rowes said:
Hi all,
I have a questions regarding options vs stocks in a specific scenario.
If i found a stock that i was interested in and it had been in a steady downwards trend and all the reversal signals where there like maybe a morning star pattern confirmed by another strong buying day and my indicators were where i wanted them and everything looked great, instead of taking a position and buying 1000 of the stock in question what if i bought 1 call option contract ATM (or close to it). I wouldn't be expecting to hold the position typically for any longer than say 2 weeks. If i treated it as i would my stock position with my stop loss in place and was prepared to close it out as usall should things not go my way what would be the major downsides that i would need to considor.
How much emphasis would i need to place on the greeks if i was to only be holding a position (unless i decide to excersise it) for a short time before time decay really set in.
I'm sure i am probably missing some very important points and would appreciate any advice.
Hello rowes,
Beware, options are considerably more involved than most beginners realise. I tend to recommend that people either paper trade for 12 months, or trade very small positions to learn how to trade options.
Options are very powerful when used correctly, but a thorough knowledge in both theory and practice is required. They are also lethal and great ways to lose money when you don’t know what you’re doing, so please be careful.
Buying a call option sounds easy. But at what strike price, with which expiry month, and at what volatility, and how liquid, how long is the trade, and how wide a spread in the bid and the ask will you accept???
Then you have to work out the best risk to reward strategy based on your view of the market, what your position size will be, and what conditions constitute failure (loss) and how you will deal with this situation if it arises. Then you also need to determine how to take profits…
Key things you need to know for single strike positions:
Theta Decay - Around 80% of theta decay occurs in the last 30 days eating away the “time value”. You need to be able to evaluate which strike is appropriate based on your view of the market.
Volatility - Often market makers will bolster the premium (increase the volatility) of calls when the underlying is volatile, more often with down moves. Hence sometimes the right time to enter is not on the reversal day. You need to understand how volatility works, both in entering and exiting. I don’t know how often newbies pay up on a reversal and pay exorbitant prices, only to see the stock inch up for a couple of days and the value of the option collapse from volatility crush. Vega measures how volatility effects different stikes.
Delta – You need to understand how the option moves in relation to the underlying as a ratio, you also need to understand that this changes and is measured by Gamma.
This is critical in calculating if it is worth entering a position given there is a market maker spread to enter and exit, and that you often will have to buy at a slightly higher price than fair value, and sell at a discounted price to fair value… there is much more to this.
Also, part of the game is to determine the probabilities for success and failure, as much as determine the static risk and reward. This is often overlooked by newbies.
I suggest you read through the extensive threads on this topic which should answer the majority of your questions.
Look up WayneL, Sails, and myself and see all the posts we’ve made on options, and read through the various threads in the derivative forum. You’d be surprised at the broad range of topics we’ve covered.
Another point: If you really want to use these instruments, get all the books we’ve recommended on the various threads, and read them thoroughly. Don’t try to do this alone either. Find a mentor to help guide you. The practice of options trading takes time to learn too. You may also consider getting good options software to help calculate the best options too – personally without this kind of tool it’s like being a caveman in skins pitted against well equipped modern people.
If you want to trade the way you describe, my general rule for such positions is to work out the magnitude I would expect out of the move, the maximum time I think I could be in the position, and buy with sufficient time to exit before 30 days till expiry if still OTM without the prospect of moving ITM (there are some exceptions of course). I’d look to have the strike finish either ATM or ITM within my projected time frame and price target.
As for volatility, Id look at the movement of the stock and the movement of volatility both, for a call in this case (you may consider using puts at some stage), and in different time frames. To buy a long call I’d prefer the volatility to be in the bottom third, preferably quarter of the recent range in the time frame I’m working in. If IV is high, I might consider a bull put or a bull call spread instead, depending on how strong a move I was expecting.
Of course if I thought a strong move was imminent, I’d calculate the probable IV crush and work out if the best strategy with the best mix of probability of success and risk and reward to determine if an options position was worthwhile or not.
OK, there is a lot more than this, this is the tip of the iceberg, but hopefully (hello Ducatti!!! Hehe) addresses some of your questions. Please do read ALL the threads on options on this site, there are some real gems embedded here.
Good Luck!!
Regards
Magdoran