The option trader s guide to probability volatility and timing phần 6 pdf

When assessing the option trading possibilities for agiven security, you must decide if you want to pursue a direc-tional strategy or a neutral strategy.. Conversely,there may be times w

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of their option-trading knowledge This is unfortunate, given themyriad possibilities available to the savvy trader The trader whocan examine a situation and decide which strategy will maxi-mize the opportunity is the trader who stands the greatestchance of real success in the long run.

The Two Key Elements in Selecting a Trading Strategy

Appendix A contains an outline of my PROVEST Option ing Method, which incorporates five key elements to aid in tradeselection In the following chapters on strategy, all the relevantcriteria for a given strategy are discussed For now, however, our

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goal is to simplify the option-trading process When you boil itall down, there are two key elements that a trader must considerwhen choosing the proper trading strategy for a given situation.One of those elements is volatility As discussed in detail,volatility is an extremely important consideration because thelevel of volatility for a security at a particular point in time tellsyou whether the options on that security are cheap, expensive, orsomewhere in between With this information, you will be able

to decide whether you are better off buying premium or sellingpremium at this moment

The other key element is a trader’s own opinion on price rection When assessing the option trading possibilities for agiven security, you must decide if you want to pursue a direc-tional strategy or a neutral strategy If you are definitely bullish

di-or bearish on a given security, you will want to pursue a tional strategy You can then look at volatility for a clue as towhether you should be buying or writing options Conversely,there may be times when you expect a given security to remainwithin a particular price range for some period, and thus may de-cide to pursue a neutral trading strategy Again, volatility pro-vides the clue as to whether option buying or option writing isthe best course of action

direc-Table 11.1 and the information presented in Chapters 12through 19 are designed to help traders decide which strategy touse and how best to execute the strategy

Table 11.1 Trading Strategy Matrix

Low Volatility High Volatility

Directional bias Buy a naked call or put (Chapter 12) Sell a vertical spread

(Chapter 16) Buy a backspread (Chapter 13) Sell a naked put

(Chapter 17)

Neutral bias Buy a calendar spread (Chapter 14) Write a covered call

(Chapter 18) Buy a long straddle (Chapter 15) Enter a butterfly spread

(Chapter 19)

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Trading Strategy Matrix

The trading strategies to be discussed in the following chaptersare categorized based on two key variables: whether the tradebenefits from neutral or directional price action, and whetherthe strategy is best initiated when implied volatility is high orlow

To use Table 11.1, first you must decide if you are bullish,bearish, or neutral on a given security Next, assess the currentlevel of implied volatility for the security in question Finally,look at Table 11.1 to determine which strategies make the mostsense, given your answers

To show how you could use this table, consider the followingscenario Based on some technical analysis, you expect a givenstock to rise in price Since you are definitely bullish on thestock you will want to employ a directional trading strategy.Your next step is to assess the current relative volatility rank forthat stock to determine if volatility is currently high or low Ifyou find that the relative volatility is at the low end of the spec-trum, you see in the trading strategy matrix that the best choices

in the “directional bias, low volatility” box are to buy a nakedcall or put or to buy a backspread Assuming that your bullish as-sessment proves to be correct, these are the two strategies youshould consider to maximize your profitability

Overview of Trading Strategy Chapters

Chapter 12, Buy a Naked Option

Chapter 13, Buy a Backspread

Chapter 14, Buy a Calendar Spread

Chapter 15, Buy a Straddle

Chapter 16, Sell a Vertical Spread

Chapter 17, Sell a Naked Put

Chapter 18, Write a Covered Call

Chapter 19, Enter a Butterfly Spread

Chapters 12 through 19 discuss in detail one of the tradingstrategies that appears in the trading strategy matrix presented in

Overview of Trading Strategy Guides 133

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Table 11.1 Each trading strategy chapter contains a discussion ofthe strategy’s primary purpose and the key factors involved inmaking the strategy work on a regular basis Each chapter alsoincludes an example trade For each example trade you will findone or more of the following features:

• Graph of underlying price action A bar chart depicting the

type of market action to look for when considering a givenstrategy is included to help you visualize the type of situa-tion in which a given strategy should be used (Figure 11.1)

• Graph of option volatility A graph of the implied option

volatility for the highlighted security is included to help youvisualize whether volatility should be high or low for you toconsider using a given trading strategy (Figure 11.2)

• Option price grid A grid of option prices for the underlying

security is included, with the option or options used in theexample trade highlighted, to help you visualize the proxim-ity to the at-the-money option and the expiration month(s)relative to the nearest expiration month (Table 11.2)

• Risk curve graph Each chapter includes a graph displaying

the risk curves for the example trade to help you visualizewhat the underlying security must do for the example trade

Figure 11.1 A buy puts signal for JDS Uniphase on February 6

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Table 11.2 America Online Option Price Grid

Figure 11.2 Toys “R” Us Implied Volatility

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to make money It also helps you visualize the worst-casescenario for the trade in question (Figure 11.3).

• Position-management considerations Getting into a trade is

often the easy part It can be more difficult to decide underwhat circumstances you should exit the trade Each strategychapter contains a discussion of the most important position-management considerations for the selected trading strategy

in general, and the example trade specifically

As discussed in each strategy chapter, the key elements volved in using any strategy successfully are

in-• When to consider using the strategy

• When to enter a trade using the strategy

• When to exit with a profit

• When to exit with a loss

• Profit-taking and loss-cutting guidelines Specific guidelines

are set for each example trade for determining when to exitthe trade Specific rules are set for exiting with a profit andexiting with a loss The trade exit criteria presented in eachchapter are not intended to serve as hard-and-fast rules but asguidelines to help you understand the importance and po-tential benefits of planning for the various contingencies as-sociated with each strategy

% Move Required: –12.0%

Figure 11.3 Reader’s Digest buy straddle risk curves

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• The end result of the example trade Each example is carried

through to exit to help you see how the position-managementcriteria set forth when the trade was entered eventuallycaused the trade to be exited

NOTE

The guidelines set forth in the following strategy chapters are not presented

as the only way to use a given trading strategy In reality there is no single bestway to trade options However, instead of attempting to enumerate the differ-ent ways in which a given strategy might be used, the goal here is to show youone specific method executed from start to finish

Over the years it has been observed that traders who follow a structured,disciplined approach to trading generally have a great deal more successthan traders who make it up as they go along or who follow one set of rulesone time and a different set the next time A set of specific trading rules doesnot always generate the maximum profit from a given trade or series oftrades However, objective trading rules can keep a trader from making themajor mistakes that tend to doom traders who rely on gut feelings

Whether you use the guidelines set forth in each strategy chapter or velop your own set of guidelines is not important What matters is that yougain an understanding of the importance of setting objective entry and exitcriteria on an ongoing basis In the long run, doing so gives you your best op-portunity to succeed

de-Overview of Trading Strategy Guides 137

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2 Low option volatility is a plus.

3 Enough delta and time remain until expiration to minimizetime decay

The strategy of buying a naked option is strictly a play on ket timing If your timing is good, you have the opportunity toleverage your gains by buying a call or put option rather thansimply buying or selling short the underlying security In fact,the only reason to consider buying a naked call or put option isthat you expect a significant price movement by the underlyingsecurity within a specific time frame Please note, however, thatalthough market timing is a key element in implementing this

mar-strategy, it is not the only important factor.

The primary mistakes traders make when buying calls andputs are

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• Relying solely on market timing to trade options

• Always buying out-of-the-money options hoping for the bigscore

• Buying options when implied volatility is high

• Buying options with little time left until expiration

Poor timing, time decay, and a decline in implied option volatility are the greatest enemies of option buyers.

Poor timing will undo a naked long call or put position everytime If you buy a call option and the underlying security de-clines significantly in price and does not rebound, you will in-variably suffer a loss The same will happen if you buy a putoption and the price of the underlying security advances sharplyand does not pull back Therefore, it is imperative that you buynaked calls and puts only when you have a solid reason for be-lieving that the underlying security is going to move in a partic-ular direction

Time decay can eat away a large portion of the option mium you pay if the underlying security fails to make the ex-pected move within a relatively short period If you buy anoption whose price contains a great deal of time premium andvolatility subsequently declines, the time premium built intothe price of your option will decline, thus requiring an evengreater move by the underlying to compensate If your markettiming is right, you may occasionally be able to get away withbuying high-priced (i.e., high-volatility) options However, if youbuy out-of-the-money options often enough when volatility ishigh, the odds will invariably catch up with you

pre-In the long run it is critical to minimize the potentially negative effects of time decay.

To put the odds in your favor when buying naked options,use the following rules:

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• Buy naked options only when you expect a significant pricemovement.

• Purchase options with a delta of 50 or more (for calls) and adelta of –50 or less (for puts)

• The lower the implied volatility, the better Lower volatilitymeans less time premium However, this does not mean thatyou should never buy options if volatility is high Rather, thehigher the implied volatility, the further in the money andthe shorter term the option you buy should be This mini-mizes the amount of time premium you pay and reducesyour exposure to time decay and a sharp decline in volatility

• Buy options with at least 30 days (and preferably more) untilexpiration

Following these rules will greatly improve your odds of success

in the long run

Two key elements to look for when selecting option trades are

buy-naked-1 Some catalyst to make you believe that a large price move isimminent

2 A way to take advantage of the expected move without beinghurt by time decay or a decline in volatility after the trade isentered

Market timing is discussed in Chapter 8 For no other egy is timing more important than when buying a naked call orput The specific timing method used may vary from trader totrader

strat-Regardless of which timing method you use, there is no reason ever to buy a naked call or put option if you do not have some objective grounds for believing that the underlying security is about to make a significant move in price Also, buying naked options when implied volatility

is low increases your probability of profit by allowing you

to buy cheap options.

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Buying naked options when volatility is low gives yougreater upside potential, as well as the opportunity to profitshould option volatility increase in the near future becausehigher implied volatility translates into higher option prices Ifvolatility is high, you must take steps to minimize the amount

of time premium you pay

One use of options is to pick tops and bottoms while limitingyour risk to a predetermined amount Because of the limited-riskaspect of buying options, you can make a bet on a market top orbottom and simultaneously limit your risk to the amount youpay for the option if your timing turns out to be wrong

Near the far right of the graph in Figure 12.1 is a solid downarrow on February 6, which indicates that a mechanical tradingsystem has generated a signal to buy puts on JDS Uniphase (sym-bol: JDSU) In Figure 12.2, you can see that option volatility forJDSU options is neither extremely high nor extremely low Nev-ertheless, with a relative volatility rank of 6, we know that theoptions are not cheap and that if we buy puts and volatilityfalls sharply, the price of the option could be adversely affected.Table 12.1 shows that the choices are to buy a March optionwith 39 days until expiration, a June option with 130 days, or aSeptember option with 221 days The February options will suf-fer the most from time decay since they expire the soonest

Figure 12.1 A buy puts signal for JDS Uniphase on February 6

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However, the time premium in the longer-dated options couldcollapse if volatility levels fall With the relative volatility rank

at 6, there is definitely room for volatility to fall A sharp decline

in volatility would cause the June and September options to lose

a great deal of time premium This combination of factorssuggests that buying an in-the-money March option and selling

it ahead of the last two weeks before option expiration is thebest play This limits the amount of time premium paid up frontand thus limits the amount by which time decay can hurt thisposition

With current option volatility in the middle of its historicalrange, Figure 12.2 shows a current relative volatility rank of 6 If

we buy options here, we hope that volatility will rise, thus flating the price of the option However, we must also recognizethat a sharp drop in volatility is a possibility

in-Table 12.1 shows that the March 65 put has a delta of –72.This means that this option will move 0.72 points for every onepoint move in the underlying stock This value also indicatesthat there is approximately a 72% probability that this optionwill be in the money—and thus retain some intrinsic value—atthe time of March expiration Most importantly, this option has

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only 1.69 points of time premium built into it For a put optionthis amount is calculated as follows:

Current stock price – (strike price minus option price) OR

51.81 – (65 – 14.88) =51.81 – 50.12 = 1.69

Table 12.1 JDS Uniphase Puts: Priority Is to Minimize Effects of Time Decay and a Decline

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