Simple option trading question...

[ironchef]

In terms of LEAPS I repeat my position, LEAPS and in general long term options are inefficient ways to play an arbitrary move. I didn't want to imply they were useless just that other instruments could be used for that kind trade with better PnL and Risk Reward (like shares, CFD's or futures). When you are trading like that you only want leverage and for that there are many ways to get it other than options. Sacrificing optionality just for the sake of getting leverage is not a good trade-off at least in my book. However of course you are free to trade as you feel more comfortable.

If I am not good at judging the mispriced and the movements/directions of the underlying, would short term options then not as forgiving as longer term ones?

My actual experiences trading were I made more money when I went longer term than short term. How can I improve my short term outlook?

Also, I had tried other leverages like using margins that ended in very bad outcome. What is CFD and would future be better than options for that?

Thanks.

 

[ironchef]

It has long been known that you can use DITM LEAPS as a surrogate for stock ownership for less risk than owning the stock outright. If you need an example then here is one:

COST @ $153
JAN 17 $100 Call @ $54 (.9 delta) - effective stock price is $154 due to small time value premium that remains.

Assuming no margin you can buy 100 shares of COSTCO for $15,300
OR buy 1 DITM Leap Call for $5,400 and get almost 1:1 movement in the underlying if the stock price moves higher and less if stock moves lower.
Your capital committed is reduced by 2/3 to still be able to participate in capital growth of the stock for almost one year. Less money in the trade means less risk but also allows you to do more with your portfolio.

You could take the remaining $10k available and invest in other stocks, options or LEAPS. The amount of money contributed to the position is much less, thus less risk for the same profit potential for the next 305 days.

It is due to the nature of delta.

Thanks. I see your points.

 

[El OchoCinco]

I recommend Natenberg's book for good discussion of variance and volatility.

 

[blueplayer]

Blueplayer,

Thanks. Can you explain variance risk premium to someone who does not have a finance background? Or point me to some books that can explain it in simple layman's ?

You need to know at least what standard deviation is:

http://www.mathsisfun.com/data/standard-deviation.html

In finance they use the name of volatility for the standard deviation of returns (log returns more exactly). And it is an integral component of option prices. So when option sellers expect the underlying to be very volatile during the lifetime of the option they charge more for the options and vice versa.

Options are priced in such a way (we'll at least in theory) that if the realized volatility matches what the price was implying then at expiration neither the buyer or the seller of the option make money at all on that trade (of course in a world of continuous dynamic hedging by both)

However in index options, it has been found that the implied volatility in the price is usually substantially higher than the one that is actually realized, it is clear that sellers (option dealers) are padding the price with a risk premium on top of fair price. We call that premium the Variance Risk Premium. It is prevalent in index options and it is very noticeable in SPX puts for instance.

 

[ironchef]

Thank you for the explanation.

Regards,

 

[ironchef]

I recommend Natenberg's book for good discussion of variance and volatility.

Thanks. I do have the book but only read the first few chapters. I will look up variance and volatility there.

 

[newwurldmn]

Read the whole book.

 

[El OchoCinco]

Thanks. I do have the book but only read the first few chapters. I will look up variance and volatility there.

New edition came out in 2015 with more variance and vol stuff..

 

[ironchef]

Read the whole book.

Yes sir. However, I did read McMillan cover to cover. Still don't understand half of what I read and don't remember most of it. That is why I have to keep asking stupid questions here.

Cheers.

 

[newwurldmn]

I never read McMillian. I did read Natenburg. I also read Hull (and did all the math problems). It was more valuable than all the derivatives pricing and finance classes I ever took on options.