Showing posts with label option- strategies-builder. Show all posts
Showing posts with label option- strategies-builder. Show all posts

OPTION STRATEGIES PART - 2

OPTION STRATEGIES PART - 2



We will examine four market outlooks with trading strategies corresponding to each:

Bullish -  The expectation of an increase in price. This category has two subcategories:


* Moderately bullish-Although the outlook is for higher prices, the increase is not likely to be dramatic.

* Extremely bullish  - Expecting a dramatic, explosive increase in price (generally anticipated to occur in the short term)

Bearish -  The expectation of a decrease in price. This category has two subcategories :


* Moderately bearish - Although the outlook is for lower prices, the decrease is not likely to be dramatic.

* Extremely bearish - Expecting a dramatic sell-off in the stock (generally anticipated to occur in the short term)

* Neutral (front spread) - Expecting little price movement over a given time period. Neutral strategies enable the trader to make money in a market where prices remain the same or move little.

* Volatile (back spread) - The anticipation that prices will move dramatically, but the direction of that move is not clear.


Our goal in separating our discussion of strategies into the four general categories of bullish, bearish, neutral, and volatile is to provide our readers (after determining your market outlook) with a reference for the potential strategies. This chapter will also discuss risk-reduction strategies for managing an existing stock portfolio.

Spreads


A number of these strategies involve option spreads. You construct a spread by being long an option(s) and being short an option(s) of the same type in the same underlying asset. For example, buying a call and selling another call with a different strike or a different expiration is a spread. Buying a put and selling another put with either a different strike or a different expiration is also a spread. In contrast, buying a call and either buying or selling a put is not a spread. 




Spreads offer the investor an array of strategies for attempting to benefit from almost any anticipated market condition while reducing risk. For example, you can use a spread to take a bull position or a bear position, for selling high volatility and buying low volatility, or to finance the purchase of other options. The degree of risk reduction varies among the different types of spreads. While some spreads have limited risk, others have risks that are comparable to buying the underlying security outright. There are several different types of spreads:


1. Calendar spread (in other words, a time or horizontal spread)-With this type of spread, all options are of the same type and have the same strike price and underlying asset, yet they have different expiration dates. The purchase (sale) of one option has a different expiration date from the sale (purchase) of another. Buying one XYZ March 85 call, for example, and selling one XYZ February 85 call would be a calendar spread.


2. Diagonal spreads-This kind of spread is similar to the time spread in that the options are of the same type and underlying asset; however, the expiration date and the strike prices are different. This time spread uses different strike prices. Buying one XYZ March 90 call and selling one XYZ February 85 call is an example of a diagonal spread.


3. Vertical spread-A vertical spread consists of options of the same type, on the same underlying asset, and with the same expiration date, but these options have different strike prices. Buying one XYZ May 90 put and selling one XYZ May 85 put is an example of a vertical spread.


4. Ratio spreads-A ratio spread is any of these types of spreads in which the number of options purchased differs from the number of options sold. Buying one XYZ July 90 call and selling two XYZ July 95 calls is an example of a ratio spread.

Legging

Several strategies involve three or more options strikes. As a practical matter, you cannot put on these positions simultaneously at reasonable prices. In order to achieve these positions at prices that produce an acceptable risk/reward profile, you must put on the positions in a series of separate trades. This process is called legging. Although the analysis of these specific positions includes a discussion of how to approach legging, we should give you some general comments concerning legging at this point. Until a position is fully legged into, your ability to complete the position at an acceptable price is subject to the risk of changing prices in the positions that you have not yet executed. The key to legging is knowing which order to execute the trades in order to minimize that risk.


To minimize this risk, we look at the supply and demand factor of each building block in the options strategy. Once we determine the supply and demand for each building block, the trader can leg into the position first from the building block that has the most demand and finish the implementation with the building block that has the most supply. This procedure is called legging the hard side first. The hard side is the trade that is the most difficult to put on. If the stock is rising rapidly in price and the trader wishes to purchase the stock, because the stock is rising, this side is considered the demand side.


The demand side refers to what the majority of traders are doing, whether buying or selling. If a stock is rising quickly, we would say that there is demand for the stock-hence, there would be more buyers than sellers. Selling the stock would be easy; because there are many buyers. We would then call this side the supply side. Because buying the stock in a rising market situation is difficult (getting a good price is difficult because of the high demand), we call this side the hard side.Consider the following example of legging the hard side


first. Assume that you are legging into a covered call in which the stock price is rising. Realizing that it will be harder to purchase the stock at a good price than it will be to sell the call, you should buy stock as the first part of the leg. Selling the call would be the easier of the two sides to fill, because the rising price of the stock should increase the demand for the call. If the trader decides to sell the call first in a rising market, he or she is taking the chance that he or she might not be filled on the stock at his or her price.

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When a trader puts on a leg and cannot complete the rest of the position because the price for remaining legs has become unacceptable, the trader is said to be legged out. He or she now has a position that has gone against him or her, and it will be hard to close it without incurring a loss. Some of the option positions that we cover in this book can only be legged into. Do not even bother calling your broker with any fancy spread terminology such as a butterfly or iron butterfly: The market makers on the trading floor will just laugh your broker right out of the trading pit. There is no market maker in the world who will hand over free money, especially to a customer.


Bullish Strategies

Bullish strategies are among the most common strategies that individual investors use, probably resulting from the general view of the market that we acquire through the media and elsewhere is that rising stock prices are good, and falling stock prices are bad. In actuality, your position relative to that market movement-not the movement itself-is either good or bad for you. For example, if you position benefits from a declining market and the market does decline, that is good, while if instead it rallied, that would be bad. Most investors, then, are programmed to buy low and sell high. 



These are bullish investors who want to gain a profit from a rise in value or stock price. In fact, when investors tend to think of bullish strategies, the only thing that typically pops into their head is to purchase stock. To be sure, this strategy is great when the stock rises in price, but when a hefty sum of the investor's capital is committed to the position, this endeavor can be risky: In other words, while long stock purchase is not necessarily the wrong idea, it can be capital intensive and can create risk parameters that the individual investor might not totally understand. 


In this topic, we will show alternatives to purchasing stock, learn how to reduce market directional risk and capital exposure, and discuss the relevance of leverage. The first bullish strategy we will consider is long stock. Because long stock is the most commonly employed strategy and the one with which most traders are familiar, it will offer a good comparison study against the other bullish strategies described in this topic.


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OPTION STRATEGIES

OPTION STRATEGIES



Options allow the investor to sculpt the returns in their portfolio. When you buy a stock and the price rises $1, you make $1. You lose $1 if the price declines $1. Your profits are linear and directly related to only the change in the price of the stock. Interest and dividends will make a slight change to the outcome though these factors are also linear. Options blow apart this linearity. Options are called convex instruments because the returns are not linear but curved. We saw that in the previous chapters. You can literally create millions of possible returns through the use of options. You can mix and match options to create just about any return possible.
 

Selecting a strategy is a multi step process. You should go through a systematic process before initiating a trade. Each step should lead to further refinement of the strategy. It can be very dangerous to your bank account to disregard some or all of the major factors that affect options prices. The most important factor that affects option prices is the price of the underlying instrument. But that is usually not the only thing that most investors look at. Only looking at the underlying instrument price can lead to significant losses for the investor. This strategy assumes that the edge that the investor has in stock selection is so superior that he can withstand a lot of headwinds caused by trading an option or options that have a lot of edges against him.
 

For example, what if the investor is buying a near dated call on U.S. Widget? But what if the options is overvalued and there is little gamma and the time decay is large. Here are three strikes against the investor. I have seen situations where the investor got the direction of the underlying instrument correct but all the other factors wrong and lost money on the trade. I am reminded of the old admonishment—don’t try this at home, kids. Options have a tremendous amount of power but also a lot of risk. So the design of your strategy should be the most important thing in your arsenal. You need to develop a particular frame of mind to trade options. You need to think multidimensional when you trade options. You must now think about time because options expire and the returns change over time.


 You need to think in terms of distance. By this I mean you must now consider how far the underlying instrument will move. For example, you may buy an out-of-the-money call that expires in three weeks. This means that you must expect the UI to rally at least up to the break-even point by expiration. This is very different from just owning the UI where you are expecting the UI to rally but you don’t need to put a time limit on it. Options require you to consider not only the fact that the underlying instrument will rally but how much and how quickly that rally will occur.


This chapter contains tables that show the main strategies that are the most suitable. One problem with a book like this is that it must, by necessity, simplify. For example, long straddles are usually considered neutral strategies, but they can actually be constructed with a market bias. The tables in this chapter generally refer to strategies as they are usually considered.


OPTION CREATIVITY


The strategies in this book are generally presented in their plain vanilla form. Yet the very nature of options gives greater scope to the creative strategist. For example, one of the interesting aspects of options is that you can combine strategies to create even more attractive opportunities. You could write a straddle and buy an underlying instrument to create a lower break even than by holding the instrument alone or to create greater profits if prices stagnate, but give up some of the upside potential. You should be able to examine a myriad of fascinating strategies after reading this book.


 Another feature of options is the ability to twist the expiration and strike prices to fit your outlook. For example, a straddle is constructed by buying a put and a call with the same strike price. That is the plain vanilla. But you can change the strike prices by, say, buying an out-of-the-money put and an out-of-the-money call and create what is called a strangle. Or why not buy the call for nearby expiration but the put for far expiration? The net effect is that you have a tremendous tool in options for creating exciting trading opportunities. Do not get stuck in the ordinary.


TRADE OFFS


Of course, the selection of any strategy involves trade offs. For every one factor that you gain, you will likely give up another. The choice of one strategy over another largely depends on your personal expectations of the future of the market. For example, you may believe that implied volatility is going to go higher. Any strategy that is long implied volatility is going to be hurt by time decay. You are assuming that implied volatility will increase quickly and strongly enough to offset the drain on your position due to time decay.



CONSTRUCTING A STRATEGY

 





There are three main ways to construct a strategy:

1. Use software to filter for different strategies using different criteria.
 
2. Use a building blocks approach.
 
3. Use tables such as the ones in this chapter.
 
We will focus on the latter two. However, we will need to use software to build our strategies using the building blocks approach. The table approach is a rule of thumb or back of the envelope approach.


BUILDING A STRATEGY


There are two major techniques to identifying an appropriate strategy:

1. Identify your ideas on the major factors that affect options prices, that is, the greeks. You will need to look at such factors as market opinion, volatility, and time decay. You will then be able to make a statement like, “I think that Widgets will move slightly higher in price, volatility will decline, and time premium will decay rapidly because we are approaching expiration.” You can then start to build the strategy.


2. Systematically rank various option strategies. This technique can easily be used in conjuction with the first. For example, you may have decided that covered call writing fits your outlook. You now want to rank the covered calls on Widget International by their various risk/reward characteristics. For example, you could rank them by expected return or perhaps by the ratio of the return if unchanged to the downside break-even point. The main problem with the use of rankings is that you will need a computer to do all the possible mathematical manipulations.


Once again, the basic way to construct a position is to make a decision on the future of the key greeks and the underlying instrument. This will nearly always lead to a final position that meets your scenario. What this means is that you must have an opinion on the future direction of the UI and on the direction and level of the implied volatility. It is best if you also have an opinion on the other greeks since, although they are usually not as important, sometimes they rise to the highest level of importance. Further, it is advantageous to have an opinion on how quickly these expected changes will occur. 


For example, suppose you are bullish on Widget Life Insurance. You look for the price of the stock to move from its current $50 per share to $60 per share over the coming three months. This means that you should only look at bullish strategies. Suppose you also believe that the options are cheap from the perspective of implied volatility. Maybe you are very bullish, expecting the price to move higher very quickly. You, therefore, should only focus on very bullish strategies where you are a net buyer of calls. This suggests that you should likely buy a call that is out-of-the-money.


Now suppose that all the same conditions apply, but that you are bearish on implied volatility. This means that you should construct a position that is neutral or bearish on volatility. You might want to consider selling a put or buying a bull spread. The point is that your outlook on a given stock, its future price behavior, and the future behavior of the greeks will all have an impact on your construction of a strategy. There are six building blocks that we can use. We can be long or short a call, a put, or the underlying instrument. We can construct any strategy with combinations of those six positions.


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