Four Tips for Better Option Trading

03/10/2011 3:01 am EST

Focus: OPTIONS

Sometimes it pays to go back to basics, and here, an option trader reviews four pillars of successful trading. Though not complicated, each one is crucial and helpful when searching for value in the market.

By Andrew Hart

This MoneyShow.com article is geared for new and intermediate options traders (though frankly, I think traders of all experience levels can benefit by getting back to basics).
Want to know what I think are the four cornerstones of sound options investing? They aren’t complicated, yet they seem to be elusive too much of the time.
First, an overview:

  • Invest in options that respond well to the underlying stock’s movement (high Delta)
  • Minimize time decay, or the natural erosion of option value over time (low Theta)
  • Buy enough time to capitalize on major moves (you don’t have to hold it the whole time)
  • Minimize volatility (since volatility can shake up confidence and account balance)

Don’t worry, you won’t need a PhD in mathematics, nor will you need to be a seasoned options trading veteran, to apply these four principles. All you need is a little willingness.

1) Choose Options That Move with the Underlying Stock (Delta)

If you’ve ever heard the term “Delta” as it pertains to options trading, this is what they’re talking about: Delta is the degree to which each individual option changes with respect to every one-dollar-change in the underlying stock’s price.

For instance, a call option with a Delta of $0.30 (30 cents) would increase in value by 30 cents for every dollar’s worth of gain for the stock. That would be a relatively low Delta. A relatively high-Delta call option might move by 90 cents (a Delta of 0.90) when the underlying stock gained a buck.

Obviously, high-Delta options are more desirable if you’re making a directional forecast for a stock.

(Note that the Delta can change as an option moves deeper in the money or deeper out of the money, and as time passes. For our purposes though, you just need to understand the concept.)

2) Minimize Time Decay Immediately (Theta)

Have you ever noticed that you pay a little more for options than they’re mathematically worth? For instance, a call option with a strike price of $30 on a stock that’s trading at $35 is intrinsically worth $5. However, you may have to pay $7 to own the call option.

That additional $2 is considered to be “time premium.” As time passes—even if the underlying stock’s price doesn’t change by a penny—an option’s time premium will sink. As expiration approaches, the time premium will eventually be whittled away to zero, meaning the option will eventually only have intrinsic value (or what the option is mathematically worth).
Option traders call this time decay “Theta.” Needless to say, keeping Theta to a minimum is critical to your long-term profitability.

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3) Buy Enough Time to Profit from a Big, Drawn-out Move

A quick rhetorical question: Realistically, can a stock move further in one month or in six months? Certainly, there are overnight sensation stocks, but those one-day surges are few and far between. By and large, the more time you give a stock to move, the further it can travel up or down a chart.

That’s probably not news to anyone, but it’s a point we want to make since it’s easy to forget…particularly for options traders.

Our traders are looking for major, macro moves from the universe of optionable stocks and ETFs. That’s where the real power is. A company works its way into a profitable situation and stays there for quite a while, perhaps month or years. (Or, we can buy bearish put options on companies that can’t find their bearings and are seeing their stocks sink.)

With this in mind, we’ve found owning options with plenty of time gives us an opportunity for enormous gains. Here’s the best part of all though: We don’t necessarily have to use that time. If we do get a nice short-term burst and decide to take profits well before the option expires, we always have that choice. You don’t have that flexibility if your option expired before a major move.

4) You Don’t Get Paid More for Surviving Volatility

It’s a generally accepted idea in the trading world that higher returns are probably going to be accompanied by greater volatility. We don’t disagree with the notion…to a point. In our observation though, there does come a time where you do stop getting paid for any extra risk and extra volatility you’re assuming.

Though we’re striving to maximize gains in our more conservative options services, we also seek to minimize swings in a portfolio’s value. Part of that effort has to do with remaining psychologically comfortable; another part of it has to do with sheer capital preservation—not losing is more important than a string of monster-sized winning trades. You can always look to the future if you have enough capital. If you wipe all or most of it out though, you’re out of the game.

Final Thoughts

Nothing Earth shattering, but the more I do this, the more attracted I become to simple ideas and strategies.

In many ways, all of the ideas above are centered around one basic concept: value. All options have risk, but the risk has to make sense compared to the reward. Just like stocks, options can be overvalued or fairly valued. It’s all about balancing the risk and reward, and getting a handle on Delta, Theta, and time can help you do just that.

By Andrew Hart, portfolio manager and editor of ETFTRADR at BigTrends.com

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