A Perfect tool for Swing Traders!

Years ago, the conventional wisdom was to sell options, placing time decay on your side. In recent years, pundits have made a case for buying options. Lawrence McMillan, the icon of options, in the April 27, 2000, issue of The Options Strategist, wrote about how often stocks make second and third standard deviation moves—more often than they should, based on the assumption that stocks follow a log normal probability distribution. This favors option buying. And it’s interesting to note that McMillan’s only managed fund, at the time of this writing, is chartered to do straddle buying.

Nassim Taleb, in the September 2000 issue of Stocks & Commodities, wrote how his fund invests constantly in both puts and calls, tolerating the drain of time decay while waiting for the big strike. Nassim loves the nonlinear performance curve of an option. And the only way to put this quality of an option in your favor is to be long the option.

An option is a beautiful thing. Buy one. When you’re correct about the direction of the market, gains are unlimited. When wrong, losses are limited. No other instrument gives you a better chance of hitting a home run. Sure, time decay works against your position while the underlying goes nowhere, or takes an excursion in the wrong direction first, but this is an acceptable cost if the option is reasonably priced; that is, when implied volatility is at normal or below normal levels. There is nothing wrong with buying a reasonably priced option.

An at-the-money option is a strike at its maximum inflection point. From there, as the underlying moves in the desired direction, your position makes money faster and faster. For example, the first point that the underlying moves in your direction, the option gains perhaps 0.5 point. The next point the underlying moves in your direction, the option gains perhaps 0.55 point. And so on until, when the option is deep in the money, it moves point for point with the underlying.

On the other hand, if the underlying moves against you, your position loses money slower and slower as the curve flattens out. This is the beauty of the nonlinear performance curve of an option.

Which Option to Buy?

The question of which option to buy is a good one, because options with different strike prices and duration will respond in widely varying degrees to price movements of the underlying and other conditions. An out-of-the-money option does the best job of multiplying your money. However, if this move does not quickly materialize, the out-of-the-money option’s performance will probably disappoint you.

At-the-money and in-the-money options move better with the underlying because their delta is greater. The delta of an at-the-money option is typically around 50—meaning that a one-point move in the underlying translates into a half-point move for the option. In-the-money options have deltas approaching 100—moving almost point-for-point with the underlying.

While in-the-money options best track their underlying, they are more expensive, lowering your leverage. They can also be less liquid, increasing your transaction costs. On the positive side, in-the-money options have a lower time premium component, so their time decay is slower. So you might be more comfortable using an in-the-money option when you wantto allow several days or even weeks for the underlying to move.

Usually, when a stock advances it exhibits less and less volatility (as measured by percentage daily price swings). Professional options traders know this, and they gradually lower the volatilities they use in their options pricing models as the price of the stock goes up. This works against call prices as the stock goes up, with the result that your call options gain less than you expected, sometimes.

In contrast, as stock prices fall, implied volatilities increase and this helps put buyers. This cause-effect relationship between stock prices and implied volatilities are called constant elasticity of volatility (or CEV for short). To draw an analogy with distance running, CEV is like having the wind at your back if you’re a put buyer (tailwind), but like having the wind in your face if you’re a call buyer (headwind).

What Is a Bullish Trader to Do?

To counter the CEV effect, you can lean toward using more at – the – money or slightly in-the-money options.  In addition to buying just-in-the-money calls, you can also sell out-of-the-money calls, entering into a vertical debit spread. This lowers your cost, and volatility risk is effectively cancelled out with the addition of the short leg. However, a spread behaves differently from a simple purchase. Reaping the full benefit from a spread requires having the anticipated exit date coincides with the expiration date of the options.

For example, if the nearby expiration is 14 days away and your expected holding time is also 14 days, a spread using the nearbys might be perfect. But if the nearby expiration is 21 days away and your expected holding time is 5 days; the spread might not fit so well; the simple call purchase might be better.

Finally, good discipline dictates that the trader set objectives and stops. These should be decided and written down the moment the position is opened. If the underlying moves in the desired direction, these should be re-evaluated and adjusted upward at intervals. I have no advice on how to set objectives and stops, nor when to adjust them—only that you should set them and obey them. Traders must settle on a system that works for them.

Happy Trading!!!

Cheers.