From the May 01, 2009 issue of Futures Magazine • Subscribe!

Learning to use options in trading

Using options and their ability to establish positions with a known risk is a good idea, but there is a catch-22. Beginner and less capitalized traders can benefit from options, but understanding them requires a more in-depth knowledge of markets and volatility than held by many beginners. Options actually can create greater risk if employed incorrectly, so education is key.

An option gives its holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before its expiration date. There are two types of options: a call, which gives the holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call is in-the-money when its strike price is less than the underlying price, at-the-money when the strike price equals the price of the underlying and out-of-the-money when the strike price is greater than the underlying. The reverse is true for puts. When you buy an option, your level of loss is limited to the option’s price, or premium. When you sell an option, your risk of loss is unlimited.

Options can be used to hedge an existing position, initiate a directional play or, in the case of certain spread strategies, make a bet on the direction of volatility. Through options you can calibrate the exact risk you take in a position. The risk depends on strike selection, volatility and time value. So-called “Greeks” are used to measure the various parameters of the value of an option (see “Going Greek”).

One primary use for options is risk management.

“The most popular hedging position involves purchasing a put to protect a long futures or equity position. This allows traders to maintain their initial position in the underlying while still protecting themselves against significant downside exposure,” says Mark Longo of The Options Insider.com.

Traders also can initiate options positions with exact profit/loss parameters. “You can establish a position with predetermined risk parameters and capital at risk and a defined reward profile. You know based on different movements in the [underlying] what your expected outcome’s going to be,” says Peter Bottini, executive vice president of trading at optionsXpress.

George Ruhana, CEO of OptionsHouse, says that one way to do risk management is through a stock replacement strategy — instead of buying stock, you buy the option.

As with trading any instrument, you want to know as much as you can about the structure of options and how they work. Brokers offer educational tools and there are online resources available through the Options Industry Council and various equity options and futures exchanges.

You need to learn how options work. “No one should trade options without understanding the mechanics of them,” says Alan Grigoletto, senior VP of business development for the Boston Options Exchange. Grigoletto says that signing off on the risk and disclosure document from your broker is not enough. He suggests taking a free seminar, keeping a diary of your trades and sticking to your trading plan. “You don’t want to be a deer in the headlights when it comes time to make a decision.

Know what you want to do in all of the circumstances,” he says.

Options News Network instructor Kevin Cook says, “Start small and keep the risk low while you continue the education process.”

Grigoletto points out that when you’re a buyer of an option, you’re always fighting against time decay because you have x amount of time before an option expires, and the stock has to move either upward if you’re long a call or downward if you’re long a put. “Within that time frame you need to be right. Conversely, for the sellers of options, that hourglass works in your favor,” he says.

While various studies have shown the tendency for a high percentage of options to expire out of the money, there is a reason traders pay a premium for a known risk. Any new trader should develop a solid understanding of options before attempting to sell “naked” options.

Cook says that new options traders should stick to buying options. “You should only buy options or buy debit spreads until you gain more experience. Option spreads are an excellent way to build knowledge and experience with selling options. And it gives you the opportunity to sell options with very defined and limited risk. Once you have gained solid experience with buying debit spreads, you can venture into selling credit spreads,” he says.

VOLATILITY BITES

The value of an option is based on its intrinsic and time value. A $10 call on a stock trading at $20 has $10 worth of intrinsic value. The more time before expiration, the more time value. This is measured by volatility. Volatility is a major factor in options pricing. The higher the volatility, the greater likelihood the underlying could rise or fall.

“As volatility goes up, it slants how you want to implement your strategy. In a high volatility environment, the cost of buying puts is very high,” Bottini says, adding that in a high volatility environment, more traders use spreads to implement their strategies rather than just buying outright options, which is cost prohibitive.

“[Beginners] are not going to outsmart the market on volatility. Most retail investors are doing some variation of a directional trade. The higher the volatility is, the higher the premium in the options are,” Ruhana says.

Volatility comes in two forms: historical and implied. Cook explains that you can measure risk by looking at historical or implied volatility. “Historical volatility tells you how much the underlying moved over a certain time period. Implied volatility is the volatility that options prices indicate is actually trading in the market,” he says.

“For example, if historical volatility is 40% and produces an option model fair value of $5, if the option is actually trading for $6, that tells us that the implied volatility is much higher, say 45-50% depending also on underlying price, strike price, and time to expiration. This means an expectation of higher future volatility is priced into this option,” Cook says.

Grigoletto says that the current high volatility means you need bigger moves to offset the costs of higher premium.

Longo says that a solid understanding of volatility is what separates professional options traders from novices. “A solid understanding of volatility, and how it impacts options prices, is crucial if a novice trader wants to advance beyond simple options strategies,” he says.

Basic guidelines such as allocating a certain amount of risk capital per trade and sticking with predefined parameters also apply to options. There are some specific traps to look out for as well.

The “lottery ticket” scenario, buying far out-of-the-money calls to speculate on the direction of a stock, is a common mistake among new options traders. These options appear cheaper, but they’re cheap for a reason. “[Traders] have to understand the probability of how much that stock’s going to move in the time period,” Grigoletto says. “Neophyte option trader[s] make directional bets on where they think the stock is going to go and if it doesn’t go their way they lose the premium and they get discouraged by that,” he says.

Cook says by buying only out-of-the-money options because they appear cheaper, investors “miss the great opportunities and risk/reward benefits of in-the-money options.”

Longo agrees that the lottery ticket scenario is probably the most common rookie mistake. “Beginner options traders should probably avoid out-of-the-money options altogether. They are cheaper because they tend to expire worthless. If beginners avoid loading up on cheap out-of-the-money options, they will save themselves a lot of money,” he says.

One common refrain of inexperienced options traders is, “the market went in my direction but I still lost money.” These traders probably miscalculated the Greeks.

The further out of the money an option is, the greater a move is needed to have any effect on price. You can buy far out-of-the-money options only if you understand precisely what type of move is needed in the specified time to profit (see “Options Strategy,” Futures, February 2009).

Options allow you to reduce your risk and enter positions with clearly defined risk/reward parameters. Learning how and why options move is important so that you never are surprised at how an option is valued.

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