Option Strangle Magic » Risk

Option Theory and Trading: A Step-by-Step Guide To Control Risk and Generate Profits (Wiley Trading) (Hardcover)

admin — Thu, 14 Jan 2010 19:19:16 +0000

Praise for Options Theory and Trading “I’ve had the pleasure of teaching with Ron Ianieri at numerous live seminars for traders and investors, and one thing is for sure-Ron knows options! Now Ron has created a thorough, easy-to-read guide that you can benefit from in many ways, whether you are experienced in options trading or just starting out. I believe you will find Options Theory and Trading like Ron himself . . . full of knowledge, entertaining, fast-paced, and a joy to be around.” —Price Headley, CFA, CMT, founder of BigTrends.com “I’ve had the pleasure of knowing and working with Ron for many years now. When managing funds in our asset management company, Ron has always been our ‘go-to guy’ on anything options-related. I’ve also taught a number of seminars side by side with Ron over the years where I’ve always come home knowing more about options than when I left! The man is truly the ‘pitbull’ of derivatives.” —Peter Reznicek, Chief Equi (more…)

Options Trading and Risk

admin — Sun, 03 Jan 2010 10:36:12 +0000

Is options trading risky? This is one of the most popular questions that options trading beginners ask. In fact, my clients ask me this same question all the time. I would then ask them “What do you mean by risky?”. The usual answer would be “Can I lose a lot of money in options trading?”.
At least this brings us somewhere. Asking if options trading is risky without a clear idea what risk is in the first place gets nobody anywhere.
Risk is defined in many different ways to different people and for most people, risk is simply an expression of their fear of losing money. Whenever I am asked by an options trading beginner if options is risky, I know what they are really telling me is that they don’t want to lose money. How can we address this “risk” then?
Even though there are many ways to define risk in the financial sense, I think my 2 parts explanation caters best to the needs of the common retail investor. In my 2 parts explanation, risk in options trading for common retail investors are made up of; 1, Probability of Loss. 2, Consequence of Loss.
It’s like crossing a street. The probability of death is small but the consequence of death is catastrophic. However, because the probability is so small, we continue to do it every day.
In stock trading, you cannot really control the probability of loss because you win only if the stock goes up. That is why stock traders reduce the consequence of loss by having sensible stop loss in place.
See how the probability of risk and the consequence of risk interact with each other now?
The good news about Options Trading is that you get to control both the probability of risk and the consequence of risk! If you can control both elements of risk, won’t options trading actually be less risky than stock trading?
Options trading reduces the probability of risk through options strategies that profit from more than one direction. In fact, there are options strategies that profit when the stock goes up, down and sideways all at once! When you can profit in so many different directions all at once, won’t your probability of risk be dramatically reduced? An example of such an options strategy is the Call Ratio Spread which makes a profit if the stock goes up to a certain limit, stay stagnant or go down endlessly.
Options trading (http://www.optiontradingpedia.com) reduces the consequence of risk through leverage. Leverage cuts both ways. If you abuse leverage and buy options like you buy stocks, then you are in big trouble. However, if you use only money you can afford to lose in each options trade and make use of its leverage to produce the same returns that you would if you have bought the stocks instead, won’t the consequence of risk always be within your acceptable limit? An example of this is the Fiduciary Call options trading strategy.
Since the probability of risk and the consequence of risk can be dramatically lower in options trading than in stock trading, is options trading still “risky”?
Risk can be defined in many ways and options trading is inherently risky due to its nature as a leveraged derivative instrument. However, with sensible control of the probability and consequence of risk, your options trading experience may be a lot less “risky” than you think. Options trading becomes “risky” when you lose control over these 2 critical elements.

Balance of Risk and Reward in Options Trading

admin — Mon, 14 Dec 2009 09:44:37 +0000

You don’t need to be a trader or an investor to know that the higher the risk, the greater the reward. This concept is true in all aspects of life and business. The more risk you are willing to undertake in life, the more life returns to you. Indeed, risk and reward are directly proportional and often in trading and investment, the more risk your account is exposed to, the greater the return on investment when things work out as planned.
Knowing that risk and reward are proportional makes finding the correct balance of risk and reward extremely important to all kinds of traders; stock traders, futures traders, options traders etc. There is no one solution that works for everyone and the correct balance is decided upon the risk appetite and risk tolerance of the individual trader.
For stock traders, balancing risk and reward primarily involves adjusting the amount of growth stocks and defensive stocks in one’s portfolio. Generally, the more growth or speculative stocks in one’s portfolio, the greater the risk due to greater uncertainty and therefore the higher the gain when things works out as expected. The more defensive stocks in one’s portfolio, the more predictable returns become and therefore the lower the return as these stocks does not generally move a lot. This degree of risk / reward balancing is at best crude compared to the surgically fine degree of balancing you can have in options trading.
Stock options are the most versatile trading instrument in the world right now due to the wide array of options strategies that are employable. Yes, not only can risk and reward be balanced through employing different mix of strategies in your portfolio, there are also different risk and reward profiles achievable by each individual options strategy. There are options strategies that range from making over 1000% profit while risking all your money to options strategies that make a mere 0.01% return while risking nothing as well as every centimeters in between.
As long as you understand what your personal risk appetite and risk tolerance is, you will be able to find an options strategy that suits your needs 100%. Here’s a general outline of the kind of risk reward balance that can be achieved through options trading:
Highest Risk, Highest Reward – OTM Call / Put buying
This is the options strategy that produces the legendary 1000% profit that amazed so many beginners. What those ads did not tell you is that the risk is losing ALL the money that you put into the strategy. This options strategy involves buying out of the money(http://www.optiontradingpedia.com/out_of_the_money_options.htm)call options when you think a stock is going to go up or buying out of the money put options when you think a stock is going to go down. Professionals use this options strategy with only a very small portion of their money in order to place a bet on an uncertain event such as leveraged buyout. Some lucky amateurs use this options strategy with all their money and then become millionaires overnight. The downside of this strategy is the fact that if the stock did not move far enough in the direction you expected it to, you can lose all the money you put into the strategy. That is also why so many beginners break their accounts overnight in options trading.
Various Degrees of Risk and Reward – Options Spreads
There are literally hundreds of possible options spread strategies out there with various degrees of risk and reward for every market condition. There are more aggressive bullish, bearish, neutral and volatile spreads and there are more conservative ones. All of them shares the same logic of higher risk compensated with a higher profit potential.
Lowest Risk, Lowest Reward – Options Arbitrage
Yes, there are literally risk free trading opportunities in options trading which also returns very small, sometimes negligible returns. These are the legendary options arbitrage strategies. Options arbitrage strategies such as conversion/reversal aims to make a fixed return totally risk free through simultaneously buying the underlying and shorting the overpriced synthetic equal or vice versa. The problem with such strategies is that the returns are so low that most of the time, it’s even lower than the commissions you will pay for the trades made. Even if you manage to return a positive return, the return can be as low as 0.01% in percentage terms. That is why arbitrageurs aim to make an absolute return using enormous amounts of money.
With this in mind, the most conservative traders may choose to specialize totally in arbitrage strategies (http://www.optiontradingpedia.com/options_arbitrage.htm) while the most aggressive traders may choose to specialize in leveraged speculation using OTM options. Everyone else would be able to find something to suit your risk appetite in the hundreds of spread possibilities. This degree of flexibility and range of risk/reward possibilities makes stock options the most versatile trading instrument in the world today and why options trading (http://www.optiontradingpedia.com) is so popular these days.

Options Trading Edge

admin — Sat, 12 Dec 2009 09:02:53 +0000

Many private traders deem that options are thought to be traded by experts with good mathematical skill. There are two reasons why many private traders think so, that are. trading options are too risky and difficult. Many private traders think that it is easier to just trade stocks or futures. So, a simple question, if trading futures or buying stocks looks so much easier and less complex to do, then why options are available to be traded? The actual reason is that options, which are unlike other trading vehicle, can offer a trading edge to the private traders and allow them to cover almost any investment strategy and risk profile with flexibility. In many ways, options are the most superior trading vehicles that many traders use nowadays. To trade options, you certainly do not need to be an expert in financing.

In the book “The New Market Wizards” written by Jack Schwager, concludes that nobody can win without an edge, even you have the world greatest discipline and money management skill. If you trade futures on the All Ordinaries Share Price Index (SPI), you have to know exactly what is your trading edge; particularly, if you are a professional floor trader. With the trading edge, you should able to see the buy and sell orders that coming into the trading pit and also who is buyer and seller. Besides, the speed of execution of your orders and the transaction costs also should able to see. The popularity of the stocks, options and futures is increasing; therefore, many people trade these products. Only a small proportion of these traders apply a real trading edge. The main reasons for the unsuccessful of many private traders in the financial markets are due to the lack of a trading edge, poor risk management and insufficient capital. The key point here is to find an edge, utilize it consistently and use the right risk and money management techniques. When the odds are in your favor, it is better that you learn how to trade options. It is also importantly when the odds are not in your favor, make sure you stand aside. You are doing yourself with the best possible chance of success if you doing so. Trading systems are as many as traders. We won’t trade a system if it doesn’t provide us with some sort of edge. If you have a system, which is able to give you an edge, why not further enhance your edge by trading options in a right circumstance. Before placing a trade, try to get as many factors that going in your favor as possible. By practicing this, you provide yourself with a much greater chance to success in the long run.

Without doubt, with any form of trading, there are no absolute guarantees. You can’t help compared to the many of the people who do not know anything about options and trade without an edge. But, you have a better chance to succeed in the long run and reach your financial ambitions. Flexibilities that can be offered by options are as follows:

i) Profit gained from an accurately anticipating rising or falling market. ii) With a relatively small disbursement, your potential returns can be greatly magnified.

iii) If the market goes to the way that you anticipate, you have unlimited profit potential, whilst you limit your risk by choosing an amount that you afford to risk.

iv) Profit still can be gained by correctly picking options where the market will not go.

v) Profit gained from flat or non-trending phases markets.

vi) Profit gained by letting the time passes by.

vii) Profit gained at an increasing rate when the market moves further in your favor.

Extremely flexible trading tool is option. You can use options trading strategies that are precisely suit your view of market, whilst sewing them closely to your personal risk tolerance level.

People who trade options for a living and as their business will try to understand and apply the principles, which have been outlined in this article. They do so because they know that there is an edge for then to be gained compare to the people who don’t. They are similar to the typical casino gambler if they do not trade with edge; their money will be destined to be lost ultimately. They are exactly like the casino itself if they trade with trading edge. For those people who trade the markets to make their living, you probably don’t have the chance to talk with them. Their occupation looks exotic and these people are imagined as weird mathematical geniuses who could give their money to Kasparov to run it in a chess tournament. The flair of occupational options traders couldn’t be going beyond from the veracity. Although many of the professional options traders who involve in the financial markets are intelligent people, they were not in the genius category. Nevertheless, they have one thing in common among them. They knew and applied certain unique principles in their options trading. The principles that they utilized offered then an edge to successfully trading in the market. Therefore, throughout their options trading life, they earn a good living.

You don’t have to be a professional options trader. The edge offered from the principles to the professional options traders also available to the private traders as well. Practically, these principles can be learnt and applied by yourself and the odds can be helped to put it more squarely in your favor. All the advantages that most of the professional options traders have may not be possessed by you. By using the same principles that they used, you can learn to make your trading more selective. In this way, you too can benefit from a trading edge.

Trading the Infamous Iron Condor

admin — Tue, 08 Dec 2009 11:05:31 +0000

Placing iron condor spreads on the broad market indexes is a relatively conservative, non-directional trading strategy that may be used for consistent income generation. This strategy profits as long as the index trades within the channel formed by the two spread positions. It is best used during sideways or slowly trending markets.Condor SpreadsA condor spread is a debit spread, established by placing a bear call spread at or above resistance and placing a bull call spread at or below support. The condor may also be established using puts with a bear put spread above and a bull put spread below. The iron condor is a variation on this trade by using a bear call spread above and a bull put spread below the price of the underlying stock or index. The iron condor is a credit spread and achieves maximum profitability if the price of the underlying closes between the short options (the strike prices we sold) of the two spreads at expiration. In that case, all options expire worthless and you achieve the maximum profit, i.e., the credits originally collected. The profitability of the iron condor is assisted by the fact that the broker only requires margin for one of the credit spreads, effectively doubling the return on investment.Condor spreads are effective when the underlying is expected to trade within the channel defined by the spreads during the life of the options. The closer one places the spreads to the current price of the underlying, the higher the returns; however, this comes with a higher risk of the price of the underlying stock or index entering one of the spreads and causing a loss on that spread.Trading the stock indexes with condors is effective for several reasons: 1) the indexes generally move slower than most individual stocks, 2) the indexes are less affected by an individual stock’s bad news, 3) the premiums of the index options are generally much higher than individual stock options, 4) index options trade in high volume because large institutional investors use these options to hedge their portfolios; this results in high liquidity, and 5) 60% of the gains with broad index options are taxed at long term capital gains rates, regardless of the length of time in the trade. Money ManagementMoney management refers to the rules used for determining the amount of capital devoted to a trade and spreading risk among strike prices and time. Determine the total dollar value you wish to devote to this strategy. For this example, we will assume we have a $100,000 account we will exclusively trade using the iron condor strategy. Take 40% of the total portfolio ($40,000) and divide by $1000 to get 40. This is the total number of contracts you will trade in this strategy each month (40 contracts total in the bear call spreads and 40 contracts total in the bull put spreads). This approach lessens your exposure during any particular month and leaves you room in the account to put on next month’s positions before last month’s positions have expired. This also reserves an additional 20% of capital as a safety margin and for possible use in trade adjustments. IMPORTANT: when learning this or any options trading strategy, start very small with one or two contracts and gradually increase your size as your experience and confidence grow.Money management also includes the concept of limiting your losses. Playing iron condors on the indexes as outlined in this paper are conservative, high probability trades. However, the potential loss is quite large, even though the loss has a low probability of occurrence. Therefore, one loss may wipe out several months of profits. Stop loss and adjustment rules and the discipline to strictly follow them are critical to the success of trading iron condors. Those stop loss and adjustment systems are taught in detail in the Advanced Options Trading Strategies course offered by Parkwood Capital, LLC.Timing (Days to Expiration)You can establish your condor position sometime in the range of 40 to 50 days until expiration. The precise time is not critical. The trade-offs are as follows: the earlier I put on my spread positions, the more time premium is present in the options and therefore I can receive the minimum credit I am willing to accept farther out from the current levels of the index; therefore, more safety margin is achieved. However, the more time I use in the spread, the more time that exists for the market to move against me; thus, I am incurring more risk. As time decay reduces the option premiums, I must move my spreads in closer to achieve a reasonable credit, reducing my safety margin and increasing my risk. It is also possible to trade the iron condor starting at about 30 days to expiration, but the system rules and adjustments must be adjusted accordingly.Determining Optimal Entry PointsSome traders place the call spreads when the index is hitting resistance and appears to be turning down, and place the put spreads when the index is hitting support and appears to be turning back upward. This will maximize the size of your credits. However, if the index continues to move in that direction, your position could be in trouble quickly and you will not have the compensating spread position helping to hedge your position. For this reason, I generally establish both the call spreads and put spreads on the same day.Choosing the StrikesWe can apply basic statistics to our deciding which strike prices are “far enough” out to be safe. The classic “bell shaped curve” we have seen in various contexts is the mathematical function known as a normal or Gaussian distribution. If we assume that future moves of the index price will be random and similar in frequency and absolute size to previous fluctuations up and down, then we can calculate the probability of the index price being at a particular price on a particular date in the future. I calculate the standard deviation for the index, based upon its level of implied volatility and the time left to expiration. The call spreads are placed just outside one standard deviation above the index price and the put spreads are placed just below one standard deviation below the index price. This results in an iron condor position with a probability of success of approximately 80-85%. The details of this methodology are taught in the Equity and Index Options course offered by Parkwood Capital, LLC.Entering the Order and Getting FilledNow that we have determined the strike prices for our spread, we need to calculate the credit we are going to ask for in our order. Compute the natural price for the credit spread, the natural debit spread price, and the midpoint of the spread (most online brokers calculate this for you).Enter your order at a credit limit at the midpoint and wait to see if the order is filled. After a few minutes, adjust the credit downward by $0.05. Repeat until both spread orders are filled. But do not drop below the lower quartile of the bid/ask spread.Never place an order for less than $0.60 to $0.70 in credit; trading commissions become too large a factor for smaller credits. My spread credits normally range from $0.60 to $1.05 per spread or about $1.20 to $2.10 per iron condor.Stop Losses and AdjustmentsThe topics of setting stop losses and the variety of adjustment methodologies available are beyond the scope of this paper. An effective, but simple, risk management technique is to monitor the debit spread necessary to close your condor spreads, and when that debit is double the original credit received for that spread, close that side of the condor. This technique will close out positions more frequently, but it will result in very small losses or near breakeven results in the “bad” months when the index moves against you.Index Option SettlementIndex options are cash settled options; there is no underlying instrument like stock shares to be called away or put to you. You simply lose or gain the dollar value at expiration, e.g., you hold 10 contracts of the $1400 call and the SPX settlement price is $1405; your account will be credited with $5,000 ((1405 – 1400) x 100 x 10). If you were short the $1400 calls, your account would be debited $5,000.Most index options are somewhat unusual in that they cease trading for the month at market close (4:15 pm ET) on the Thursday before expiration, but the settlement price is not that closing price on Thursday or the opening price Friday morning. Therefore, all final adjustments to positions must be done on Thursday before the close. On Friday morning, the settlement price will be computed based upon the opening prices of each of the stocks that make up that index. Since each stock may not trade immediately at the open, the settlement value may not be available until later that Friday morning. Since the settlement price may vary several dollars up or down from Thursday’s close, one must be cautious about going into settlement with any spread positions remaining open.Expected ReturnsIf you are placing your spreads for credits of $0.70 or more, then the returns for that iron condor will be about 15% for the month (remember that margin is only charged for one half of the iron condor). If we are using roughly half of our capital for an iron condor each month, then you can expect to average returns of about 6% to 8% per month. Of course, you may have to defensively close one of the spreads a few times per year and that will reduce the annualized return of this strategy. SummaryThe iron condor trading strategy is a relatively conservative, non-directional options strategy that may be used for consistent income. However, this strategy is typical of low return strategies with high probabilities of success. The probability of a loss is small, but one large loss will wipe out several months of profits. Thus, the key to success for trading iron condors is solid risk management rules for entry and exit, stop losses, and adjustments. When deployed conservatively as outlined herein, this strategy should reasonably be expected to return 5% or more per month.