Good option traders understand that there is more to options trading than buying calls when you are bullish or buying puts when you are bearish, writes Trent Wagner of Futures & Options Xecution, LLC.
Even if you are in the beginning stages of learning options, you are probably aware that options allow you a few different ways to set up bullish or bearish trades. For example, let's say that you want to establish a long position in a futures market using options. There are two simple ways to do this using options, you can either:
1 - Buy call options above where the market is trading.
or
2 - Sell put options below where the market is trading.
Although these strategies can both provide profits for traders if the market moves in the desired direction (in this example, up), the mechanics behind how those profits are generated are very different. In the case of buying calls, the idea is that we pay (spend premium upfront) to acquire the call with the intention of selling the call option for more money than what we originally paid for it (collecting premium). From a directional standpoint, the buyer of the call option would want the underlying market to move higher with the hopes that the move higher creates a market for the call option that will yield a higher premium than the amount he originally paid for the option.
If a trader were to sell puts to establish a long position, the idea here is to sell the put (collect premium upfront) with the intention of buying it back for less money than what we originally sold it for. Much like the case for the call buyer, the seller of the put option would want the market to move higher with the hopes that as a result the put option that was sold when the position was established would lose value, at which point in time the option could be bought back for less than what he originally collected for the option.
So, if you are bullish a market, which strategy makes the most sense? The first factor to consider is determining if you have the risk profile to sell options in any capacity. Although most options traders will tell you that selling premium has a higher success rate than option buying strategies, selling uncovered options does entail a limited profit with theoretical unlimited risk of loss. Therefore, if that is something that you are uncomfortable with, the decision to buy calls is made for you already.
NEXT PAGE: What Implied Volatility Tells You
|pagebreak|However, if your appetite for risk allows for option selling strategies, then we need to identify which type of strategy makes the most sense. When making this decision, looking at how the options are priced and, specifically, the implied volatility levels of the options involved is extremely important. The premium that an option trades for is made up of a combination of how close the strike price is to the actual underlying market (delta), how long the option has until it expires (theta), and lastly the implied volatility (vega). Implied volatility as it pertains to option pricing can be viewed essentially as fear premium. To illustrate implied volatility, take the following two hypothetical option pricing scenarios (6 months apart):
Fig.
8.22(a)
Click to Enlarge
Notice that in both scenarios above, the options involved are call options that are 5.00 points out of the money (105 calls when the underlying market is trading at 100.00). Also notice that both options have 58 days left until they expire. Intuitively, one would think that these options would trade at the same price-seeing as the options in both scenarios above are the same distance from the market and have equal time left until they expire. However, you can see that the call option in the July 16 scenario is trading $250 higher than the call option in the January 16 scenario. With the distance from the market (delta) and the time until expiration (theta) of these options equal, we know that this difference in price must come from the implied volatility. The effect of the implied volatility being higher in July than what it was in January is that call buyers in July have to pay $250 more for an option that structurally was the exact same in January. Stated another way, it's $250 more in pure "fluff."
In essence, implied volatility (pure "fluff", fear premium, etc.) levels can tell us if options are trading at premiums that are over or under where they typically should be. If we have a market where the implied volatility is higher than normal, then that will translate to options trading at higher prices taking into account how far they are from the market and how long they have until expiration. On the other hand, markets where the implied volatility is lower than normal will result in options trading at lower prices as a result. It's important to remember that option trading is no different than any other type of trading-ideally you want to buy low and sell high. So, if implied volatility levels are high and option premiums are inflated as a result, it may make more sense to sell options in that environment and collect that extra "fluff" money. That way, you take advantage of someone willing to pay an inflated premium for the contract.
Conversely, if implied volatility levels are lower than normal and option prices are commanding less premium than the norm, then it may be best to establish a position in which you are long options. You are essentially paying for the option at a discount in this type of market-no different than finding a vehicle or house for sale at a price lower than market value. Just like with any other type of trading, if you buy it lower at the start it makes it much easier to sell it higher at the end.
Good options traders understand that there is more to options trading than buying calls when you are bullish or buying puts when you are bearish. Knowing what strategy to implement with respect to the way the options are priced is a key component to building consistency in your options trading.
By Trent Wagner of Futures & Options Xecution, LLC
