Directional Trading With Options Pt2

Part 1 HERE.

In part one of this article, I stated that IF long option buys have any chance of outperforming straight out stock trading, it is the the "swing trading" time frame or momentum plays, generally moves that last 3 - 20 trading days. This is my opinion based on my experience and is not to say that one cannot be successful in other time frames, but let's just say my goal in option trading is outperforming stock trading over the long term; In other time frames, I doubt that the additional contest risk (extra brokerage and bid ask/spread in the notionally larger position size) and theta risk can be overcome by the advantages of gamma over the long term.

I m quite happy to stand to be corrected on this and I haven't done a scholarly thesis on this, but this matches the consensus of many other experienced option traders.

Firstly, lets look at the advantages and disadvantages of options versus stocks as I see it, always working with the assumption that an equal number of deltas is used, as described in Part 1

Complexity
Stocks have the advantage of being very simple to trade. You buy x number of stocks and that is the number of deltas you have, you can calculate the exact profit or loss that is possible from a given move. For example if you want to acquire 500 deltas of x stock, you simply buy 500 shares, if your stock goes up $1 you have made $500, if your stock goes down $1, you lose $500 - easy.

However to acquire 500 deltas in x's options, some qualitative decisions must first be made. Obviously those deltas are positive so we are looking at calls, but am I going ITM, ATM, OTM? What delta is the option I want to buy - and why? If the delta of the option is .33 we're going to need 15 contracts to get our 500 deltas. Fine, but what expiry? How far out to we want to buy - and why?

How will these decisions affect the outcome of the trade.

Stop Loss
There is an advantage in a long option position that the absolute maximum risk is known, that is the cost of the options. Stock traders will protest that a stop loss order can be placed on a stock position, however that does not protect the trader in the event of a large gap. If the stock gaps down 50% overnight, there is no stop loss in the world that will save you. In addition, once the stop loss order is triggered, you are out of the trade; and how often have you been stopped out only to see the stock immediately bounce higher?

Although the maximum loss of the option position may or may not equate to the calculated loss of a stopped out stock position, a maximum loss on the option position does not necessitate the exit of the trade. If that stock bounces back hard, you may still be in the money.

Gamma
Another advantage for the long option trader is gamma. This is the Greek that measures the change in delta as the stock price moves. If you are long the above calls, all things being equal, the position will increase in deltas as the stock goes up. So if that puppy is going in your favour, you have some automatic pyramiding of the position, and the higher it goes, the longer you get.

Likewise, if the position goes against you, deltas will decrease getting you less and less long as the stock moves down. The stock position never changes its delta however.

This is good news, the more gamma you have, the more accentuated this affect. There is a flip side to gamma though, which is...

Theta
Countering the positive effect of gamma, is theta (or time decay). Every day that you are in a long option position, you are losing time value on your option. Actually it is more complicated than that; the time value will vary in relation to the option's moneyness and volatility, but as a general principle it is true, an option devalues as time goes by.

Theta has a direct relationship to gamma, so the more gamma you have, so too the more theta you will have.

This is the prime reason I believe swing trading/momentum plays are the spot where long options may have an advantage over stocks; providing one makes intelligent choices regarding strike and expiry. You can acquire sufficient gamma to give you a real boost if you get on a strong move, yet not suffering to any great extent from the effects of theta.

Vega
Vega measures the effect of changes in volatility on the price of the option. Stocks don't have vega, so not a consideration. Whether vega is an advantage or disadvantage to a long option position is... well, it can be either and is not something to be ignored.

If you punt on some calls at what you think is the bottom of a big swoon at very high IVs, you will suffer some degree of premium sag if it starts moving your way, particularly if you buy OTM options and your position gets toward being at the money. You were right and you may be in profit, but it will be like having left the handbrake on.

It is possible to be right on the direction and still lose.

On the other hand, volatility tends to increase on down moves. Buying puts at low IVs can be spectacularly profitable if you catch a high volatility down move, because of vega.

These Greeks are all something to be considered when selecting strikes and expiries, or even whether to select a long option at all in a given situation, which goes back to the first point - Complexity.

These points I have only really touched on and there are deeper considerations to these Greeks, such as when and where their effect is greatest.

Part Three coming soon.

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

Day Trading Options - Contest Risk

This is a follow on from the previous post Options and Day Trading.

Firstly, let me define what I mean by contest risk, as it is not a term that is generally used in retail trader land. It is simple the cost of playing the game, in other words, the cost of commission plus the bid/ask spread.

It can be simply quantified by asking the question - what would be my loss if I entered and exited straight away and there was no movement in the underlying. So if the bid/ask spread on a stock was two cents you would lose that two cents in the trade, plus commission. If commission is one cent a share, the total contest risk is four cents a share, or $4.00 per hundred shares traded.

In the aforementioned interchange with my profane friend, he cherry picked a profitable trade where he purportedly made a $3,000 odd profit. Nice when looked at in isolation. But lets dig a bit further:

He told us he traded 27 x 1000 share contracts (the contract size in Australia at the time) = 27,000 shares of underlying, with a delta of approx 0.5 giving a total number of 13,500 deltas.

 The bid ask spread is typically about 5 - 8 cents... lets say 5 cents to be generous. That is 27,000 x $0.05 = $1,350 This means that if the share did not move and he exited, it would have resulted in a $1,350 loss PLUS commission.

It also means that the underlying has to move > 10 cents just to break even (remember our 0.5 delta) That's a massive impost to overcome in a daytrading system. Now compare that to Shares or CFDs, where to gain the same 13500 deltas, we only need 13500 shares with a spread of typically 1 cent.

That's $135 plus commission contest risk. In this instance the options are 10 TIMES more expensive to trade in terms of contest risk. Daytrading sytems, if positively expectant, are not greatly so, because you never get huge outliers. They rely on trade frequency to make money.

Maybe Bill is a good enough trader to overcome 10x contest risk, maybe not, but are the people he teaches?

I know I'm not a good enough day trader to overcome that sort of contest risk over the long term and I would bet London to a brick and Mombasa to a melon that very very few retail traders can overcome this either.

I have had the gamma argument thrown at me which if it moves enough can help, but countering this is theta, which depending on time til expiry and time of day can work against you. Over the great bulk of trades, it's line ball on those arguments in my opinion.

An important point is that our friend operates on the Australian stock exchange where there is much less liquidity and wider spreads than most US tickers. On the American exchanges there are options with much skinnier bid/ask spreads and if feels they must day trade options, that's where I would be looking...

...but for me, I'll just trade the underlying when I'm day trading.

Day Trading and Options

I am a fan of Day Trading. At various times in my trading career I have day traded as my primary means of income... paying for the groceries, the mortgage and the lease on the Por..... errr, I mean the Toyota.

To quote Ernie Chan from his 'QuantitativeTrading' blog:

Which brings me to day-trading. In the popular press, day-trading has been given a bad-name. Everyone seems to think that those people who sit in sordid offices buying and selling stocks every minute and never holding over-night positions are no better than gamblers. And we all know how gamblers end up, right? Let me tell you a little secret: in my years working for hedge funds and prop-trading groups in investment banks, I have seen all kinds of trading strategies. In 100% of the cases, traders who have achieved spectacularly high Sharpe ratio (like 6 or higher), with minimal drawdown, are day-traders.

I'm also a fan of options for a number of reasons; they are my vehicle of choice for trading and augmenting my long term stock holdings.

So what about combining day trading and options? Buying puts and calls in place of stocks or CFDs?

Ummmmm..... no.

I had and interesting exchange with a cretin from Australia by the name of Bill Stacy, who sells a course to ostensibly noooobie traders purportedly training them to earn "a few grand a week" day trading options on the Australian Stock Exchange with a $20,000 bank.

Questioned about the size of delta and contest risk with what he was teaching, the conversation deteriorated into one of those comedic threads you find on internet fora with name calling and the whole shebang. Well, it was amusing until Bill hightailed it off into the sunset.

So over the next few posts I want to have a look at day trading options, whether it's a good idea or not.