Option trading with DanPickUp

[DanPickUp]

What should be our time frame and SL for both of the above trades ?

Hi Jain.er

You are quit free with any time frame you want choose. It mainly depends on what kind of options the Exchange offers to its option traders. As this offers are quit limited on the Bombay Exchange, you not really can trade such strategies on a bigger time frame like three months or even longer.

For the short strangle you could plan a time frame of three weeks or less. Just be clear about the range you choose for the sold options, as market not should touch your break even points on either side, which are at the same time your stop losses if you would not adjust the strategy. Will talk later about adjustments of strategies.

For the long straddle can be told the same with the time frame as told above. As we are long, we have to watch the daily time decay of the options, specially if market not moves in one or the other direction. For the stop loss of each side you can choose a fix amount of value you defined in advance to risk and if this amount/value is gone in your option, you sell it. An other way is to define a range on the chart and to use this range as stop loss. This range can be defined with Pivot Points or Standard Deviation Channels. Will also have again a look at that when coming to the stop loss subject.

DanPickUp

 

[timepass]

Dan,

1) "Naked Option" means one leg ? Either buy or sell an option, no second leg. Is that it ??

2) Moving averages : If "median" or "average" is not available, is there any alternative to it ? My software (Sharekhan Trade Tiger has options for drawing moving average considering High/Low/Open/Close only, no median.

 

[shiva5109]

respected sir ,
suppose abc stock is trading at rs 50 and i like to buy call of 55 and put of 45 at a premium of a call is 7 and a premium of put is 6 ,

tomorrow abc is trading at 56 now my confusion is this where i have to book profit above the strike price or above the break even point


please help

 

[DanPickUp]

Hi

Timepass, yes you are right with your answers to the first question.

To your second question check this link: http://i44.tinypic.com/153bq81.png . Instead of median I choosed closed and then shifted it horizontal. The effect now is the same as with median MA. Remember: The tool is mainly used as an add visualization to spot trends a bit more easy.

Shiva5109, what you talk about is a long strangle. I did not mention that strategy. Even then: Main request for a long strategy is low vola. Now where to take profit? This screen shot should help:

Now lets move on to the sixth subject which is: Margins for the strategy or any trade.

Definition of option margins:

The cash or securities an investor must deposit in his account as collateral before writing options. This cash is may also be needed to close losing positions.

Why do I mention that little subject? Because of its importance in any kind of trading you do. First rule I was told when I traded the first time in my live: Never ever get a margin call from your broker.

Hmm? What did that mean? If I have a bad trade and I loose money, the broker will check my account I have with him and he will decide if I have to bring in some more money to trade further. If I not can bring that money, the trade will be closed with the margin money (security money) the broker blocked in my account. If all that money has gone and he needs more money, he will call my house bank or me and ask for some more money. This money he will see now. This then is called: Margin call.

We do not want such calls and we do not get such calls, as we know what margin means and that is why I mention that subject. So, before implementing any trade or strategy we planned, we check the margin which is asked for that trade. This is a MUST and not a maybe. With the time you will know automatically what margins you have with your routine trades.

We can be pure margin traders. That would mean, that we always only have that money with our broker which is needed as margin for this trade we do. As we now had the MFGlobal bankruptcy, which showed the risk we face when putting much money with one broker, I recommend you to place your money with different brokers and never put too much money in to one account. It is all your choice as the meanings about that are various.

Long option trades do not need any margin, as you buy the option and you only can buy what you can pay with the amount which is in your brokers account. If there is not enough money for what you want to buy, it not will be bought. As simple as that.

Shorting options is different. In India the margin for one sold option is always 27000 Rp. As far as I know, it is the same amount like it is for Nify future trading.

If you now buy one option, stock or future and you sell one option in the same strategy, ICICI still want to see the fully 27000 Rp even you are long one other derivative in the same strategy. That means that ICICI not will accept, that you can use an underlying of any kind as collateral. In the USA, this is not of a problem. Example: Neither covered calls nor covered puts have a margin requirement. I hope to the gods of you that the day comes when ICICI changes that rules in India.

Sixth subject closed.

DanPickUp

 

[DanPickUp]

Hi

Subject number seven: Choosing the strike level/s.

To choose our strike levels we want to use for our trades, we have to look at the option chain which is offered from the exchange we trade with, on the underlying we want to use. You have to be clear that not all option chains are the same. It various from underlying to underlying.

In stock option trading and in future option trading you will be confronted with various option chain systems. It can start with the offer of one option on each half point strike level and moves up to just being offered one option on each 100 strike point levels. Be careful with that.

If you want to know exactly what kind of option chain is offered on your shares or futures you want to trade with options, clear this point with your broker and ask about what strike levels are offered? This is important for both kinds of traders: Pure directional option traders and for strategically option trading. Why?

Otm, atm and itm options are your choice and if you do not know the strikes which are offered from the exchange on the underlying you trade, you could loose money because of not knowing basics about offered option strike price levels.

We have discussed in post 27 about how otm, atm and itm options are priced. Remember: Time Value and intrinsic value! If you do not exactly know what strike levels you can use or are offered on the underlying, your used option may never get in the money or may is far to expensive for the risk you wanted to take.

If this subject number seven is new to you: Play around a bit in the following link and compare the option chains which are offered from the NSE. There is a small field which is written: Search for an underlying stock. Here you write in the name from the stock you want to see and then you will get the option chain from that stock or from that future. By the way: If you never have seen this page before, read a bit through it. Many ways to use all this informations.

http://www.nseindia.com/live_market...t=OPTSTK&date=-&segmentLink=17&segmentLink=17

Now one other thing you have to consider and to understand are the expiration days from the underlying you trade on and from the option you use on it. This is quit important for the traders which trade or plan to trade options on futures. Why? Always be sure that your traded option is traded on the right underlying expiration month. How to know?

Check the expiry day of the future and compare the expiry days from he options on that future. If the future expires today or tomorrow and the option expires in one week and you plan an option trade of two weeks, you should take options from the new month series and not from the old month series. Other wise you may have to roll them in to the new month and this will cost commission. This point even becomes more important if you are a short time hedger. As you not really can trade on many futures in India, this should be easy to control.

To give you an example what is offered in the USA, have a look in the coming link. On the right upper side you can choose option contract specification and you can choose the month and then submit: http://www.rjobrien.com/calendars/index.php?type=fcs&month=2&sub_cal=Submit

Now you see the months when this option are traded (Just letters as each month has his own letter which is explained at the bottom of the page) and then choose the next link to find out the exactly option expiration date: http://www.cboe.com/AboutCBOE/xcal2012.pdf. Now you should understand why I posted about this expiration dates and the importance of being clear about that subject, specially when trading on the CME in the US.

Follow up post on this subject will be made.

DanPickUp

 

[DanPickUp]

Hi

Depending on the way of trading, we have to choose one or more option we want to trade with. We now have an idea about what an option chain is and how important it is to choose the right option month on the underlying we trade on.

Now knowing that: The next step we can do is to have a look at the Open Interest (OI) on important option strike levels. What ever kind of option trader you are, you will first check the vola in the market which gives you an idea about the range the market moves and you will check the time frame you want to be in the market.

If vola is low and you prefer to do directional option trades, you can use options deep in the money, as they represent in a better way the moves of the underling. Why? Because the Delta (*)of the option is higher and if vola of the market is low, the market moves less. If you choose an otm option, this option may never comes in to the money. So you then choose your option strike levels build on that fact.

If vola is high, you also could use otm, as market moves fast and your option could get atm or even itm quit quick. But as I told: Could and not must. Also here, you then would choose an option strike level based on that fact.

Definition of open interest:

The total number of options and/or futures contracts that are not closed or delivered on a particular day. A common misconception is that open interest is the same thing as volume of options and futures trades. This is not correct, as demonstrated in the following example:

-On January 1, A buys an option, which leaves an open interest and also creates trading volume of 1.
-On January 2, C and D create trading volume of 5 and there are also five more options left open.
-On January 3, A takes an offsetting position, open interest is reduced by 1 and trading volume is 1.
-On January 4, E simply replaces C and open interest does not change, trading volume increases by 5. (**)

Now what is it useful for to have a look at this OI? OI tells me, if this option is asked from other traders. If there is big OI on certain levels, we know that these strikes are asked for and we easily can buy and sell these options.

If there is very low OI on certain levels and we choose those strike levels, we really can get in trouble to trade with this option. As there is not much interest on such levels and we may own options from it, we could lose money on this options only because we not can sell them or buy them back, as there are no or only a few traders interest in this option. The bid ask spread (***) will be very bad and so we not need to choose such option strike levels.

Many try to predict the market through analyzing OI. If OI raises on certain strike levels, this is valued as a signal that the underlying could move to that strike levels and if OI falls, that is valued as a signal that market could move away from that levels. This analyzes is done on both sides, means on the call side and the put side. This knowledge can be quit useful in day trading and longer term trading. Kiranjakka has a thread in which he gives examples how to analyze this OI in your home market. Columbus, Linkon and others also have threads with lots of information on OI trading.

If we do strategically option trading and we want to implement for example a long strangle, like showed in post 44, we have to choose more than one option strike level. A simple way to choose this strike levels is the following:

One way to choose strike levels is to use the bell curve or also called the normal distribution and the OI for the strikes we choose.

If vola is high in the market we trade, we get automatically a bigger range and if vola is low, we get automatically a smaller range in the bell curve. The bell curve we use on the time frame we want to be in the market. Do not use the BC on a one hour time frame when you want to have results on a five day time frame.

As we now know the strike of the put and the call from the result of the BC, we check the OI on those levels. If they are good, we use those levels for our long strangle trade. If you do not know what the bell curve is, please read through the link given at the end of this post (****). Most important is to understand the following:

The Empirical Rule

The empirical rule is a handy quick estimate of the spread of the data given the mean and standard deviation of a data set that follows the normal distribution. The empirical rule states that for a normal distribution:

• 68% of the data will fall within 1 standard deviation of the mean.
• 95% of the data will fall within 2 standard deviations of the mean
• Almost all (99.7%) of the data will fall within 3 standard deviations of the mean

Note that these values are approximations. For example, according to the normal curve probability density function, 95% of the data will fall within 1.96 standard deviations of the mean; 2 standard deviations is a convenient approximation.

With simple words:

68% of the whole range is touched most. That is Standard Deviation one in the middle part of the curve. Both other Stdv, two and three, are looked at as support and resistance levels, which will be less touched mathematically.

This curve you can lay over any time frame you trade with. It will show you in what range market most likely will trade in this time frame. If we know that, we for example can place limit orders which have a chance to be filled, because of the math we used behind the strike level we place an order on. Check in your software if you have such a math tool and if not, paint ranges in your traded time frames to have an idea about any range which market maybe will trade.

Seventh subject closed .

DanPickUp

(*) Will explain more about Delta in the next post
(**)Source: http://www.investopedia.com/terms/o/openinterest.asp
(***)http://www.investopedia.com/terms/b/bid-askspread.asp
(****)http://www.netmba.com/statistics/distribution/normal/

 

[DanPickUp]

Hi

Before spotting on the next subject let us have a quick look at Delta. Delta is the third option greek you are confronted with in this thread. Until now we had a look at Vega (Post 14) and we had a look at Theta (Post 27).

I repeat:

ϒ(Vega) represents the rate of change between an option portfolio's value and the underlying asset's volatility - in other words, sensitivity to volatility.

Θ(Theta) represents the rate of change between an option portfolio and time, or time sensitivity.

Definition of Delta:

Δ(Delta) represents the rate of change between the option's price and the underlying asset's price - in other words, price sensitivity.

For example, with respect to call options, a delta of 0.7 means that for every $1 the underlying stock increases, the call option will increase by $0.70.

Put option deltas, on the other hand, will be negative, because as the underlying security increases, the value of the option will decrease. So a put option with a delta of -0.7 will decrease by $0.70 for every $1 the underlying increases in price.

As an in-the-money call option nears expiration, it will approach a delta of 1.00, and as an in-the-money put option nears expiration, it will approach a delta of -1.00. (*)

You may heard once that some body talked about: This is a pure delta trader. That means that this trader takes trading decisions purely on the change of the delta of the option he trades. Hedgers use delta to see when they have to act. To not make this post too long, as delta trading could fill one thread, I made you a PDF you can read through (**). It includes:

Background information to delta trading
What is neutral option trading
What is the premium purpose of a neutral option spread
How to initiate delta neutral spreads
Adjusting delta neutral spreads
Will I make money when trading delta neutral spreads
Delta neutral trading tips

https://rapidshare.com/files/734897675/Delta.pdf

If you have any questions about delta or about how to choose our strike levels, please post it now before I move on to the next subjects.

DanPickUp

(*) Source: http://www.investopedia.com/terms/d/delta.asp
(**) Source: P. Forchone : How to trade options visually

 

[DanPickUp]

Hi

A quick update to the long straddle and short strangle we had a look at in post 32.

Our long straddle is doing fine. First date shown was Feb. 06. 2012. As vola was low, we went long one 155 put and one 155 call. Market moved up and touched 159 after we had a nice bullish Harami, which was finally formed on Feb. 13. 2012.

http://i44.tinypic.com/wvzfah.png

We now have the choice to add one more option on the downside. We could buy one more cheap 155 put to reduce our entry price we had on that side of the trade. We then would have converted our long straddle in to a strip. Why do I mention a put as market moves up?

On the stochastic, a regular divergence is forming beside the slowly rising vola. That could be an other sign, that market could change direction.

If you believe that market only will rise, you could sell your long put now and go for a straight forward naked call.

Or you convert your long straddle in a bear call spread by selling the long put and by selling a call 150. You then have a long call 155 and a short call 150.

There are more ways you can play around with options. I only can give you impulses how to think about your option trades. Testing your ideas you really should do on a simple matrix and then you see also your risk analyzing picture. At begin it may is a bit complicated, but with the time it goes more easy and easy.

Now to the short strangle: As thought, market jumped up at the moment vola starts to fall.

http://i43.tinypic.com/2uh94lf.png

What to do in that situation? We just can leave the trade as it is, as this was the main idea behind it. The range works until today. Vola decreases in our favor. Until now, a simple trade witch works and we do not have to sit in front of the screen and watch all the times. Even the weekend is in our favor as time is passing and the option losses value with that.

DanPickUp

 

[traderjaya]

Hi Dan

How to get the Vola for stocks? Is it a standard formula that one can code in AMIBROKER or is it something that comes from the exchange?

Thanks,
Jaya

 

[SavantGarde]

http://www.nseindia.com/content/nsccl/FOVOLT.csv

Hi Dan

How to get the Vola for stocks? Is it a standard formula that one can code in AMIBROKER or is it something that comes from the exchange?

Thanks,
Jaya