A few newbie option questions....

[user83248324]

Hey guys, thanks for taking the time to check out my question. As I have been studying options for the past few weeks, these have been the questions lingering in my mind that I have not been able to find an answer to.

1. Why would anyone buy extremely far OTM calls? It would seem almost impossible to make money on these calls due to the huge IV drop one would see at those price targets, which would in turn drop the price of the call. Is there something I am not seeing as to why anyone would make OTM calls part of their trading strategy?

2. Following up with the above thought about calls, am I wrong to be more inclined to base my option trading strategy around puts then calls. It seems that the most a calls value can do(even on high beta/ extremely volatile stocks) is possibly double, triple, or maybe quadruple. But with puts, if you pick the right stock you can make as much as 10,20,30, or even more times your money. Now I realize calls do better when the market is going down then puts do when the market is going up, but since I am mainly interested in tight OTM options, this added protection would not seem worth it to me since an OTM call would still eventually expire worthless not matter how high the IV was. Now I understand the market generally has an upward bias so would this be why I would not want to trade puts in favor or calls, or what would be the reasoning behind making calls a large part of your strategy? With my current understanding of calls, the only calls that seem to be worth it are the deep in the money calls that have a delta of 1 where your premium would be safe and you would essentially be buying the underlining security but adding a bit of volatility.

3. Are options price action based of off a formula using the IV, time decay, and stock price, or is it just based off the bid and ask? I would think it would just be the bid/ask, but when using thinkorswims option theoretical price calculator, I am amazed at how I can go back in time to different dates and enter in current dates price action, IV, and time left and it will tell me the price spot on of what the market it has it at? This makes me question whether options are based on the markets bid or whether it is just based of a formula?

4. When selling straddles, wouldn’t the seller have to always be concerned about one of the in the money options being exercised? Or am I misunderstanding how selling options and them being exercised works? I have also heard that very few options ever get exercised, if this is the case why not just take the chance selling expensive ITM covered calls and risk whether you get exercised on or not? Or is it that all ITM options are always exercised, but relative to how often they change hands very few options are actually exercised?

5. Are ETFs and Options on ETFs (such as SPY, DIA, etc) taxed as futures are (the 60/40 rule) or are they just taxed at the normal short term capital gains rate? I this topic had been brought up before when I searched the forum, but no one was able to provide a definitive answer, so I was hoping someone could help.

6. Does anyone know of a good back-testing software package specifically made for options and futures, or is there any other software I should look into to help me with options trading.

Thanks for any help you can provide with any of these questions, and if anything is to confusing at this point please tell me and I will try to elaborate more on what I was trying to say.

 

[JJacksET4]

user83248324,

I'll try to answer the questions the best that I can. There are a few others here who might have better answers for some of the questions.

Quote from user83248324:

1. Why would anyone buy extremely far OTM calls? It would seem almost impossible to make money on these calls due to the huge IV drop one would see at those price targets, which would in turn drop the price of the call. Is there something I am not seeing as to why anyone would make OTM calls part of their trading strategy?

This is an example where sometimes I worry if a person is taking IV too seriously. Once a call moves into the money, it has "intrinsic value" and no matter what the IV is will have a certain value based on the stock price minus the strike price. So if XYZ is currently say $60 and a way OTM 90 strike is $50, if the stock soared to $100, yes IV would probably fall, but the call would be worth a minimum of $1000 - for a 20 fold increase in money. That is why some people like to speculate with OTM options. The call is worth at least $1000 at that point because (price ($100) - strike price ($90)) * 100 = $1000.



2. Following up with the above thought about calls, am I wrong to be more inclined to base my option trading strategy around puts then calls. It seems that the most a calls value can do(even on high beta/ extremely volatile stocks) is possibly double, triple, or maybe quadruple. But with puts, if you pick the right stock you can make as much as 10,20,30, or even more times your money. Now I realize calls do better when the market is going down then puts do when the market is going up, but since I am mainly interested in tight OTM options, this added protection would not seem worth it to me since an OTM call would still eventually expire worthless not matter how high the IV was. Now I understand the market generally has an upward bias so would this be why I would not want to trade puts in favor or calls, or what would be the reasoning behind making calls a large part of your strategy? With my current understanding of calls, the only calls that seem to be worth it are the deep in the money calls that have a delta of 1 where your premium would be safe and you would essentially be buying the underlining security but adding a bit of volatility.


Here, I think you are confused about something, maybe relating to intrinsic value and IV again. Calls can go up many, many fold and in fact, puts are usually considered limited, since the stock can only go down to 0. If XYZ is at $50 and a put and call are each $200, the put can only to to $5000 (25 fold), but the call could go to $50,000 or more - there would be no actual limit for the call (of course, this would require a pretty insane stock move higher!)


3. Are options price action based of off a formula using the IV, time decay, and stock price, or is it just based off the bid and ask? I would think it would just be the bid/ask, but when using thinkorswims option theoretical price calculator, I am amazed at how I can go back in time to different dates and enter in current dates price action, IV, and time left and it will tell me the price spot on of what the market it has it at? This makes me question whether options are based on the markets bid or whether it is just based of a formula?


Options trade like stocks with bid/ask, etc. One of the reaons that the calculations can see so close is that the IV is based on the price. So if a 30 strike call on XYZ has 3 months left and is worth $300 for example, the IV might calculate out as say 40. Now, if you said what would be the price of a 30 strike call with 3 months left and an IV of 40, the answer would be "about $300".


4. When selling straddles, wouldn’t the seller have to always be concerned about one of the in the money options being exercised? Or am I misunderstanding how selling options and them being exercised works? I have also heard that very few options ever get exercised, if this is the case why not just take the chance selling expensive ITM covered calls and risk whether you get exercised on or not? Or is it that all ITM options are always exercised, but relative to how often they change hands very few options are actually exercised?


Options are rarely exercised until near the end of expiration, and/or until there is no longer time value in the option. If a seller sells a straddle for 3 months out, neither options will likely be execised until either time runs way low and/or one of the options looses it's time value. If the stock soared or plunged that could happen and that would of course hurt the seller of the straddle anyways. The idea if you sell a straddle is if the stock stays near the strike price, each day or week profits can accumulate and you can close the position. For example, say a person sells a 50 strike straddle for $600 with 3 months left. After 2 months, the stock is still around 50 - first of all, neither option will be exercised yet (since there is still time value), and the straddle might fall to say $250 and the seller could either buy back and make their $350 profit, or continue on. There is usually never a good reason for a holder of an option to exercise an option until the time value goes near 0 (otherwise they lose that value).


5. Are ETFs and Options on ETFs (such as SPY, DIA, etc) taxed as futures are (the 60/40 rule) or are they just taxed at the normal short term capital gains rate? I this topic had been brought up before when I searched the forum, but no one was able to provide a definitive answer, so I was hoping someone could help.


This question I will leave for others.



6. Does anyone know of a good back-testing software package specifically made for options and futures, or is there any other software I should look into to help me with options trading.


This question I will leave for others as I haven't used enough options software to have a good answer.


Thanks for any help you can provide with any of these questions, and if anything is to confusing at this point please tell me and I will try to elaborate more on what I was trying to say.

JJacksET4

 

[spindr0]

I'm going to assume that we're talking about the outriight buying puts and calls - no complex strategies.

1. Why would anyone buy extremely far OTM calls?

It's not much of an idea to buy extremely far OTM options. However, you'd buy OTM calls for the same reason that you'd buy OTM puts ---> LEVERAGE. Going up? Buy calls. Going down? Buy puts.

2. Following up with the above thought about calls, am I wrong to be more inclined to base my option trading strategy around puts then calls?

If the stock is at the strike and you're comparing a 5 pt OTM put with a 5 pt OTM call, if the stock drops 5 pts, the put will gain approx same pct gain as the call will make on a 5 pt rise (pre expiration). So again, going up? Buy calls. Going down? Buy puts.

3. Are options price action based of off a formula using the IV, time decay, and stock price, or is it just based off the bid and ask? Going up? Buy calls.

Option pricing is based on formula utilizing stock price, strike price, time remaining, volatility, interest rate and dividends, if any.

4. When selling straddles, wouldn’t the seller have to always be concerned about one of the in the money options being exercised? I have also heard that very few options ever get exercised, if this is the case why not just take the chance selling expensive ITM covered calls and risk whether you get exercised on or not? Or is it that all ITM options are always exercised, but relative to how often they change hands very few options are actually exercised

a)Options that have time premium remaining are unlikely to be exercised.

b) If the option is ITM at expiration, it WILL be exercised.

c) Never "take a chance" on an option and just let market movement dictate your result.

d) Never sell (or buy) an option w/o a follow plan in place as to what you will do as events occur (time passes, volatility changes, underlying price changes, etc.)

5. Are ETFs and Options on ETFs (such as SPY, DIA, etc) taxed as futures are (the 60/40 rule) or are they just taxed at the normal short term capital gains rate?

Dunno...maybe an expert who knows will show up (g)

6. Does anyone know of a good back-testing software package specifically made for options and futures, or is there any other software I should look into to help me with options trading.

Various brokers have trading simulators. I wouldn't be too concerned about back testing options as much as figuring out where the underlying is going and what option strategy will do best under those circumstances.. as well as learning how to adjust positions as well as some good money managemment.

I'd suggest that you concentrate on learning as much as you can about options.

It's not this simple or this easy but you're a self proclaimed newbie (g) so let's not get way ahead of basics. And if you've grasped this much after studying options for only a few weeks, you should own Manhattan within a few years

 

[dagnyt]

Quote from user83248324:


1. Why would anyone buy extremely far OTM calls?

Adding to the previous reply:

The same reason people buy lottery tickets. there is always the <i>chance</i> to have a huge win. But, it's very much against the odds.

2. am I wrong to be more inclined to base my option trading strategy around puts then calls.

I would be more inclined to worry about market direction than in making the decision about puts vs. calls. When buying options, direction is your primary consideration, not the potential jackpot.

I also recommend that you not consider 'buying' options as a strategy. You would be working with a strategy that may pay off handsomely on occasion, but it's very difficult to make money when buying options.

Before deciding, look into selling put spreads and or call spreads.

3. Are options price action based of off a formula using the IV, time decay, and stock price, or is it just based off the bid and ask?

Options are based on everything. Supply and demand drives prices. In addition, if uncertainty enters the marketplace (such as the markets are diving), the market makers increase the implied volatility in the computer model THAT DRIVES THE BID AND ASK QUOTES. Higher IV means more expensive options.

The fact that you can go back in time to see what the IV was is meaningless. The reason the older quote is 'spot on' is because TOS takes the quote and then calculates the IV. Thus, by definition, the market quote must be correct.

4. When selling straddles, wouldn’t the seller have to always be concerned about one of the in the money options being exercised?....I have also heard that very few options ever get exercised.

a) The reason a small number of options get exercised is NOT because they expire worthless. It's because the people who own options that are in the money at expiration sell those options rather than exercise them. When that happens, the options are often purchased by people who are short those specific options. thus, the options get canceled and no longer exist. The argument that 80% or any such number, of options expire worthless ignores the number of options written <i>originally</i>, and only counts options still in existence when expiration arrives. It's another worthless and misleading piece of information.

What's the big deal about being assigned an exercise notice? When you are short an option that has reached 100 delta and has no remaining time premium, you are already essentially long or short the underlying security. Being assigned changes nothing, unless you cannot meet the margin call. And if you cannot meet that margin call, you have no business selling straddles. That is an extremely risky proposition. Especially today. Learn about iron condors instead.



5. Are ETFs and Options on ETFs (such as SPY, DIA, etc) taxed as futures are (the 60/40 rule) or are they just taxed at the normal short term capital gains rate?

See IRS publication 550.
Options on broad based market INDEXES (NOT ETFS) are taxed at the 60/40 rate. That means SPX, not SPY.

But you should doublecheck that IRS publication for the answer.


6. Does anyone know of a good back-testing software package specifically made for options and futures

Backtesting options is a fruitless endeavor. So many factors affect the price of options that there is no way you can ever backtest for a specific set of future conditions.

Trading options is NOT like trading stocks.

Mark
The Rookies Guide to Options
http://blog.mdwoptions.com/options_for_rookies/



Thanks for any help you can provide with any of these questions, and if anything is to confusing at this point please tell me and I will try to elaborate more on what I was trying to say. [/B]

 

[spindr0]

Calls can go up many, many fold and in fact, puts are usually considered limited, since the stock can only go down to 0. If XYZ is at $50 and a put and call are each $200, the put can only to to $5000 (25 fold), but the call could go to $50,000 or more - there would be no actual limit for the call (of course, this would require a pretty insane stock move higher!)

Hey Jjacks. It's a minor point but John Q Public has been spooked by brokers, authors, etc. into believing that shorting is bad because of potential unlimited losses. Ergo, shorting has more risk than errrrr, longing. Kinda like thier advice that covered calls is a safe strategy for newbies. LOL.

Technically, that's true and might have some merit if one was dealing with a $5 stock. But AFAIK, markets and regular stocks (not distressed $5 ones) don't melt up. Most of the time they go down a lot faster than they go up (let's ignore infrequent takeovers). And earnings announcements as well since that's a known event that one would play or get out of the way of.

 

[JJacksET4]

Spin,

I'm not quite sure what you are referring to in my comments, as I didn't say anything about shorting options. I was writing about long puts versus long calls. No matter what, the most a 5 strike put can ever go to is $500. On the other hand, a 5 strike call theoretically has unlimited value. Of course, I realize as much as anyone that a $5 stock has little hope of going to $50 in a short time, but it is possible.

I think the original poster is confused about time value, intrinsic value and the real meaning and use of IV, because he states that calls can only go up 2, 3 or at most 4 fold, where as puts can go up 10, 20 or 40 fold. That is of course completely false. I think he is thinking that as a stock rises, the IV will drop, thus offsetting any gains, but as you well know, as a stock moves higher and higher, the instrinsic value of the calls will continue to rise and what the actual IV is becomes less and less important.

I understand of course that brokers have taught that shorting is risky, whereas for example selling a put is basically the same as doing a buy/write, yet most brokers frown at the first one, yet endorse the second one.

To start to have a good understanding of options, the OP is going to have to sit down and study Time Value, Instrinsic value, Time Decay and what IV and HV really mean IMO.

JJacksET4

 

[spindr0]

Jjacks,

It wasn't about short options. What I was referring to was your comment that calls can go up many fold compared to puts. IMHO, stocks go down much faster than they go up so I'd rather be playing the downside with long puts (or short stock) than trying to catch an increase to the upside with long calls (or long stock).

IOW, while theoretically you can get a larger multiple gain to the upside with long calls versus long puts whose stock can only go down to zero, in reality, it's easier to catch a bigger move with falling stocks. Just my opinion about velocity.

No biggie... No correction or criticism intended.

Spin

 

[forex-forex]

Quote from user83248324:
1. Why would anyone buy extremely far OTM calls? It would seem almost impossible to make money on these calls due to the huge IV drop one would see at those price targets, which would in turn drop the price of the call. Is there something I am not seeing as to why anyone would make OTM calls part of their trading strategy?

Buying OTM Calls could be part of a spread position to cap the maximum potential loss of a short call position. Sort of like buying insurance.







forex-forex
---------------
Trading Guru

 

[E R]

Regarding the ETF question, it's possible that certain ETFs can get 60/40 treatment (ETFs on interest rates and futures commodities), but still open to debate.

For example, check out this discussion: http://www.gainskeeper.com/us/articles/Stock_Index_Options.aspx also: http://www.twenty-first.com/articles/indexoptioninvestors.htm

Also, here is a nice list of broad-based indexes that definitely get 60/40 treatment: http://www.twenty-first.com/exchange-traded_index_options.htm


Good luck!
E

 

[murray t turtle]

Quote from user83248324:

Hey guys, thanks for taking the time to check out my question. As I have been studying options for the past few weeks, these have been the questions lingering in my mind that I have not been able to find an answer to.

1. Why would anyone buy extremely far OTM calls? It would seem almost impossible to make money on these calls due to the huge IV drop one would see at those price targets, which would in turn drop the price of the call. Is there something I am not seeing as to why anyone would make OTM calls part of their trading strategy?

2. Following up with the above thought about calls, am I wrong to be more inclined to base my option trading strategy around puts then calls. It seems that the most a calls value can do(even on high beta/ extremely volatile stocks) is possibly double, triple, or maybe quadruple. But with puts, if you pick the right stock you can make as much as 10,20,30, or even more times your money. Now I realize calls do better when the market is going down then puts do when the market is going up, but since I am mainly interested in tight OTM options, this added protection would not seem worth it to me since an OTM call would still eventually expire worthless not matter how high the IV was. Now I understand the market generally has an upward bias so would this be why I would not want to trade puts in favor or calls, or what would be the reasoning behind making calls a large part of your strategy? With my current understanding of calls, the only calls that seem to be worth it are the deep in the money calls that have a delta of 1 where your premium would be safe and you would essentially be buying the underlining security but adding a bit of volatility.


6. Does anyone know of a good back-testing software package specifically made for options and futures, or is there any other software I should look into to help me with options trading.

Thanks for any help you can provide with any of these questions, and if anything is to confusing at this point please tell me and I will try to elaborate more on what I was trying to say.

=======================
User832-777
1]-3 [Three ]answers, but not limited to 3], on OTM calls.
Asked a lottery buyer in the BP station one time-''ever won anything-''No he said but i got close'' Dave Ramsey [on FOX business]called lottery, ''stupid tax on those who cant do math.''LOL.

2]Same wise reason i shop well, buy earthquake insurance;
and really dont hope to collect.................... Live in west TN,beautiful, big Reelfoot lake was created by a killer quake.

3]Ever seen/recorded a good/strong uptrend in a bull market-QQQQ,POT??
You may change your mind .

6]Yes but had to custom design it;
including end of day prices recorded.Wisdom is limited to a few words on this one.