# What am I missing...



## rowes (9 January 2007)

Hi all,

I have a questions regarding options vs stocks in a specific scenario.

If i found a stock that i was interested in and it had been in a steady downwards trend and all the reversal signals where there like maybe a morning star pattern confirmed by another strong buying day and my indicators were where i wanted them and everything looked great, instead of taking a position and buying 1000 of the stock in question what if i bought 1 call option contract ATM (or close to it). I wouldn't be expecting to hold the position typically for any longer than say 2 weeks. If i treated it as i would my stock position with my stop loss in place and was prepared to close it out as usall should things not go my way what would be the major downsides that i would need to considor.
How much emphasis would i need to place on the greeks if i was to only be holding a position (unless i decide to excersise it) for a short time before time decay really set in.
I'm sure i am probably missing some very important points and would appreciate any advice.


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## ducati916 (9 January 2007)

*rowes*



> _instead of taking a position and buying 1000 of the stock in question what if i bought 1 call option contract ATM (or close to it). I wouldn't be expecting to hold the position typically for any longer than say 2 weeks. If i treated it as i would my stock position with my stop loss in place and was prepared to close it out as usall should things not go my way what would be the major downsides that i would need to considor.
> How much emphasis would i need to place on the greeks if i was to only be holding a position (unless i decide to excersise it) for a short time before time decay really set in._




When you trade Options instead of Stock, immediately you have additional considerations [risks] 

Each greek [theoretically] defines and quantifies these additional risks and considerations.
With stock you have generally directional risk. With Options you take on;
*volatility
*time
*interest or cost of carry
*direction

You need to consider all of them. If you don't, pound to a pinch of salt, that's the one that will get you.

jog on
d998


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## rowes (9 January 2007)

Thanks for the reply ducati916

Volatility - this would be taken into consideration when setting my stops.
Time - the time decay shouldn't factor too much, i wouldn't hold the contract for long enough (under the assumption i the contract would be 1 or 2 months and i only had it for say 2 weeks) i would be taking the approach same as i would with my stock position, if its not doing as expected, close out and move on to something that has a higher probability of doing so.
Direction - this would hopefully be going the way i anticipate... 

Not sure what you are refering to with - Interest or cost of carry, is this relating to the premium i would pay up front?


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## cuttlefish (9 January 2007)

rowes - I'd concur with ducati.  I'm an options 'novice' but traded them a bit last year as a learning exercise.  I tried the strategy that you've spoken of with TLS using long dated calls.  Its worked but only becuase there's been a good reversal.  

A couple of comments:

* the trading strategy you're speaking of is a difficult one to exercise as you're trying to catch the proverbial 'falling knife'.   The reversal will rarely happen in a text book like fashion, such that even if you do pick it it might take a little longer to play out than expected in which case theta will get you.  Alternately if you wait until there's a very definite confirmation then you'll find that the IV's and directional premium in the options have risen and the stock will need to rise considerably before you start to see a corresponding leveraged return worthy of the options risk.  

If you pick the reversal early enough then in theory your strategy should work - the stock is in a steady downtrend so IV should be fairly low, so you're not paying too much for volatility.  Upon reversal the IV's should rise thus inflating the premiums even if the price doesn't rise that significantly and then as it goes up you're away with delta and gamma taking over - then just be careful to close out your position quickly before the theta decay takes away your profit.

I've had a go at the strategy you're speaking of with TLS last year.  Its worked out however I missed the timing the first time and so lost out on that position. Second time around I went for longer dated options to give more time for the reversal to occur and am profitable across both positions - however I was still surprised how long it took for the IV's and theta to rise after the reversal, and then as the expiry date approaches for some of them the theta decay is starting to battle the delta from the price rises (and I've started closing out the nearer dated positions).

The other tricky part is that in most stocks the only liquid series are one or two months out so you're into having to battle with the market makers if you go for longer dated options - thus I paid full price premium I believe for my long dated calls (9 months and 18 months out).

I would strongly recommend having a go at options trading with some money you can afford to lose as a way of really starting to understand how they work - its one of those one's where the theory just doesn't register until tried in practise (from my perspective this is how it was anyway).

I'm not yet convinced of their worth as a way of doing synthetic equity trades in the underlying - in particular because of the lack of liquidity - in a liquid market I would see more value in using them.


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## ducati916 (9 January 2007)

rowes said:
			
		

> Thanks for the reply ducati916
> 
> Volatility - this would be taken into consideration when setting my stops.
> Time - the time decay shouldn't factor too much, i wouldn't hold the contract for long enough (under the assumption i the contract would be 1 or 2 months and i only had it for say 2 weeks) i would be taking the approach same as i would with my stock position, if its not doing as expected, close out and move on to something that has a higher probability of doing so.
> ...






> _Volatility - this would be taken into consideration when setting my stops._




Well with volatility we have;
*Actualised volatility
*Implied Volatility
*Future Volatility

Each one will give a completely different set of values for your greeks.
How you select your volatility, can scupper your trade, even if you get the direction correct. You *may* require high gamma, and bleed to death on theta. There are any number of fascinating permutations.



> _Time - the time decay shouldn't factor too much, i wouldn't hold the contract for long enough (under the assumption i the contract would be 1 or 2 months and i only had it for say 2 weeks)_




theta can kill your trade if you need it, and have priced it incorrectly. This I am sure is a graveyard of many a retail options trader.



> _Direction - this would *hopefully* be going the way i anticipate... _




I hate seeing that..................*word*



> _Not sure what you are refering to with - Interest or cost of carry, is this relating to the premium i would pay up front_




You most certainly will be paying for it, and, although the least important of the greeks, rho, may still hurt your position if there are news releases during your holding period, and how interest rate sensitive the security is.

jog on
d998


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## rowes (9 January 2007)

Thanks Cuttlefish & ducati916

I was sure it wouldn't be that easy just didn't know why.
all taking on board. Maybe a good idea for me would be when i take a trade simultaniously take a option contract (on paper) and monitor what effects happen and when

Options sure are fasinating, back to the books!!


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## rowes (9 January 2007)

Oh one more thing...

you's will probably think this is a stupid question but i have to ask...

if the stock i bought was at say $7.00 and i closed out of my contract when the stock price hit $8.50 are you saying that more than likely my premium wouldn't be worth $1.50 intrinsic value and maybe alittle more extra for time on top (if i had plenty of time left)


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## cuttlefish (9 January 2007)

It would have some time premium - but also if it were in a steady downtrend and reversed by that amount in a relatively short period of time ($7 to $8.50) then the volatility premium in the options would rise as well - so you would benefit from both scenario's - as long as you picked the reversal before those two factors were already built into the premium you paid.

If the stock is in a downtrend but is a volatile stock then you're premiums will be quite high compared to a low volatilty downtrending stock.

Just as a quick comparison I looked at two similarly priced stocks.

TAH price 17.24  cost of a FEb 17.00 call  spread is .50 and .62
ZFX price 16.70  cost of a FEB 16.50 call  spread is 1.21 and 1.36

Note the massive difference in premium for basically a similarly priced option - both 20c in the money - underlyings are similar order of magnitude price wise and the expiry date is the same - the difference is the implied volatility (as I understand it)  - ZFX is a much more erratically moving stock than TAH.  Also interesting to note that TAH has been in a short term uptrend while ZFX has been in a short term downtrend. Both are up by about the same amount in cent terms today.

Make a mistake on that volatility factor (e.g. if implied volatility drops) there goes your premium without the price even having to move much at all. If IV's on ZFX dropped rapidly then the premium would dissappear - IV's can drop quite quickly over the space of a few days or weeks (and conversely can rise quickly).


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## rowes (9 January 2007)

Wow,

Big differences, I see what you mean about the volatility, ZFX gaps and jumps all over the show as opposed to TAH

The difference in pricing, does this also somehow take into account that ZFX stochastics is in the way oversold area pherhaps indicating that a reversal may not be far away and the TAH is just steadily cruising along mid range or is that kind of thing irelevant to the pricing structure of the contracts?


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## cuttlefish (9 January 2007)

no the puts have pretty much the same premium for the same distance from the money.

e.g. ZFX feb 17.00 puts (30c in the money at time of viewing) spread is 1.18 and 1.30.


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## rowes (9 January 2007)

Oh,

blows that theory then. 
thanks for your help.
Back to the ol books!!


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## cuttlefish (9 January 2007)

Just having another look - ZFX price is now 16.90 - 20c more than the last call spread I gave.


So at   16.70 the Feb 16.50 call spread was 1.21 - 1.36
Now at 16.90 the Feb 16.50 call spread is    1.34 - 150.5

Usually you can split the spread a little but this situation helps to demonstrate how the lack of liquidity and reliance on the market makers pricing makes it difficult to make money on simple options trades.

If you had bought at the sell price of 1.36 when the price was 16.70 and now at 16.90 wanted to sell you would take out the bottom bid price which is 1.34.   So the underlying has RISEN by 20c but you would make a 2c LOSS on selling based on the spread.  The other thing to note is that the bid price has only risen by 13c even though the underlying has risen by 20c.

Its usually possible to split the spread a little, particularly if the stock is moving against the position you want to take, but if its moving in favour (e.g. you want to chase a rise) then its unlikely.  Similarly if you want to exit a position because of a stop loss trigger you'll be in a situation where its unlikelly you'll be able to split the spread much because the price of the underlying will be moving against you.  (e.g. if you ZFX was falling and you were trying to exit a call position due to stop loss trigger its unlikely you would get a better bid than the current bottom spread bid because the bidders know the underlying stock price is falling).

Note also that most of the time the spread is being set by a market maker and not fellow traders because of the lack of liquidity in most options series.


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## Magdoran (11 January 2007)

rowes said:
			
		

> Hi all,
> 
> I have a questions regarding options vs stocks in a specific scenario.
> 
> ...



Hello rowes,


Beware, options are considerably more involved than most beginners realise.  I tend to recommend that people either paper trade for 12 months, or trade very small positions to learn how to trade options.

Options are very powerful when used correctly, but a thorough knowledge in both theory and practice is required.  They are also lethal and great ways to lose money when you don’t know what you’re doing, so please be careful.

Buying a call option sounds easy.  But at what strike price, with which expiry month, and at what volatility, and how liquid, how long is the trade, and how wide a spread in the bid and the ask will you accept???

Then you have to work out the best risk to reward strategy based on your view of the market, what your position size will be, and what conditions constitute failure (loss) and how you will deal with this situation if it arises.  Then you also need to determine how to take profits…

Key things you need to know for single strike positions:

Theta Decay - Around 80% of theta decay occurs in the last 30 days eating away the “time value”.  You need to be able to evaluate which strike is appropriate based on your view of the market.

Volatility - Often market makers will bolster the premium (increase the volatility) of calls when the underlying is volatile, more often with down moves.  Hence sometimes the right time to enter is not on the reversal day.  You need to understand how volatility works, both in entering and exiting.  I don’t know how often newbies pay up on a reversal and pay exorbitant prices, only to see the stock inch up for a couple of days and the value of the option collapse from volatility crush. Vega measures how volatility effects different stikes.

Delta – You need to understand how the option moves in relation to the underlying as a ratio, you also need to understand that this changes and is measured by Gamma.  

This is critical in calculating if it is worth entering a position given there is a market maker spread to enter and exit, and that you often will have to buy at a slightly higher price than fair value, and sell at a discounted price to fair value… there is much more to this.

Also, part of the game is to determine the probabilities for success and failure, as much as determine the static risk and reward.  This is often overlooked by newbies.

I suggest you read through the extensive threads on this topic which should answer the majority of your questions.

Look up WayneL, Sails, and myself and see all the posts we’ve made on options, and read through the various threads in the derivative forum.  You’d be surprised at the broad range of topics we’ve covered.

Another point:  If you really want to use these instruments, get all the books we’ve recommended on the various threads, and read them thoroughly.  Don’t try to do this alone either.  Find a mentor to help guide you.  The practice of options trading takes time to learn too.  You may also consider getting good options software to help calculate the best options too – personally without this kind of tool it’s like being a caveman in skins pitted against well equipped modern people.

If you want to trade the way you describe, my general rule for such positions is to work out the magnitude I would expect out of the move, the maximum time I think I could be in the position, and buy with sufficient time to exit before 30 days till expiry if still OTM without the prospect of moving ITM (there are some exceptions of course).  I’d look to have the strike finish either ATM or ITM within my projected time frame and price target.

As for volatility, Id look at the movement of the stock and the movement of volatility both, for a call in this case (you may consider using puts at some stage), and in different time frames.  To buy a long call I’d prefer the volatility to be in the bottom third, preferably quarter of the recent range in the time frame I’m working in.  If IV is high, I might consider a bull put or a bull call spread instead, depending on how strong a move I was expecting.  

Of course if I thought a strong move was imminent, I’d calculate the probable IV crush and work out if the best strategy with the best mix of probability of success and risk and reward to determine if an options position was worthwhile or not.


OK, there is a lot more than this, this is the tip of the iceberg, but hopefully (hello Ducatti!!! Hehe) addresses some of your questions.  Please do read ALL the threads on options on this site, there are some real gems embedded here.

Good Luck!!


Regards


Magdoran


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## tech/a (11 January 2007)

Hi Moggy have a good 2007? dont see you round much?


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## Magdoran (11 January 2007)

tech/a said:
			
		

> Hi Moggy have a good 2007? dont see you round much?



Hello tech,

Hope you had a nice festive season.  I was actually in Adelaide over part of the break and spent a nice time around Glenelg.  Quite relaxing.  First time I’ve been in Adelaide for years now.  Nice city.

Almost thought of looking you up, and finding a tennis court and play a friendly game of doubles (I’m really rusty now, and prefer to play a more “civilised” game of doubles now…).

I noticed you posted a kind of farewell on a thread recently to great fanfare…  I’ve just been busy with a few things, and have been focussed on trading recently there has been such a “smorgasborg” of opportunities.  

I’ve also refined some ratio diagonal techniques for playing counter trends.  Very effective, but a bit tricky even for me to fully master and execute effectively.  Using the cycle T/A I managed to enter on the day of an impulse low and ratio on the impulse high, then buy back the profit hedge around the counter trend low… etc.  I actually locked in some very nice hedges.

Hence I’ve been busy with that and working on a few things, and will probably remain focussed on this for a while…

How about you?  I thought you were off the scene for a while?


Regards


Magdoran


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## lesm (11 January 2007)

Hi mags,

Good to see you  back. Thought you may have been on holiday.

Very well presented and informative post as usual.

Sure that you will get on top of your refinements in due course.

Cheers


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## Magdoran (11 January 2007)

lesm said:
			
		

> Hi mags,
> 
> Good to see you  back. Thought you may have been on holiday.
> 
> ...



Hello Les,

How are you?  Hope you had a nice break!

Thanks, although it’s a bit ramshackle in the structure and language.  I was up late working on some charts and strategies, and just typed it like a flow of consciousness…

Refinements are in play as we speak, just waiting for the right time now.  Love this market!


Regards


Magdoran


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## sails (11 January 2007)

Magdoran said:
			
		

> ...I’ve also refined some ratio diagonal techniques for playing counter trends.  Very effective, but a bit tricky even for me to fully master and execute effectively.  Using the cycle T/A I managed to enter on the day of an impulse low and ratio on the impulse high, then buy back the profit hedge around the counter trend low… etc.  I actually locked in some very nice hedges....



Hi Mag, welcome back and well done on the trade!  Always happy to help if you need a second opinion, LOL (apparently our MM's have been known to lurk here - so best to pm!)


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