Basic Options Strategy

By Sir Pipsalot

Recorded webinar available for Diamonds users at:

http://www.forexdiamonds.com/diamonds/extras/watchvideo.aspx?vfile=112508_tut1.swf

Pros/Cons of Options

• Pros:– No stop loss required– Risk limited to the amount of the principle– Leveraged upside potential

• Cons:– Time decay erodes value– Eventual expiration of contract– Only traded during NY market

Basic Definitions

• Calls – Options trades betting on a long• Puts – Options trades betting on a short

• Strike Price – The price level the option will represent at expiry

• At the money – Strike price right at market price• Out of the money – Strike worse than market price• In the money – Strike better than market price

• Expiration Date – usually the 3rd Friday of the expiration month• Front month – the contract expiring within the next month

Option Values

Option Price = Intrinsic Value + Time Value

• Intrinsic Value:– The value the option would have if exercised today.

• Time Value:– The premium on top of the intrinsic value that pays for the time

until expiration.

• Contract purchase price is 100 times the quoted price– A $5 option actually costs $500 per contract

Option “Greeks”

• Delta – The amount the option will change in value relative to a change in the underlying asset.– Ex. A delta of 0.52 means if the asset goes up by $1,

the value of the option changes by $0.52– Delta goes up as an option trade goes your way

• Gamma – The amount Delta will increase with each $1 the asset moves your direction.– Ex. A gamma of 0.05 means if the asset goes up (and

you have a call) by $1, that delta increases from 0.52 to 0.57.

Greeks continued

• Theta – This is the amount of daily time decay for the option contract.– Ex. A $4.25 option with a theta of 0.05 will be

worth $4.20 tomorrow if the asset doesn’t move

• Vega – This measures the built in premium on the option due to volatility– As volatility goes up, vega goes up and the

prices of BOTH puts and calls increases

My Basic Strategy

• Only buy calls and puts, no fancy stuff• Position trade them…

– buy calls on big selloffs when you have a long bias– buy puts on big rallies when you have a sell bias– Be prepared to hold them awhile

• Always give your trade extra time by buying contracts with expiries further out then you need.– NEVER trade front month contracts

• Buy options at or near the money for the most benefit

• NEVER hold an option through to expiration

Why only buy calls and puts?

• Limited risk

• Simple to manage

• Easy to understand

• Leveraged upside potential

Why position trade them?

• Spreads and volatility make it not very profitable to jump in and out too often.

• The bigger moves are a lot easier to see

• With many months to expiration, you can afford to wait since you have no SL

Why give your trade extra time?

• It’s a lot easier to know the “where” without an exact “when” or “how”

• The market usually goes where it needs to go, but can move at a frustrating pace at times.

• Time decay is smaller per day when you’re a ways out. When you get closer to expiry time decay starts to ramp up.

Why buy at or near the money?

• Good delta and theta– You will see a bigger benefit when the trade starts

going your way then if you bought options too far out of the money.

• They have intrinsic value almost right away.

• They tend to be traded much more actively– Gives tighter spreads and more counterparties

When should I go far out of the money?

• You’ll want to do a theoretical “what if” analysis to see if this is a good idea.

• You need to have a strong bias towards a quicker, stronger move developing

• You need to consider far out of the money options as a “lottery ticket,” not a pure trade.

• These are most profitably done by buying far out of the money puts after a calmingly long period of rallying.

What I do specifically

• I try to capture 1-3+ month trends with a very long term bias down.

• So far I’ve bought puts with 3-9 months until expiration and taken profits on 20%+ selloffs into support

• Currently I’m closing the last of those and buying some Mar 09 calls to hold for a month or so before I phase back into puts.

• I prefer to trade the overall S&P 500 index by trading SPY options (The SPYDERS track the S&P 500 but trade at 1/10th the value making it cheaper)

*side notes*

• In today’s market, puts will make you a lot more money than calls due to higher vega’s.– Calls will lose some of their value as stocks

rise since volatility will fall– Puts will gain extra value as stocks sell off

due to more volatility value built in