Trade the Option or the Underlying?

02/23/2012 6:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

With options, you always have a choice of trading the underlying or the option itself.

Recently, I received an e-mail from a student that took our Options Trader course at our Stamford, Connecticut center. He was faced with a delicate dilemma: He had the choice of either trading options on a stock that had come up to resistance, or simply shorting the physical underlying itself. I wish to share with the MoneyShow.com audience some insights about his trade.

Below is the actual e-mail that I received from him:

“Josip, I’m having a hard time with risk/reward. To have positions that would generate a worthwhile gain, you have to risk an amount that could wreck an account.

Ex: February 3 XYZ entered a supply zone (14.67 to 14.90) and should retrace (14.35 at least)—implied volatility is in low 10%,

To buy-to-open (BTO) April 12 $16 put would cost $1.52 (1.32 intrinsic value & -.70 Delta). With a rule to only risk 1% of my account, I would only be allowed 2 contracts. So, risking (1.52 x 2 =) 3.04 to make (.30 move @ .70 delta x 2=) less than .60, minus commissions.

That’s a risk 5 to make 1 ratio; doesn’t really seem worth the risk.

If I just shorted with stock—stop @ 14.90—entry 14.70—target 14.36—that would be risk 1 to make 1.55 ratio.

Any insight would be great.”

To recap what is in the above e-mail: The underlying is at resistance. The exact supply zone (SZ) extends from 14.67 to 14.90, which is about 20 cents.

He is anticipating a short-term pullback due to the fact that this rally into the SZ would be the first retest and most likely also a failure to break out. Such a set-up is one of the higher probability trades, technically speaking. He also states that the implied volatility (IV) is low, which means that option traders should be considering buying premium.

When the IV is low, premiums are underpriced, which is self-evident from his reference to the April 16 put, which has intrinsic value of 1.32 and a total premium cost of 1.52. Since the Stamford trader has provided me with the intrinsic value at 1.32 of the April 16 put, we are easily able to decrypt where the underlying was at the time of writing his e-mail (16.00—1.32 = 14.68). The put that he has selected was based on the Delta value of 70 cents, and his contract size (only two contracts) was properly done.

Nevertheless, the fact that he expected a retracement to approximately 14.35 meant that the target was not attractive enough for the risk he would be taking on with this particular trade using the April 16 put. He calculated that his risk was five times the reward and concluded that he would have the better risk to reward (1:1.55) had he traded the underlying by simply shorting it.

My answer to him was a gentle reminder that in our Online Trading Academy Professional Trader class, we teach our students two simple rules: Do not trade stocks that are trading below $15, because the ATR (average true range) on such products is not very great and it would take a long time for the trader to make a significant profit on a $15 underlying. Secondly, we discourage the students from an underlying that does not have ADV (average daily volume) of at least one million shares traded per session.

Having said that, I have seen a lot of students trading the Bank of America (BAC), which is currently well below $15, so it could be that they are grocery-selecting from our Online Trading Academy rules? Out of all the USA-tradable issues, is the underlying that he is addressing the best he could find? Open-ended question.

If the volume is greater than one million, could he compromise and take a trade with the physical underlying? Yes, very possibly. However, as he concluded himself, trading it with options would not make sense from a risk management viewpoint.

Read more about trading the option or the underlying at Online Trading Academy.

Related Articles on OPTIONS