How to Deal with Option Confusion

11/28/2013 6:00 am EST

Focus: OPTIONS

James Bittman

Senior Instructor, Chicago Board Options Exchange

With so many option strategies available, it's easy for less-experienced traders to get confused, so Jim Bittman offers words of wisdom on the best way to proceed.

SPEAKER 1:  My guest today is Jim Bittman from the CBOE and we’re talking about options strategies as there are a ton out there and they can get pretty complex, but which one should you be being paying attention to?  Jim, there is iron condors and butterflies and strangles and straddles.  There’s so much out there.  What’s a trader to do in deciding what to do?

JIM:  Well go slow is perhaps the best piece of advice I could give somebody, but learn one strategy at a time, okay.  You know the iron condor is a very popular strategy today but it has its own way of thinking, its own way of choosing strike prices, its own way of setting stop losses.  Now there isn’t just one way.  You might be a little bit more bullish.  You might be a little bit more bearish, and so you’ll set your stop losses differently than maybe I would, but learn.  The iron condor is a variation on credit spreads.  Another strategy called the broken wing butterfly is still another strategy with its own unique price behavior, so if you learn one strategy at a time then you might learn one and it might work for you, but you don’t have to know 20 different spreads and you don’t have to trade them all the time.

SPEAKER 1:  How comfortable should I be knowing the behavior of the underlying?  I may be familiar with this options strategy, but if I don’t really know the behavior of that particular stock or that index or that ETF that I’m doing options on, is it a problem?

JIM:  Well it always starts with a feel for the underlying, so I would personally never do one of these complex spreads on some underlying that I never really followed at all, okay, so it is crucial that you know the underlying.

SPEAKER 1:  How about seasonal trades for some of these strategies?  I mean are there certain times a year where some options strategies work better than others?

JIM:  I do not believe so for these complex spreads.  Most complex spreads kind of have a mathematical relationship between the behavior of the spread and the price behavior of the underlying and I don’t believe that that’s seasonal.  I think it’s mathematical and you have to understand the relationship and then pick your positions.

SPEAKER 1:  When you talk about mathematical I think the Black Scholes model.  Do I need to understand and read and really know how options are priced?  I mean how deep do I have to get into this?

JIM:  Not deep at all.  You have to know, and it’s a very simple calculation, the standard deviation calculation, understanding the time erosion of options, and understanding whether your spread makes money from price movement of the underlying, which is called Delta, or whether it makes money from time erosion, but you don’t have to know the Black Scholes model.  You don’t have to become a mathematician.  You have to know a few concepts, but I can’t do the Black Scholes model, so I’m pretty sure you don’t need it.

SPEAKER 1:  Jim thanks for your time.

JIM:  Glad to be here Tim.

SPEAKER 1:  You’re watching the Moneyshow.com video network.

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