Hello “Mr NEW Mexico” (Wayne),
I bet your family back home can’t understand you with a Geraldton accent!
Now, you raise a lot of valid points:
Low IV:
Implied volatility is usually lower in Australia, around 15-20, some times lower, sometimes higher – this is certainly an important criteria to factor in to decide to go long a call or put, so agree here.
Significant move:
Why I chose a significant move is because it highlights the effect of a finer gradation in strikes. Certainly entering an OTM long option requires a sufficient move to make a good profit (although you can still make 30-100%with a more common move as long as you don’t go too far OTM and ride the IV favourably).
The idea is to look for patterns where you are expecting an explosive move, and position accordingly to capture significant profits (partly to offset the times you get it wrong and do 30%, 50% or even 100% losses, plus the spread slippages and brokerage you correctly refer to). You have to get 3 elements reasonably right – time frame, magnitude, and direction.
Implied Volatility:
Yes, IV is key. If it is too high, this effects your strategy options, hence you start to consider either ignoring the opportunity, finding a different instrument, looking at credit spreads (like bull puts or bear calls for instance). But it also requires analysing the IV history, and projecting IV pretty much as you project stock movements, although the logic is different (as you know). I try to project what is likely to happen in tandem with the underlying, and especially how it will affect the chosen strategy. In fact, I have been known to spend more time working through the volatility scenarios than I did on the underlying chart.
Position Size:
Excellent point Wayne (MNM). You are right, you have to balance the position size with the risk, take into account the likely slippage and transaction costs, work out the probability of success, and look at the ramifications if you get it wrong (as well as if you get it right of course too).
When I trade this kind of high risk trade, I accept I may make significant losses (up to 100%). But if I can make higher returns from a sufficient number of successful trades, enough to counteract the costs and losses, I’m ahead. But this is still a work in progress, and far from a proven methodology – it will probably take me another 2-3 years to fully develop it. It is not for newbies, that’s for sure.
One point here is that the further OTM you go, the more time you should consider buying if long. You can play diagonal/calendar strategies here sometimes to help fund the position by selling at the same strike if conservative, or strike or two towards the money if more agressive in the current month (aiming to sell the most premium possible, usually with around 30 days to maximise theta decay in the sold position). Again not for newbies, but works nicely in an orderly trending underlying.
Contest Risk:
Can’t say I really understand this. I didn’t think the transaction costs were that great in the Australian market when the contract size is 10 times that in the states (1000 vs 100). This also has a marked advantage for the Australian market.
As for theta decay, the rules are straight forward. If long look to exit by the time the option is hitting 30 days (exception is to hang on when you bought OTM and it is deeply ITM – the theta decay and time value are often then a negligible component – one trick is to exit partial positions to lock in profit, say half, one third, or if conservative two thirds).
If short, try to sell with under 45 days time value and above 20 days if possible, also looking for IV skews in your favour.
Another trick in the book is to also enter a bull put or bear call at the same time as the single series long option – but only if you’re really sure it will either go sideways or in your direction, otherwise your exposure is much higher. The idea is that if your OTM position does nothing for a month, the credit spread helped to negate the theta decay, and finance holding onto the long option If still confident of a move (if not wind it out on the trading plan criteria – time, stop loss, profit stop, or partial /complete exit). The risk though is you get it really wrong, but at least your risk is limited in both cases.
Gamma:
Do you really use this a lot independently from all the other variables? I don’t, it just factors in with my model, so I know what things are likely to look like within a range, based on price action and time (includes forecasting IV too by the way). Gamma just helps to calculate how quickly the delta will change if your position moves in or out of the money, doesn’t it?
Significant moves in actuality:
Yes, if the underlying does move substantially in the direction you think it will, in the time you think it will, OTM positions really rake in the big profits, and this is really the challenge with this style of trading – time, direction, magnitude (and correct forecasting of IV).
What tickles my fancy???
Many things Wayne. I’m not a “satisfiser” by nature, but a “maximiser”. The ultimate objective is quite complex actually (funny, no one has asked me that for a long time), but in trading involves longer term targets, job satisfaction (I actually get a kick out of what I do), I like being able to recognise my errors and correct them (ala Soros), but it’s certainly nice to be right sometimes (which is probably universally true for everyone).
How about you?
Hope your lactic acid build up abated!
Regards
Magdoran