Sunday, September 16, 2012

Directional Trading With Options Pt1

There are several philosophies used in options trading; premium collection, volatility trading etc. But the one I want to focus on for a while is straight out directional trading.

Yet again there are several means to trade directionally, from straight out option buys, to vertical spreads, to just about any other spread you can think of.

All require some consideration of direction, volatility and magnitude (yes there is a difference) of the anticipated move, and hence the effect of the Greeks... or rather a quantification of risk and reward via the Greeks.

The simplest way to trade direction with options of course, is straight out option buys, but once more the decision to buy an option is more complicated than straight out stock. We are faced with dozens of alternatives in the form of strike, expiry and quantity of options relative to an equivalent stock position. Though we may attempt to ignore them, the Greeks will still quantify risk and reward.

Some options educators recommend long dated, deep In The Money options as a stock replacement strategy, with delta greater 0.7, yet some others recommend short dated, way Out of The Money options in some hope to hit the occasional home run.

I think it's kind of futile to make such blanket statements without knowing what it is the trader is trying to do. There are various styles of directional traders, from long term strategic traders, trend traders, swing traders and day traders. The trader's goal in taking a trade is going to be important in what strike or expiry he or she selects... or indeed whether an option has an advantage over the underlying; there is no point in complicating a trade for no advantage.

The successful stock trader will have a risk management and position sizing regime in place, so for any trade, a position size will be calculated. In option lingo terms, we can describe this as the number of deltas. As the share delta is 1.0, the number of shares will be the number of deltas exposure in the trade. If a long position size is calculated as 1000 shares, we have 1000 deltas exposure.

If we are considering replacing stock with options, that is also how we should view our directional exposure, by the number of deltas. For example, if we bought ATM options with a delta of 0.5, we would need 20 contracts to make up the equivalent 1000 deltas of exposure. DITM options with a delta of 0.7 would need 14 contracts to approximate the 1000 deltas and OTM options with a delta of 0.25 would require 40 contracts to do the same.

It is the with other Greeks where things get interesting and how we can define whether there is anything to gain... or lose from option buys. A stock position is not affected by these Greeks, so we know absolutely our profit or loss from a given move. However options are non-linear and profit or loss parameters exist a in a more chaotic system. We can know profit or loss within a range,with a given move in the underlying, but the randomness of volatility changes and time in the trade make the absolute results more variable.

An examination of each type of trading is beyond the scope of this article and it is my belief that if long options have potential to outperform stock trading, it is in the swing trading time frame or momentum plays, trades of 3 - 20 days duration.

That's the time frame I want to look at.

Part 2 HERE