Options trading parameters

Options Greeks: Options and Risk Parameters.

One other Greek is known as the Gamma of the Gamma , which measures the rate of change of the rate of change of Delta . Not often used by strategists, it may become an important risk measure of extremely volatile commodities or stocks, which have potential for large changes in Delta .

In terms of position Greeks, a strategy can have a positive or negative value. In subsequent tutorial segments covering each of the Greeks, the positive and negative position values for each strategy will be identified and related to potential risk and reward scenarios. Figure 1 presents a summary of the essential characteristics of the Greeks in terms of what they tell us about potential changes in options valuation. For example, a long (positive) Vega position will experience gains from a rise in volatility, and a short (negative) Delta position will benefit from a decline in the underlying, other things remaining the same.

Risk & Money Management.

Correctly managing your capital and risk exposure is essential when trading options. While risk is essentially unavoidable with any form of investment, your exposure to risk doesn't have to be a problem. The key is to manage the risk funds effectively; always ensure that you are comfortable with the level of risk being taken and that you aren't exposing yourself to unsustainable losses.

The same concepts can be applied when managing your money too. You should be trading using capital that you can afford to lose; avoid overstretching yourself. As effective risk and money management is absolutely crucial to successful options trading, it's a subject that you really need to understand. On this page we look at some of the methods you can, and should, use for managing your risk exposure and controlling your budget.

Using Your Trading Plan Managing Risk with Options Spreads Managing Risk through Diversification Managing Risk using Options Orders Money Management & Position Sizing.

Using Your Trading Plan.

It's very important to have a detailed trading plan that lays out guidelines and parameters for your trading activities. One of the practical uses of such a plan is to help you manage your money and your risk exposure. Your plan should include details of what level of risk you are comfortable with and the amount of capital you have to use.

By following your plan and only using money that you have specifically allocated for options trading, you can avoid one of the biggest mistakes that investors and traders make: using “scared” money.

When you are trading with money that you either can’t afford to lose or should have set aside for other purposes, you are far less likely to make rational decisions in your trades. While it's difficult to completely remove the emotion involved with options trading, you really want to be as focused as possible on what you are doing and why.

Once emotion takes over, you potentially start to lose your focus and are liable to behave irrationally. It could possibly cause you to chase losses from previous trades gone bad, for example, or making transactions that you wouldn’t usually make. If you follow your plan, and stick to using your investment capital then you should stand a much better chance of keeping your emotions under control.

Equally, you should really adhere to the levels of risk that you outline in your plan. If you prefer to make low risk trades, then there really is no reason why you should start exposing yourself to higher levels of risk. It's often tempting to do this, perhaps because you have made a few losses and you want to try and fix them, or maybe you have done well with some low risk trades and want to start increasing your profits at a faster rate.

However, if you planned to make low risk trades then you obviously did so for a reason, and there is no point in taking yourself out of your comfort zone because of the same emotional reasons mentioned above.

If you find it difficult to manage risk, or struggle to know how to calculate the risk involved in a particular trade, you may find the following article useful – Understanding Risk Graphs & Risk to Reward Ratio. Below, you will find information on some of the techniques that can be used to manage risk when trading options.

Managing Risk with Options Spreads.

Options spreads are important and powerful tools in options trading. An options spread is basically when you combine more than one position on options contracts based on the same underlying security to effectively create one overall trading position.

For example, if you bought in the money calls on a specific stock and then wrote cheaper out of the money calls on the same stock, then you would have created a spread known as a bull call spread. Buying the calls means you stand to gain if the underlying stock goes up in value, but you would lose some or all of the money spent to buy them if the price of the stock failed to go up. By writing calls on the same stock you would be able to control some of the initial costs and therefore reduce the maximum amount of money you could lose.

All options trading strategies involve the use of spreads, and these spreads represent a very useful way to manage risk. You can use them to reduce the upfront costs of entering a position and to minimize how much money you stand to lose, as with the bull call spread example given above. This means that you potentially reduce the profits you would make, but it reduces the overall risk.

Spreads can also be used to reduce the risks involved when entering a short position. For example, if you wrote in the money puts on a stock then you would receive an upfront payment for writing those options, but you would be exposed to potential losses if the stock declined in value. If you also bought cheaper out of money puts, then you would have to spend some of your upfront payment, but you would cap any potential losses that a decline in the stock would cause. This particular type of spread is known as a bull put spread.

As you can see from both these examples, it's possible to enter positions where you still stand to gain if the price moves the right way for you, but you can strictly limit any losses you might incur if the price moves against you. This is why spreads are so widely used by options traders; they are excellent devices for risk management.

There is a large range of spreads that can be used to take advantage of pretty much any market condition. In our section on Options Trading Strategies, we have provided a list of all options spreads and details on how and when they can be used. You may want to refer to this section when you are planning your options trades.

Managing Risk Through Diversification.

Diversification is a risk management technique that is typically used by investors that are building a portfolio of stocks by using a buy and hold strategy. The basic principle of diversification for such investors is that spreading investments over different companies and sectors creates a balanced portfolio rather than having too much money tied up in one particular company or sector. A diversified portfolio is generally considered to be less exposed to risk than a portfolio that is made up largely of one specific type of investment.

When it comes to options, diversification isn't important in quite the same way; however it does still have its uses and you can actually diversify in a number of different ways. Although the principle largely remains the same, you don’t want too much of your capital committed to one particular form of investment, diversification is used in options trading through a variety of methods.

You can diversify by using a selection of different strategies, by trading options that are based on a range of underlying securities, and by trading different types of options. Essentially, the idea of using diversification is that you stand to make profits in a number of ways and you aren't entirely reliant on one particular outcome for all your trades to be successful.

Managing Risk Using Options Orders.

A relatively simple way to manage risk is to utilize the range of different orders that you can place. In addition to the four main order types that you use to open and close positions, there are a number of additional orders that you can place, and many of these can help you with risk management.

For example, a typical market order will be filled at the best available price at the time of execution. This is a perfectly normal way to buy and sell options, but in a volatile market your order may end up getting filled at a price that is higher or lower than you need it to be. By using limit orders, where you can set minimum and maximum prices at which your order can be filled, you can avoid buying or selling at less favorable prices.

There are also orders that you can use to automate exiting a position: whether that is to lock in profit already made or to cut losses on a trade that has not worked out well. By using orders such as the limit stop order, the market stop order, or the trailing stop order, you can easily control at what point you exit a position.

This will help you avoid scenarios where you miss out on profits through holding on to a position for too long, or incur big losses by not closing out on a bad position quickly enough. By using options orders appropriately, you can limit the risk you are exposed to on each and every trade you make.

Money Management and Position Sizing.

Managing your money is inextricably linked to managing risk and both are equally important. You ultimately have a finite amount of money to use, and because of this it's vital to keep a tight control of your capital budget and to make sure that you don’t lose everything and find yourself unable to make any more trades.

The single best way to manage your money is to use a fairly simple concept known as position sizing. Position sizing is basically deciding how much of your capital you want to use to enter any particular position.

In order to effectively use position sizing, you need to consider how much to invest in each individual trade in terms of a percentage of your overall investment capital. In many respects, position sizing is a form of diversification. By only using a small percentage of your capital in any one trade, you will never be too reliant on one specific outcome. Even the most successful traders will make trades that turn out badly from time to time; the key is to ensure that the bad ones don’t affect you too badly.

For example, if you have 50% of your investment capital tied up in one trade and it ends up losing you money, then you will have probably lost a significant amount of your available funds. If you tend to only use 5% to 10% of your capital per trade, then even a few consecutive losing trades shouldn’t wipe you out.

If you are confident that your trading plan will be successful in the long run, then you need to be able to get through the bad periods and still have enough capital to turn things around. Position sizing will help you do exactly that.

Pick The Right Options To Trade In Six Steps.

Two major benefits of options are (a) the extensive range of options available, and (b) their inherent versatility that allows any conceivable trading strategy to be implemented. Options are currently offered on a vast range of stocks, currencies, commodities, exchange-traded funds and other financial instruments; on each single asset, there are generally dozens of strike prices and expiration dates available. Options can also be used to implement a dazzling array of trading strategies, ranging from plain-vanilla call / put buying or writing, to bullish or bearish spreads, calendar spreads and ratio spreads, straddles and strangles, and so on. But these same advantages also pose a challenge to the option neophyte, since the plethora of choices available makes it difficult to identify a suitable option to trade. Read on to learn how to pick the right option/s to trade in six easy steps.

We start with the assumption that you have already identified the financial asset – such as a stock or ETF – you wish to trade using options. You may have arrived at this “underlying” asset in a variety of ways – using a stock screener, by employing technical or fundamental analysis, or through third-party research. Or it may simply be a stock or fund about which you have a strong opinion. Once you have identified the underlying asset, the six steps required to identify a suitable option are as follows:

Formulate your investment objective Determine your risk-reward payoff Check out volatility Identify events Devise a strategy Establish option parameters.

In my opinion, the order shown of the six steps follows a logical thought process that makes it easier to pick a specific option for trading. These six steps can be memorized through a handy mnemonic (although not in the desired order) – PROVES – which stands for Parameters, Risk/Reward, Objective, Volatility, Events, and Strategy.

A step-by-step guide to picking an option.

Objective : The starting point when making any investment is your investment objective, and option trading is no different. What objective do you want to achieve with your option trade? Is it to speculate on a bullish or bearish view of the underlying asset? Or is it to hedge potential downside risk on a stock in which you have a significant position? Are you putting on the trade to earn some premium income? Whatever your specific objective, your first step should be to formulate it because it forms the foundation for the subsequent steps. Risk/Reward : The next step is to determine your risk-reward payoff, which is very dependent on your risk tolerance or appetite for risk. If you are a conservative investor or trader, then aggressive strategies such as writing naked calls or buying a large amount of deep out of the money (OTM) options may not really be suited to you. Every option strategy has a well-defined risk and reward profile, so make sure you understand it thoroughly. Volatility : Implied volatility is the most important determinant of an option’s price, so get a good read on the level of implied volatility for the options you are considering. Compare the level of implied volatility with the stock’s historical volatility and the level of volatility in the broad market, since this will be a key factor in identifying your option trade / strategy. Events: Events can be classified into two broad categories – market-wide and stock-specific. Market-wide events are those that impact the broad markets, such as Federal Reserve announcements and economic data releases, while stock-specific events are things like earnings reports, product launches and spin-offs. (Note that we only consider expected events here, since unexpected events are by definition unpredictable and thus impossible to factor in a trading strategy). An event can have a significant effect on implied volatility in the run-up to its actual occurrence, and can have a huge impact on the stock price when it does occur. So do you want to capitalize on the surge in volatility before a key event, or would you rather wait on the sidelines until things settle down? Identifying events that may impact the underlying asset can help you decide on the appropriate expiration for your option trade. Strategy : This is the penultimate step in picking an option. Based on the analysis conducted in the previous steps, you now know your investment objective, desired risk-reward payoff, level of implied and historical volatility, and key events that may affect the underlying stock. This makes it much easier to identify a specific option strategy. Let’s say you are a conservative investor with a sizeable stock portfolio, and want to earn some premium income before companies commence reporting their quarterly earnings in a couple of months. You may therefore opt for a covered call strategy, which involves writing calls on some or all of the stocks in your portfolio. As another example, if you are an aggressive investor who likes long shots and are convinced that the markets are headed for a big decline within six months, you may decide to buy deeply OTM puts on major stock indices. Parameters : Now that you have identified the specific option strategy you want to implement, all that remains to be done is establish option parameters like expiration, strike price, and option delta. For example, you may want to buy a call with the longest possible expiration but at the lowest possible cost, in which case an OTM call may be suitable. Conversely, if you desire a call with a high delta, you may prefer an ITM option.

We run through these six steps in a couple of examples below.

1. Conservative investor Bateman owns 1,000 shares of McDonalds and is concerned about the possibility of a 5% decline in the stock over the next month or two.

Objective : Hedge downside risk in current McDonald’s holding (1,000 shares); the stock (MCD) is trading at $93.75.

Risk/Reward : Bateman does not mind a little risk as long as it is quantifiable, but is loath to take on unlimited risk.

Volatility : Implied volatility on slightly ITM call options (strike price of $92.50) is 13.3% for one-month calls and 14.6% for two-month calls. Implied volatility on slightly ITM put options (strike price of $95.00) is 12.8% for one-month puts and 13.7% for two-month puts. Market volatility as measured by the CBOE Volatility index (VIX) is 12.7%.

Events : Bateman desires a hedge that extends past McDonald’s earnings report, which is scheduled to be released in a little over a month.

Strategy : Buy puts to hedge the risk of a decline in the underlying stock.

Option Parameters : One-month $95 puts on MCD are available at $2.15, while two-month $95 puts are offered at $2.90.

Option Pick : Since Bateman wants to hedge his MCD position for more than a month, he goes for the two-month $95 puts. The total cost of the put position to hedge 1,000 shares of MCD is $2,900 ($2.90 x 100 shares per contract x 10 contracts); this cost excludes commissions. The maximum loss that Bateman will incur is the total premium paid for the puts, or $2,900. On the other hand, the maximum theoretical gain is $93,750, which would occur in the extremely unlikely event that McDonald’s plunges to zero in the two months before the puts expire. If the stock stays flat and is trading unchanged at $93.75 very shortly before the puts expire, they would have an intrinsic value of $1.25, which means that Bateman could recoup about $1,250 of the amount invested in the puts, or about 43%.

2. Aggressive trader Robin is bullish on the prospects for Bank of America, but has limited capital ($1,000) and wants to implement an option trading strategy.

Objective : Buy speculative long-term calls on Bank of America; the stock (BAC) is trading at $16.70.

Risk/Reward : Robin does not mind losing her entire investment of $1,000, but wants to get as many options as possible to maximize her potential profit.

Volatility : Implied volatility on OTM call options (strike price of $20) is 23.4% for four-month calls and 24.3% for 16-month calls. Market volatility as measured by the CBOE Volatility index (VIX) is 12.7%.

Events : None. The four-month calls expire in January, and Robin thinks the tendency of equity markets to finish the year on a strong note will benefit BAC and her option position.

Strategy : Buy OTM calls to speculate on a surge in BAC stock.

Option Parameters : Four-month $20 calls on BAC are available at $0.10, and 16-month $20 calls are offered at $0.78.

Option Pick : As Robin wants to purchase as many cheap calls as possible, she opts for the four-month $20 calls. Excluding commissions, she can acquire as many as 10,000 calls or 100 contracts, at the current price of $0.10. Although buying the 16-month $20 calls would give her option trade an additional year to work out, they cost almost eight times as much as the four-month calls. The maximum loss that Robin would incur is the total premium of $1,000 paid for the calls. The maximum gain is theoretically infinite. If a global banking conglomerate – call it GigaBank – comes along and offers to acquire Bank of America for $30 in cash in the next couple of months, the $20 calls would be worth at least $10 each, and Robin’s option position would be worth a cool $100,000 (for a 100-fold return on her initial $1,000 investment). Note that the strike price of $20 is 20% higher than the stock’s current price, so Robin has to be pretty confident in her bullish view on BAC.

While the wide range of strike prices and expirations may make it challenging for an inexperienced investor to zero in on a specific option, the six steps outlined here follow a logical thought process that may help in selecting an option to trade. The mnemonic PROVES will help one recall the six steps.

Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.

How Options are Traded.

Many day traders who trade futures, also trade options, either on the same markets or on different markets. Options are similar to futures, in that they are often based upon the same underlying instruments, and have similar contract specifications, but options are traded quite differently. Options are available on futures markets, on stock indexes, and on individual stocks, and can be traded on their own using various strategies, or they can be combined with futures contracts or stocks and used as a form of trade insurance.

Options Contracts.

Options markets trade options contracts, with the smallest trading unit being one contract. Options contracts specify the trading parameters of the market, such as the type of option, the expiration or exercise date, the tick size, and the tick value. For example, the contract specifications for the ZG (Gold 100 Troy Ounce) options market are as follows:

Symbol (IB / Sierra Chart format): ZG (OZG / OZP) Expiration date (as of February 2007): March 27 2007 (April 2007 contract) Exchange: ECBOT Currency: USD Multiplier / Contract value: $100 Tick size / Minimum price change: 0.1 Tick value / Minimum price value: $10 Strike or exercise price intervals: $5, $10, and $25 Exercise style: US Delivery: Futures contract.

The contract specifications are specified for one contract, so the tick value shown above is the tick value per contract. If a trade is made with more than one contract, then the tick value is increased accordingly.

For example, a trade made on the ZG options market with three contracts would have an equivalent tick value of 3 X $10 = $30, which would mean that for every 0.1 change in price, the trade's profit or loss would change by $30.

Call and Put.

Options are available as either a Call or a Put, depending on whether they give the right to buy, or the right to sell.

Call options give the holder the right to buy the underlying commodity, and Put options give the right to sell the underlying commodity. The buying or selling right only takes effect when the option is exercised, which can happen on the expiration date (European options), or at any time up until the expiration date (US options).

Like futures markets, options markets can be traded in both directions (up or down). If a trader thinks that the market will go up, they will buy a Call option, and if they think that the market will go down, they will buy a Put option. There are also options strategies that involve buying both a Call and a Put, and in this case, the trader does not care which direction the market moves.

Long and Short.

With options markets, as with futures markets, long and short refer to the buying and selling of one or more contracts, but unlike futures markets, they do not refer to the direction of the trade. For example, if a futures trade is entered by buying a contract, the trade is a long trade, and the trader wants the price to go up, but with options, a trade can be entered by buying a Put contract, and is still a long trade, even though the trader wants the price to go down.

The following chart may help explain this further:

Limited Risk or Limitless Risk.

Basic options trades can be either long or short and can have two different risk to reward ratios. The risk to reward ratios for long and short options trades are as follows:

As shown above, a long options trade has unlimited profit potential, and limited risk, but a short options trade has limited profit potential and unlimited risk.

However, this is not a complete risk analysis, and in reality, short options trades have no more risk than individual stock trades (and actually have less risk than buy and hold stock trades).

Options Premium.

When a trader buys an options contract (either a Call or a Put), they have the rights given by the contract, and for these rights, they pay an up front fee to the trader selling the options contract. This fee is called the options premium, which varies from one options market to another, and also within the same options market depending upon when the premium is calculated. The options premium is calculated using three main criteria, which are as follows:

In, At, or Out of the Money - If an option is in the money, its premium will have additional value because the option is already in profit, and the profit will be immediately available to the buyer of the option. If an option is at the money, or out of the money, its premium will not have any additional value because the options is not yet in profit. Therefore, options that are at the money, or out of the money, always have lower premiums (i. e. cost less) than options that are already in the money. Time Value - All options contracts have an expiration date, after which they become worthless. The more time that an option has before its expiration date, the more time there is available for the option to come into profit, so its premium will have additional time value. The less time that an option has until its expiration date, the less time there is available for the option to come into profit, so its premium will have either lower additional time value or no additional time value. Volatility - If an options market is highly volatile (i. e. if its daily price range is large), the premium will be higher, because the option has the potential to make more profit for the buyer. Conversely, if an options market is not volatile (i. e. if its daily price range is small), the premium will be lower. An options market's volatility is calculated using its long term price range, its recent price range, and its expected price range before its expiration date, using various volatility pricing models.

Entering and Exiting a Trade.

A long options trade is entered by buying an options contract and paying the premium to the options seller. If the market then moves in the desired direction, the options contract will come into profit (in the money). There are two different ways that an in the money option can be turned into realized profit. The first is to sell the contract (as with futures contracts) and keep the difference between the buying and selling prices as the profit. Selling an options contract to exit a long trade is safe because the sale is of an already owned contract. The second way to exit a trade is to exercise the option, and take delivery of the underlying futures contract, which can then be sold to realize the profit. The preferred way to exit a trade is to sell the contract, as this is the easier than exercising, and in theory is more profitable, because the option may still have some remaining time value.