Simple option trading question...

[blueplayer]

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.

Ironchef, Natenberg, Hull, Sinclair are all very good writers and their books are fantastic. If you want something a little simpler about playing long gamma you could read this two simple sections:

http://www.anixcorp.com/the-adventurous-gamma-trader
http://www.anixcorp.com/walking-on-the-long-side-of-the-force

They were written by me as part of a volatility book that I never got to finish so I decided to put the info there (anixcorp is not a company, just an old domain I got around).

If you have the time give it a try and of course any feedback is greatly appreciated.

 

[ironchef]

blueplayer,

Thank you for the links. The section on gamma is excellent. It summarized the basics very well. I stumbled into your conclusions by trial and error and now I know why some of my trades worked and some didn't.

The second section is more complex but I don't normally trade this way so hard to comment.

However, one thing holds true: You basically said what everyone here were saying: Everything started with an understand and judgement of the directional of the underlying and one then designed a trade around it. Your mentioned of the optimal trade is interesting and I need to play with the equations a little more to understand it better. My tools to play around will be just the simple Black Scholes and Excel as I am not capable of doing anything more sophisticated.

Another comment is since I am not that sophisticated, my judgement of directional is not that good. Does that mean I should go longer duration and not so DOTM? Looking at your plots, the returns are lower but risk is also lower? All the longer duration returns beat B&H so why not just do that?

Any comment is greatly appreciated.

Regards,

P.S. By the way folks, if you are new to options, reading the sections will be very helpful like they are to me.

 

[jimmyjazz]

Consistent with the previous point about higher implied volatility leading to higher option prices is the idea that the breakeven points of a long straddle are further displaced in periods of high volatility. Without starting another thread, does anyone have a good explanation of the TRUE meaning of those breakeven points? Are they the market's cumulative vote of the most likely price of the underlying (+/-) at expiry? Are they the expected outer bounds of price? Inner bounds? Neither?

 

[OptionGuru]

Consistent with the previous point about higher implied volatility leading to higher option prices is the idea that the breakeven points of a long straddle are further displaced in periods of high volatility. Without starting another thread, does anyone have a good explanation of the TRUE meaning of those breakeven points? Are they the market's cumulative vote of the most likely price of the underlying (+/-) at expiry? Are they the expected outer bounds of price? Inner bounds? Neither?

Yes .......... The price of an ATM straddle is indication of the expected move (+/-) of the underlying. No free money for the seller or buyer.

 

[sss12]

Ironchef, Natenberg, Hull, Sinclair are all very good writers and their books are fantastic. If you want something a little simpler about playing long gamma you could read this two simple sections:

http://www.anixcorp.com/the-adventurous-gamma-trader
http://www.anixcorp.com/walking-on-the-long-side-of-the-force

They were written by me as part of a volatility book that I never got to finish so I decided to put the info there (anixcorp is not a company, just an old domain I got around).

If you have the time give it a try and of course any feedback is greatly appreciated.

 

[sss12]

@blueplayer..I found your links quite informative. In your "on the long side" piece you stated that you did not think generally long puts were an effective way to short SPX. Besides selling calls or call spreads , what would you suggest ? Thanks.

 

[sle]

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.

Are you telling me that sellers of convexity in single stock options do not get compensated for the risk they take?

 

[blueplayer]

Are you telling me that sellers of convexity in single stock options do not get compensated for the risk they take?

I don't think so, I posted the comment quite some time ago but I'm pretty sure that the main gist of the post was to highlight the excess variance risk premium in index options (I don't think I was commenting on single names). While I'm answering this, the variance risk premium in Index option it is substantially richer than the one present in single names (both favoring sellers of convexity).

 

[Buy1Sell2]

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....

depends on how much you want to risk. Also the more ITM , the less time premium and decay there will be. ITM is preferable if you have decent directional analysis, since you will likely profit from direction. If you are not good with that, best use out of the money and risk a small amount on a gamble.

 

[Buy1Sell2]

Bottom line---options trading is preferred for folks who either don't want to, or don't know how to, place stops to control risk.