Options Trading: How to pick the right trades?

Great forum this one – found lots of helpful tips from here. Like many others out there, I checked out Optionetics, but never signed up due to the prohibitive costs – and dove in my reading a few books by the founder of Optionetics – George Fontallis along with few other online tutorials.
I’m on the verge of buying a few books mentioned in the forums on other threads such as Natenberg and McMillan. I understand the basics of Options and the strategies involved. However, I’m finding it difficult to find the confidence in risking my (very little) capital on any trades yet!
I have two questions:

1. Can someone help me in pointing the right direction in the process of picking a stock and understanding how to employ any relevant strategy?

2. How important is charting to predict the future movement to maximise profit in Options Trading – and what books etc. should I use to master it?

Thanks in advance and HAPPY NEW YEAR 2010!

Welcome to ASF, Sensitiveteeth!

I wish options trading was so easy that I could type a simple answer to both your questions...

Unfortunately, I don't know of any shortcuts. It is a journey and part of that journey is to find out what strategies and management works for you. There are so many strategies and variations available.

I don't think there are necessarily "right" trades as we cannot know in advance if a trade is going to be OK or turn against us. I believe that management of the trade and of the inherent risks is paramount - and that takes time to learn the greeks and understand exactly where the risks are lurking.

There are quite a few gotchas out there in options trading - some have already been discussed here at ASF - so it would be prudent to make very sure you are well educated before risking your own funds in the options market.

All the best and take care...

Thanks Salis for those wise words and the warm welcome. You make complete sense, and I've just been reading up on many risk management techniques and strategies to use in various market conditions. Maybe I require more time to be confident in market movement.

Further to the earlier question, out of your experience (and anyone else reading this) - how important is charting/technical analysis to options trading? Say on a scale of 1-10 (10 being very important).

And what books/resources would you recommend for me to kick start my education in charting?
Thanks again!

sensitiveteeth said:

Further to the earlier question, out of your experience (and anyone else reading this) - how important is charting/technical analysis to options trading? Say on a scale of 1-10 (10 being very important).

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It depends on what you're trying to achieve and how you like to trade.

As there is a huge spectrum of option trades to choose from, it can be anywhere from 0 to 10.

sensitiveteeth said:

...Further to the earlier question, out of your experience (and anyone else reading this) - how important is charting/technical analysis to options trading? Say on a scale of 1-10 (10 being very important).

And what books/resources would you recommend for me to kick start my education in charting?
Thanks again!

Click to expand...

Sorry, realised I hadn't mentioned this in my reply.

The reality is that it's a mixed bag. Some use charting, others don't. IV (implied volatility) is generally a must in selecting a strategy. Understanding volatility and it's effect on options pricing is critical, IMHO.

I know Optionetics are keen on charting software for options trading and I can see where you are coming from. I purchased Advanced Get believing it a must have at the end of what I now believe was a sales intense two day course. Sadly, AG doesn't get it right all the time - so I would not have spent the money. I still use it occasionally.

I also paid for a year's subscription to Platinum. I don't know if that is what they still use to search for option strategies - but it only did US options at the time. Due to low liquidity in the Oz market, there are probably only half a dozen stocks that are worth trading here - and even that's debatable. It's not hard to watch those few manually to look for opportunities. If you are planning to trade US options, ThinkOrSwim brokers have free software and data which includes charts, option scanning and all sorts of wonderful things we can't get out here.

Hoadley has great software for risk graphs and other things - some of it for free - otherwise a modest subscription will pay for a year of updates. Just google "Hoadley options" - that should get you there.

One of the best books on trading in general would have to be one by Nick Radge - can't remember the name of it and all my trading books are packed. Do a search here at ASF on Nick Radge - there was a thread started specifically on the book by Tech/A. Nick gives useful information on Elliot Wave in his book. He also has a good subscription service and he used to cover some option trades - google "The Chartist" for more info.

There is a lot of free help online for charting - try doing some google searches on technical analysis. There is an enormous variety of Technical Analysis out there and it's a case of finding out what works for you.

Bigcharts.com have free Aussie charts. You have to type au: in front of the Aussie code. eg. au:anz will bring up our local ANZ chart.

There are also threads here at ASF on all sorts of analysis - technical and fundamental and everything beyond and inbetween. ASF has a good advanced search engine and would suggest you use that to check things out and to see what you are more likely to gravitate to.

Regardless of whether you use expensive software, volatility analysis or flip a coin, there is no guarantee of trade success. As I said in my last post, management of risk is critical - we usually have to take some risk in order to make money, but it's making sure we keep losses to a minimum with a sound knowledge and understanding of the greeks. For simple example, we can easily remove directional risk with options by placing a straddle, but we have then transferred our risk primarily to IV fluctuations and theta.

Hopefully that gives you enough to go on with and maybe others here can help you as we are in the process of moving house and time is running out for me to type these lengthy posts!

Cheers...

EDIT: here's a thread I just spotted on "The Chartist" - mentions Nick's book too: https://www.aussiestockforums.com/forums/showthread.php?t=10398

I'm a beginner to options as well and I'd highly recommend "The Rookie's Guide to Options" by Mark Wolfinger. It is a great introductory book on options (I'm biased since it is the only one intro book I have) with practical advice and it isn't too deep on theory.

His blog, http://blog.mdwoptions.com, is a great resource as well and I read it regularly. If you like the ideas presented on his blog.

Natenberg's book is a weatlh of information, but seems to be a little over my head and I can't digest the whole lot yet. It does drive home the point that there are a lot of factors that weigh on on option pricing and it isn't just as simple as "buy+hope prices go up/down = mega profits".

I picked up McMillan as well, but haven't gone through that yet.

Apologies if this hijack this thread.

I have a sound understanding of options, but was just curious of what greeks and other factors to consider before entering an options position.

Quite simply; if one had a view that the XAO/XJO had reached a medium term top; what factors would one look at when deciding if an index Put was worth purchasing?

I have access to IB TWS; so I assume I can find a lot of the greeks in there.

So I guess what I'm asking is; what factors should one look at when deciding between purchasing say a 6 month put, or a 12 month put? Apart from the obvious of paying for time value and suffering time decay; what other factors should be considered?

Cheers.

RazzaDazzla said:

So I guess what I'm asking is; what factors should one look at when deciding between purchasing say a 6 month put, or a 12 month put? Apart from the obvious of paying for time value and suffering time decay; what other factors should be considered?

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volatility

So if I was say selling a credit call spread I would be looking for high volatitility on the short and low volatility on the long.

If I was purchasing a put; I would be trying to get one with lower volatility.

RazzaDazzla said:

So if I was say selling a credit call spread I would be looking for high volatitility on the short and low volatility on the long.

If I was purchasing a put; I would be trying to get one with lower volatility.

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Actually Razza,

Doesn't always work that way because OTM contracts normally trade with a higher volatility ( hence the smile ).

I think what mazza is getting at is picking the appropriate strategy for the volatility of the day and what your outlook is for the future, ie you wouldn't want to have a ratio spread on if you're predicting higher volatility , a back spread would be more appropriate.

RazzaDazzla said:

So if I was say selling a credit call spread I would be looking for high volatitility on the short and low volatility on the long.

If I was purchasing a put; I would be trying to get one with lower volatility.

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If you're buying a put, low volatility would be great; it means you pay less for it. Higher volatility is not a problem if you think volatility will increase even more, which usually happens if you get the direction right and it happens SOON.

The risk is that if you get direction wrong, or nothing happens, volatility will decline, inflicting the double whammy of losing via delta and vega. The longer dated the option the greater the vega and it's possible effect on your bottom line profit or loss from the trade.

It's a directional play with non-linear considerations... risk versus reward. Just have to know the precise nature of risks and reward. These are measured via the greeks, that's what they're for.

Take the following as an example:

With an overall view that the XJO will continue to decline from 4700 I am considering the following;

A call credit spread on the XJO
Short XJO Mar 4650 Call @ 127
Long XJO Mar 4700 Call @ 102
That is; 50 point risk for 25 point profit per contract.
($500 risk for $210)

Long XJO put
This is where I am unstuck as to which put would be 'best value' to buy.
I understand why atm/itm puts are more expensive that otm. I also understand why puts with longer to expire are more expensive.

So what numbers do I look for that represent "best value" for going long a put?

I am also aware that there is probably significant demand for puts at the moment as people worry about there falling portfolios

Thanks WayneL; Very insightful as always.

I almost missed your post as it must have come after while I was doing my previous reply.

Looking at TWS;
March 4725 Put IV = 18.54%, Delta = -0.6097, Bid 187, Ask 194
March 4625 Put IV = 19.70%, Delta = -0.4979, Bid 137, Ask 143

So on a value scale; the 4725 Put offers better vale than the 4625 Put.
It seems odd in my mind that a more ITM put offers 'better value' than an OTM/ATM put.

The delta of the 4725 loosely translated means that it has a ~%60 chance of expiring ITM and currently 1 point move in the XJO will represent a 0.6 point move in the option price.

So the 4725 looks like the value buy!

Or now looking at the screen I'm even considering the April 4700 Put.

Razza,

I'm having trouble understanding what you consider to be a value buy.

If the 4725 represents good value as a buy what would you sell, naturally the one you will sell will be cheaper ( lower IV ) because the market makers have already modeled the skew, you will never buy for less and sell for more unless you fluke it legging it.

cutz said:

Razza,

I'm having trouble understanding what you consider to be a value buy.

If the 4725 represents good value as a buy what would you sell, naturally the one you will sell will be cheaper ( lower IV ) because the market makers have already modeled the skew, you will never buy for less and sell for more unless you fluke it legging it.

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Cutz,

In regard to "value buy" I am speaking of going LONG a XJO Index PUT.

The only thing I am considering doing a credit spread for is the XJO 4650/4700 Call.

So my complete strategy would be a credit call spread at 4650/4700

AND

a long put

RazzaDazzla said:

In regard to "value buy" I am speaking of going LONG a XJO Index PUT.

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Here's my 2 cents. IMO there are two ways of defining value.

1. Good value meaning that the put option is underpriced
This can be viewed from the perspective of insurance premiums. Assume that your car is parked in your garage and you take it out for a drive only once a year. Despite letting your insurance company know about your driving habits, they still charge you 10% the value of your car as your yearly premium. Joe, next door, drives his car like a maniac everyday, and the same insurance company charges him the same premium of 10% the value of his car. Joe's premium is obviously "good value". Likewise, if your put option premium is priced as if XJO is hibernating for winter, then it is good value.

2. Good value meaning the put option has good bang for buck
If you are a soothsayer and have a strong opinion about the future, then "good value" means picking a put option that will give you maximum gain when your prediction comes true. Reading your previous posts, you have a view that XJO will fall and you rightly picked a put option with a large delta as you want to profit from falling prices. However, you must also predict the future volatility. If you believe that volatility is going up, then you would also pick the option that will appreciate most when volatility goes up. Likewise, you want the option that gives the best outcome for you when you consider the effects of time, interest rate etc.

Ultimately, "good value" can only be arrived at if you have an opinion about the future (price, vol, interest rate etc). Both definitions of value above require some predictive power on your part, before you can find good value. If only K-Mart had crystal balls on sale this week .

RazzaDazzla said:

So my complete strategy would be a credit call spread at 4650/4700

AND

a long put

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Why go to all that trouble by paying for 3 spreads ?

One long put will achieve a similar outcome.

cutz said:

Why go to all that trouble by paying for 3 spreads ?

One long put will achieve a similar outcome.

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3 spreads??????

I am looking to do one Call credit spread and one long put. How does that equal 3 spreads?

RazzaDazzla said:

3 spreads??????

I am looking to do one Call credit spread and one long put. How does that equal 3 spreads?

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3 bid/ask spreads - I think cutz meant 3 legs
Unnecessary slippage and commissions for protecting an equity portfolio
Whether it is value will depend on you vol outlook vs. implied in op prices

Have you tried Think or Swim their platform is fantastic with a trade analysis tool to help with your trade selection, and it's free. Also check out The Trade Pro System by Dave Valleries. His videos are great he explains how the Greeks and volitility will affect your trade. Try options4beginners.com or youtube for links