Simple option trading question...

Mo06

Mo06

I have traded options a few times, but it's not been my main trading vehicle.

My question is... if I want to take a position in an index like the Dax, and I want to trade an option rather than take a long or short position in the index futures so that:

a) I limit my risk to the premium paid
b) I use leverage to maximise profit potential

Do I buy an ITM, ATM or OTM option ?

Please explain the reasons....
 
Mo06 said:
I have traded options a few times, but it's not been my main trading vehicle.

My question is... if I want to take a position in an index like the Dax, and I want to trade an option rather than take a long or short position in the index futures so that:

a) I limit my risk to the premium paid
b) I use leverage to maximise profit potential

Do I buy an ITM, ATM or OTM option ?

Please explain the reasons....
More...

Read everything by Euan Sinclair and Allen Jan Baird. Head over to tastytrade and watch their videos. By then, you should know enough to make your own decisions about this trade. Best of luck.
 
Mo06 said:
I have traded options a few times, but it's not been my main trading vehicle.

My question is... if I want to take a position in an index like the Dax, and I want to trade an option rather than take a long or short position in the index futures so that:

a) I limit my risk to the premium paid
b) I use leverage to maximise profit potential

Do I buy an ITM, ATM or OTM option ?

Please explain the reasons....
More...

Stick to near-OTM where spreads are tightest.

Keep reading. I think the board is hostile due to lack interesting of content.
 
You will lose on theta and volatility by buying an ATM option. Buying an OTM option is basically insurance or gambling. It sounds like you want a proxy for the underlying, with some leverage. That is the deep ITM option. If the bid-ask spread is too wide (I have no idea what the DAX is like), you could also consider a bullish vertical spread, but it will limit your upside. A synthetic gets you the leverage you need but involves a naked option. Based on your preferences and the DAX, you'll have to choose the least dirty shirt among those.
 
drcha said:
You will lose on theta and volatility by buying an ATM option. Buying an OTM option is basically insurance or gambling. It sounds like you want a proxy for the underlying, with some leverage. That is the deep ITM option. If the bid-ask spread is too wide (I have no idea what the DAX is like), you could also consider a bullish vertical spread, but it will limit your upside. A synthetic gets you the leverage you need but involves a naked option.
More...

That is a really nice summary.
 
Great advice drcha. I understand the gambling part buying OTM but insurance? I thought of using collar to protect my profitable long options but after some of your comments and thinking through, taking profit/partial profit on a profitable trade seemed to be my best shot in most cases. Any comments will be greatly appreciated.
 
drcha,

Thank you for asking. A specific example:

I am holding long Calls of RIG with more than six months till expiration. Had two chances to double my money in Feb and May when RIG traded over $20. Unfortunately I did not hedge or take profit. If you were in my situation, what would you have done and are there good inexpensive way to hedge without limiting the up side? Since volatility was very high then, buying put to protect wasn't attractive to me.

Regards,
 
IMHO, there are no inexpensive hedges, and the best hedge is not to get too big. A long call is a hedge in itself, yes? It could be considered a substitute for buying a stock and a put.

What to do in terms of taking profit depends on the characteristics of your system. For example, when I trade long calls on front-month ETFs, I usually roll up when I make 100%. However, I know from backtesting and experience that this will only happen about 3% of the time on a front-month call. You, however, are trading longer-dated options, so the best take-profit order might be higher--I don't know.

I would suggest reading a little bit of McMillan's Options as a Strategic Investment. On pages 97-101 of the fifth edition, he compares 4 different strategies for the scenario you describe and discusses the pros and cons of each. As is usual for options, there is no right answer. Suppose you like 2 of the strategies but it's difficult to decide between them. You could split your calls into 2 batches and use a different technique for each batch.

I don't mean to be evasive here, but it really is a judgment call that should include weighing of factors such as the proportion of your portfolio you have at risk and whether your options are under pressure from loss of time value.
 
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