The Four Cornerstones of ETF Options Trading

02/11/2010 12:01 am EST

Focus: ETFS

Here’s one for you 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.

They are:

  1. Invest in options that respond well to the underlying stock’s movement (high delta)
  2. Minimize time decay (the natural erosion of an option’s value over time)
  3. Buy enough time to capitalize on major moves (you don’t have to hold it the whole time)
  4. Minimize volatility (since volatility can shake up your confidence and your 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. In addition to these four cornerstones of option trading, I’ve also made my newest report, “The Next Generation ETF Portfolio,” available to MoneyShow.com readers today—you will find my complete model portfolio (a specific mix of 19 ETFs to revolutionize your portfolio) along with my favorite options strategy here at ETFTradr.com

1) Invest in Options That Move Well with the Underlying Stock

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 $1 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 Your Time Decay Right Off the Bat

Have you ever noticed 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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NEXT: Two More Cornerstones for Trading Options on ETFs

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3) Give Yourself Enough Time to Take Advantage of 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.

ETFTradr systems are looking for major, sustained moves from the universe of optionable ETFs. That’s where the real power is. A sector or country will work its way into a positive trend, and stays there for quite a while, perhaps months or years. (Or, we can buy bearish put options on ETFs that can’t find their bearings and are seeing their value 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 Any Extra 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 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; and 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, then you’re out of the game.

Final Thoughts

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. Getting a handle on delta, theta, and time can help you do just that.

By Andrew Hart of ETFTradr.com

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