OPTIONS: TRADING STRATEGIES THAT WORK
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Australian Options Introduction by Series Editor - Daryl Guppy
(selected extract only) Daryl Guppy ?999
Buyers of hope, or sellers of hope? The options market has one dreadful statistic - 85% of options expire out of the money - essentially worthless. The buyers of hope lose money. These statistics should terrify most wannabe option traders. The options market is a zero sum game which simply means that what I win you must lose.
This is not an introduction to options. It assumes you are familiar with the options market, although a comprehensive glossary is provided. This is a book about nuts and bolts tactics, about risk management and profitable ways to trade options.
Options trading is a world filled with many niche opportunities involving more than just the buying and selling of listed options. The writers and traders Eng has bought together in this book consider in detail many of these niche strategies from vertical bull spreads to overlapping straddles. These are not always complex. Some, such as covered writes, are a low risk way to make steady, if undramatic profits.
Many options strategies require the trader to take a view of the market. They believe the market is going up, or down, and options are traded as a way of capitalising on this belief. The skills of charting and technical analysis are an essential part of the option traders market approach. As many of the writers suggest, this is a market where traditional equity fundamentals play a very small role.
The most conservative of these option selling strategies is the covered write. It is recommended as an introductory strategy by many experienced option client advisors. Use this, and you are selling hope to eager buyers of call options. By offering an call option for sale - writing an option - that is out-of-the-money you provide the opportunity for others to speculate on the future value of the stock, and in particular, of the stock you hold. Few brokers are skilled at this and it is worth taking the time to understand the process so you are in a better position to identify brokers who also know what they are talking about.
The key idea is to only sell your securities at the price which you would have sold them for in any case. The covered write strategy provides an additional opportunity to collect a steady income stream from the stock while you wait for your sell price to be hit. It is an important way to generate additional income from stock. Although each covered write returns only a small amount of cash this does add up over twelve months. This strategy generates steady, but not spectacular returns.
Using this strategy marks a shift in the understanding of risk and the way money management is used to derive income from idle assets. In Chapter 1, Bonwell explains this process clearly, identifying the risk and showing how it is minimised.
Trading options is a game of skill and experience and Jerry Kopf provides a range of selections taken from his newsletter, OEX Blue Page. No single strategy fits all markets but Kopf suggests that market timers do not do particularly well with options trading. They make subjective decisions based on news, opinions and feelings. Traders in the equity market can afford to be right and enter too early. Options traders do not have the advantage of time. Kopf believes successful options traders are relationship players who make objective decisions based on knowing the precise mathematical relationships between options and their underlying cash instrument. This also extends into a better understanding of the impact of volatility.
David Caplan continues this smorgasbord of titbits of option trading information in Chapter 4. Perhaps most usefully he explains the failings of each of the option strategies discussed. Too often authors suggest that an options strategy has no risk, or limited risk. This is quite correct if the theoretical conditions remain intact, but this over emphasis on the limited risk aspects of options purchases is exposed when markets do not conform to the theoretical conditions. Recognising these changes, and knowing when to take appropriate action, is a key to survival. Often the anticipated outcomes is not the actual outcomes, and in the confusion, profits are destroyed and losses mount.
Computers evaluate outcomes and crunch numbers, but the trader must make the decision. Caplan provides useful reference tables for strategies at the end of the book. These have been modified for the Australian options markets with assistance from Wil Evans. Details of Australian futures and options markets have been supplied by Guy Bower and Jeff Worboys of P. G. Moloney and Associates, futures brokers.
Ultimately traders make the buy and sell decisions and just how this decision is deflected and distorted by our own failures of judgement and preconceptions is explored more fully in Chapter 5 by Van Tharp.
Many options strategies exist solely within the context of the options market. The various options selling combinations are examples of this. But options are also frequently used to leverage a specific view of the market. This involves basic chart analysis of the underlying instrument, or parent, and then turning to the options market to leverage the trading opportunity. In chapter 6 Gfeller takes the reader through this basic bar chart analysis and the way it is leveraged both in the futures market and in the options market. The starting point is a clearly defined trading plan with rules.
He argues that selling options effectively limits the profit potential. He sees buying options as a way of increasing profit potential, but only if the trader knows exactly what he is trying to achieve. This is guerrilla warfare, with short, sharp strikes - hit and run trading. The short term horizon is necessary because of the impact of time decay on all options positions.
Although chapter 8 by Jim Yates is called Stock Market Hi-Lo Poker, the title conceals an informed discussion of using odds and probability to effectively trade options. Hi-Low poker creates two winners - the person with the highest hand and the lowest hand. This is directly comparable to a bullish and bearish outcome after a trade entry. Whereas a poker game starts with a known number of cards, the option trading game starts with a known price, or more effectively, a known trend.
Yates shows how to trade options rather than using the options premium as a speculative tool. His analysis is based upon the normal distribution of price rises and falls which resemble a bell curve. This is the distribution of volatility. He believes regression to the mean analysis provides the best entry and exit points. His objective is high probability trades which fade the volatility trend.Yates takes a closer look at the mathematics of options trading, and discusses how the option trader can build a table of odds.
By far the most difficult chapter is Using Overlapping Straddles. Here Dufield provides a clear explanation of straddle, and 3 option straddle strategies.
What is important is his discussion of overlapping straddles. He clearly explains the process of legging into a straddle strategy by using a series of three open option positions as a hedge against a possible reversal of market direction. In particular he suggests this and associated strategies are very applicable to overheated markets because they allow the trader to participate in the last rise of a bull market with a minimum of risk.
Options are widely considered as a way of controlling risk because, unlike futures, the risk is capped at the amount paid for the premium. Futures expose traders to unlimited risk, and to high margin costs. Additionally, option series are structured so the strike or exercise levels allow the trader to create strategies that are not available with futures.
For spread traders interested in making a profit from the absolute difference in prices between two futures contracts for the same market, or between two related commodities, options offer additional trading strategies. Frost considers these in practical detail in Chapter 10. He examines seven possible market outcomes for each of his three spread examples. He compares the results from using a futures spread, and from using an options spread. This is detailed practical trading, and although not beyond the ability of private traders, it does require considerable experience.
Program trading is restricted to very large market players and usually does not fall fould of securities regulations. From our perspective as private traders it is useful to know what it is, how it developed, how it works, and the potential impacts on our market. The impact of triple witching days in the United States does have an impact of option expiry pricing in Australia. These days occur on the third Friday in March, June, September and December. Often there is extraordinary volatility as US equity, index options and index future contracts all expire on the same day. Jon Najarians explanation of program trading is clear and recommended background reading.
More complex options trading strategies have been described as like a 3-D chess game. The dimensions are price, time and volatility. Trading the differences between implied volatility and statistical volatility is the third leg of options trading strategies.
Statistical volatility measures how volatile the price behaviour of the underlying asset has been over the previous days, or weeks, or months. This is sometimes referred to as historical volatility. The strategies discussed by Yates are designed to fade the extremes of volatility in the expectation that volatility will return to normalcy. He discusses five different ways to take advantage of volatility.
Options trading is not for everyone. It is a complex and sophisticated market and the very real dangers are disguised by the impressive returns accumulated by a few at the expense of the many. Your objective is to avoid holding one of the 85% of losing positions. This book introduces many strategies designed to get you amongst the 15% of winning positions.
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