting to balance the scale! We put on the other side of the scale the opposite option position, and we still have our balanced position. But guess what? What we have really done is to offset our position, and no position exists on either side of the balanced scale. We can only make money in certain situations, but we must know what we can do to move our position around when required.

Now we get into the ifs. There is no limit to what we can do -- almost no limit, I should say. What we want to do is to come up with a plan to make money in almost any situation. We must also find a way to include Rules 1 and 2.

We discover we can balance the scale by using different strike prices and not just the same strike price. We also can tilt the scale to one side and leave it biased to the long or short side. Pretty simple still.

Now add a balanced scale on each side of the existing balanced scale. You have three balanced scales to work with. You can add four more balanced scales to the last two on each side. You see, you now have the possibility of each of the balanced scales giving you an opportunity to move positions around but still keeping it balanced. It becomes trickier with each set of balanced scales you place in use. You can even add as many balanced scales as you wish, but you are out of control trying to stay balanced. This is what happens to some option positions not well thought out.

I hope I didn't confuse anyone with the balanced scales and ice cubes, but it is critical to understand what each move can do to your overall position. My option model is a combination of balanced scales as data input to the program, which determines what each variable will do to my position. You can make money when you know how to use volatility, time decay and price movement. The criteria research becomes a little more intense and expanded.

Without getting into specific programs, we'll discuss the fact there are certain option positions that work with my rules. Extensive options understanding is beyond the scope of what I am trying to teach you. I only want to show you how you can incorporate options trading into a good method of trading while using Rules 1 and 2 to protect your drawdown.

ALS: I know you use vectors, weights, volumes and angles as part of your computer program to establish criteria of balance as well as the usual research of option evaluation. I also know you developed your own evaluation of options' worth, which is different from most programs. Is it because you don't want to play someone else's game?

POP: It's like a basketball, which retains the same shape but has a different bounce when the pressure changes. Same with options. I consider an option evaluation in a bull market different than in a bear market. The market just considers the volatility different. It is how you can best work with options.

If I gave you a notice that from now on we would consider bearish options and bullish options and not just change the volatility to fit the price, you could better understand what is expected of your trade instead of guessing the changing volatility every day. This has all been debated before, and we aren't going to change what is believed to be the best method. In fact, sometimes when you are trading with a different view, you are better off.

I am going to explore some option possibilities that use Rule 1 to start. Because we are going to assume we are wrong until proven correct in options also, we will put a fairly protected position on to start. Let us say we have a bull market started as we see from our criteria platform. Okay but we could be wrong so we will not go long an option. We will instead put on a bull spread. A bull spread is buying a lower strike and selling a higher strike price. This leaves Rule 1 in use.

Options experts are going to say we only put a smaller options position on. Yes, that is correct for the purpose of requiring the market to prove us correct. Let us say we bought a 1000 strike when the future was at 990 and we sold a 1010 strike just for an example.

If we had bought a 1000 call outright, we would have paid more for the call than we would by also selling a 1010 strike. We have limited our potential loss at this point to the debit we paid out. Let us say we had a debit of 3. An outright call bought without the bull spread would have cost us, say, 5. We have already started to use Rule 1 by reducing our possible loss to 3. Our maximum loss is 3 at any time.

What can now happen? Three things can happen. One of them isn't going to happen as the price never remains the same very long. So prices are going up or down. What else can happen to our position? We can lose time value as the ice cube melts, and we can lose volatility as the interest in trading falls.

We have used Rule 1 so we are slightly protected from time decay because we don't have as large of a position as we could have with an outright call. We are also slightly protected form falling volatility because we are not with as large a position as we could have had with an outright call.

Okay, but the experts are saying we did all this at the expense of potential profit. Yes, indeed, right again. But isn't Rule 1 to keep our losses as small as we can? Isn't the name of the game to stay in the game forever? Yes, so we need Rule 2 to make our money!

Rule 2 actually works better in options than futures. The main reason is that volatility can increase and decrease. With futures, sure, the market may go limit up or down, but options move that value as expected and then some extra because of what the experts call volatility changes. I call it changes form liquid to solid! Water freezes with higher volume as a solid.

At any time you are not risking more than 3 in our example and you are long a 1000 call and short a 1010 call (bull spread.) Let us say that our criteria for being correct is that the market moves at least 15 points. So at 1005 we accept being correct at this price.

We will make our position larger at this point. How? We have many option possibilities but the best option is to buy a higher strike than where our current position is due to the increase in volatility. We want a delta (position size) that can more than double. A delta of 50, 60, 75 can only go to 100. A lower delta gives us a possible double plus, triple plus, etc. Also we are risking less equity.

Okay, we buy a 1020 strike for example purposes. Let us say we pay 6 for it due to increased volatility. So what do we risk now? We risk our original 3 but, because of volatility increase and price movement, we have a value of, let us say, 6 on our original bull spread. Okay, because we paid 6 for the 1020 strike we still have only 3 at risk or do we? We have a value of 6 (1000/1010 bull spread value) + 6 (1020 call purchase price) or a value of 12 and have only paid out 3+6 or 9. We show a profit of 3 at this point and can work with our Rule 1 and have no additional risk on our position by using criteria here forward, which protects us from negative drawdown. To do this we remain alert to be swift and use Rule 1 properly. We don't know this position is okay yet. We have also used Rule 2 here by adding.

The values of these moves will depend on time remaining and volatility changes but, for example purposes of using Rules 1 and 2, we won't consider those variables at this time. After two weeks we have a move to say 1030. We are flagged that it is time to reverse. What do we do now?

Now comes the interesting part in options. Most traders want to take their profits. But we are using Rule 2 again here. We must press our position, and the market looks like a reversal. We don't take our profits but decide to set up our payday. We do this by selling another 1010 call. This leaves us with a bull spread and a bear spread with 3 strike prices. In fact, we could call this a butterfly.

We sell the 1010 call at 20 due to increased volatility again. Okay, so what do we have at risk in the trade. We paid 3 for the first bull spread of 1000 long call and short 1010 call plus we paid 6 for the 1020 call. But, wait, we sold the last 1010 call at 20. That means we have -3+(-6)= -9 paid out and +20 received. We are up 11 points. Okay, the experts say you could have had more if we had just offset the positions. Okay, so we're bad! We still have 367% profit so far. That isn't bad, is it?

Two weeks later the market is at option expiration and the price of futures is at 1009. Oh, darn, we forgot our butterfly position! Well, let us salvage what we can!

What is the butterfly worth now? The answer is 9. Okay, so we offset it and take commission charges or we don't offset it and let it offset by our exercising the 1000 call. In the end, by leaving the butterfly on, we set up a payday provided the market was within 1000-1020 at expiration. We made anywhere from 11 to 21 (depending on where the butterfly is offset) on the trade.We made the 11 from the sale of the 1010 call and anywhere from 0 to 10, depending on where the butterfly is offset. Don't take all your profits but let leverage work for you in options.

Our maximum risk was our original 3 and never more, using Rule 1 correctly in options by having a limited risk. We also added to our position and used Rule 2. But, wait, there is more! Once we put the second short call on to establish the butterfly, we were never going to lose anything because we bought our butterfly by being given 11 to take the total trade of four options over the range of movement. Two options long at 1000 and 1020 strikes and short two options at 1010 strike for a butterfly legged into. In other words, as soon as we neutralized or balanced the scales on each side, we could never lose.

The experts again say, "What if the market had gone to 980 instead of up to 1005 and then 1030?" Well, we would have lost 3. So what kind of ratio did we set up for our trade in options? Risk 3 to gain 20 equals 6.6:1 (slightly less with commission and depending on where the market price established itself at expiration).

ALS: It looks easy. Is that all there is to it?

POP: I don't want anyone to think it is that easy because you must be aware of what is required in exercising options and the effects of increased volatility and decreased volatility. This is a start to give you the desire to learn more about options.

One of the big keys in options is the hidden secret of putting on no-risk or low-risk trades and working the positions into a no-risk trade with the potential of a big payday toward expiration. If you are to trade butterflies, you must learn that the proper time to buy them outright is with a long time out when the liquidity may not always be good to put them on. You can often put them on with bull spreads and then a bear spread. Commission costs are a concern if you are at a full brokerage. You must figure all of the costs to reduce the ratio of payout.

ALS: Do you want to go into some other strategies?

POP: Let us put this on the back burner and see what the traders want?

ALS: Okay.

NOTE: There are so many good books on options trading and, because it was not the purpose to show different strategies here, we will leave you to further research. The main point Phantom wanted to make is that you can and should incorporate Rules 1 and 2 in options trading as well as futures only trading.

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