Trading Options? Are You Analyzing the Important Factors?

11/04/2015 8:00 am EST

Focus: OPTIONS

Fred Oltarsh

, OPTIONS STRATEGY NETWORK

For those trading options—or even simply learning about the process—there is so much to take in, so Fred Oltarsh, at Options Strategy Network, highlights the major factors that should be considered and understood before entering an options transaction.

Each and every trade has a need for significant analysis. Technical analysis is frequently a good place to start for establishing a position in a stock, commodity, or option. In addition, a strong fundamental understanding of the underlying instrument is also quite important. For those trading options, there is so much more to consider. The following factors should be considered and understood before entering an options transaction. If you are winging it, your long-term profit potential is substantially reduced. At Options Strategy Network™ we value the discussion of these variables.

Goals: Analyze entry and exit points, examine volatilities of different months, and choose from a multitude of strategies in order to pick the type of options position which is most likely to meet your trading needs.

Risk:Reward Ratio: Is the contract big enough and are the potential gains large enough to cover commissions and slippage? If an individual trades small contracts and the costs of trading are too high as a percentage of the potential gains, then it is very difficult to make money in the long run.

Liquidity: If there isn't depth to the market, then it is not worth putting on a position. It will be too costly to get in and out of the position. Executions costs must be examined when considering the profitability outlook. Looking at quotes and understanding execution prices can determine whether an options series is the right one to trade.

Implied vs. Historical Volatility: Whether you are getting long or short options, it is important to gain insight into the relative value of the options you are trading. Implied Volatility is the market's expectation of future volatility, but it must be analyzed in terms of the market's historical volatility. During earnings season or other expected announcements, implied volatility can be substantially above historical volatility. This aberration will rarely persist for an extended period of time. On the other side, after an announcement or substantial move, implied volatility can be substantially below the historical volatility.

Skew: The skew enables a trader to create interesting trading opportunities that would not exist in a market with a flat implied volatility curve. By analyzing the skew, a trader can initiate a position that meets his or her trading objectives and provides a theoretical advantage in establishing the position. In stocks, most options have a considerable skew in favor of the puts.

Delta: The Delta provides one with the number of shares they are long or short at that moment due to the options position they have established. Understanding the Delta means you understand the current long or short position stock position you have created through trading options.

Gamma: When establishing a position in options, understanding the gamma of your position is essential in understanding the ramifications of your risk:reward profile. Gamma provides one who is long options tremendous opportunity to experience delta change due to price changes in the underlying market. Managing these changes can provide significant opportunity for profit. On the short side, negative gamma has blown out many traders. Gamma must be considered and understood when trading large options positions.

Vega: When selling options the trader must understand the potential risk to the position due to changes in implied volatility. Due to large increases in implied volatility, traders often have trouble meeting margin requirements which are caused by movements in Vega. Analysis of this is important before the position is established. Certain markets have histories of large volatility explosions. Selling large quantities of volatility in certain stocks or asset classes—when the implied volatility is historically low—can be a disaster.

Understanding these concepts and utilizing them when establishing an options position can go a long way towards increasing a traders’ profitability. Multitudes of traders establish positions without fully analyzing these essential points. At Options Strategy Network™ we attempt to eliminate the unnecessary mistakes of trading and improve the bottom line.

Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is no way guaranteed. Past results are not indicative of future results.

By Fred Oltarsh, Proprietary Trader and Editor, Options Strategy Network

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