Options Mentoring

cbc said:

Valued they can move around with nothing really setting them off at all.

I entered in a swing trade on XOM using opt and I brought in at 65c near the start of the day. XOM went down, then swung back up and was at roughly the same level near close and I went to close my option out thinking tis was going to be the same however the spread had moved down to 37c and I suffered quite a loss.

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There is something I don't understand here though. If the underlying was steady and you were still confident in the trade, why not just keep the option? I assume you were the buyer of the option and not the writer (quite honestly, I am not sure how writing options works and I don't want to do that at this stage anyway). Wouldn't you have saved money just exercising your option or keeping it if the underlying swing trade looks solid still?

That being said, if I was buying the option I would have much preferred to wait until the end of day and buy it at 37c than 65c in the morning. The 65c would have been factored into my risk and the trade would (imo) still be profitable, but it can only be more profitable if I could see an option dropping in price. Therefore, I see some merit in understanding options value so I know if I should wait until I buy it. That being said, if the premium price fits within my risk profile/cheaper than alternative or slightly more expensive but less risk than alternatives, I am going to be happy purchasing it even if it subsequently falls in value since I will just exercise it if my directional trade proves correct.

I am reading Options Pricing and Volatility by Sheldon Natenberg. I understand what the author is saying regarding long directional movements. You not only have to be right about the market direction but also about the market speed and that this is beyond most traders' capabilities. Therefore, I have to assess the costs of the option and various expiration dates with other instruments that might suit that particular trade better.

Valued said:

If the underlying moves 5% there is no way you can't be on a winning trade.

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If you have a option with 1 day left and strike is 6% away and underlying moves 5% and expires worthless you will be at a losing trade.

Play around with volatility and time against price movement you will easily find you can lose with a 5% move in your favor. Reverse could be true also, you can have a 5% price move against you and still be at a winning trade.

Valued said:

Am I missing something? Why don't people just exercise the options and get their full value? IS there some reason for this? Exception would be if your option is worth more on the market. Is it that I might just be getting a bad deal if it's priced too high?

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Exercising means you are giving up the time premium you paid extra for on top of the intrinsic premium. 99% of the time no one will do this, it is just giving away free money. There are only exceptional situations where options will get exercised early. You are missing the premium part.

Also not everyone has the capital to buy the underlying. If you are trading just 5 contracts of SPY options you will need around $90,000 to buy the shares. 5 contracts can be traded with just a few thousand dollars.

Valued said:

There is something I don't understand here though. If the underlying was steady and you were still confident in the trade, why not just keep the option? I assume you were the buyer of the option and not the writer (quite honestly, I am not sure how writing options works and I don't want to do that at this stage anyway). Wouldn't you have saved money just exercising your option or keeping it if the underlying swing trade looks solid still?

That being said, if I was buying the option I would have much preferred to wait until the end of day and buy it at 37c than 65c in the morning. Therefore, I see some merit in understanding options value so I know if I should wait until I buy it. That being said, if the premium price fits within my risk profile/cheaper than alternative or slightly more expensive but less risk than alternatives, I am going to be happy purchasing it even if it subsequently falls in value since I will just exercise it if my directional trade proves correct.

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If at the start of the day the option is 67c and you KNOW that the price is going to be sideways and KNOW at the end of the day it is going to be 37c then you have a holy grail that can see into the future ? I doubt it..no one knows without hindsight what the price is going to be later so it is unfair for you to say that, the price could go from 67c to $1.20 and you would be the loser for not buying it at 67c. You are talking hindsight. Also you will almost never save money exercising your option early, arbitrageours will make sure of that.

(quite honestly, I am not sure how writing options works and I don't want to do that at this stage anyway).

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Learn a bit how the writing side of the option works and many of your answers will be answered.

Yea, I get that if you pay less for an option far out of the money, there is less chance the underlying can move in your favour. I was thinking about options at the money/close to.

I will look into how time premiums work, thanks. I understand it might be better to sell an option that's in the money then go on to exercise it (unless it's almost expired!).

With exercising though, you shouldn't need the capital for ASX ETOs (this might be different for overseas markets etc though). I checked with Commsec and they said if you say buy a long put, for example, that if you bought the shares at the market then sold via your option right away, these would offset so you would be returned the difference or only up for the difference. I have an email of them saying this, I am just making them confirm it and asking them if it applies to calls as well (buy under the option then sell same day). For calls, somewhere down the line they would have to front me the money so I am not sure how keen they are on this - since the sale money would not have come in yet and I have to provide funds to the option writer. They might not care though if they can see both transactions.

As for the holy grail, I might think there is a good probability that the underlying will trade sideways for the rest of the day then it makes sense to understand how that might effect the option price e.g. if it is more likely to go up or down. Everything is based on probabilities. The holy grail is positive expected value. The issue is that the math is so complex that at least I can't work it out. Humans don't always need the math though. For example, you can catch a ball without knowing calculus.

Valued said:

Yea, I get that if you pay less for an option far out of the money, there is less chance the underlying can move in your favour. I was thinking about options at the money/close to.

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No. The price of an OTM has no influence on what the underlying will do, its the other way around. The stock will do what it will do and the options will follow at different rates depending on how far away from the underlying, time, and volatility.

You also need to understand the difference between the stocks volatility and the options implied volatility, as well as time decay rates. These play a big part in pricing.

beachlife said:

No. The price of an OTM has no influence on what the underlying will do, its the other way around. The stock will do what it will do and the options will follow at different rates depending on how far away from the underlying, time, and volatility.

You also need to understand the difference between the stocks volatility and the options implied volatility, as well as time decay rates. These play a big part in pricing.

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Sorry that's what I meant. I meant that if an option is far out of the money, any moves in the underlying won't really make a difference to it. I just read about delta in a book. I thought that before reading the book though. It's obvious - who is going to pay more for an option far OTM even if the underlying goes in the correct direction and therefore the delta will be very low.

I just worded it wrong. It just means the more OTM you are, the less chance the trade will go in your favour. I am not suggesting that options prices have any effect on the underlying! That would be silly. Options are a derivative. Of course a derivative cannot effect the price of an underlying (but I will say that the price of a derivative if marked up or down by market makers may indicate what they believe the underlying will do).

What I need to work on now is factoring in time value since I may be able to sell an option for more money than if I exercised it. I would assume if I wanted to buy an option though that's ATM or ITM I would want to be paying the least time premium possible and selling for the highest time premium possible. I will look into this next.

Valued said:

I may be able to sell an option for more money than if I exercised it.

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Yup,

Also, the risk / reward is the same no matter how far out of the money you go.