Some Basic Options questions...

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user83248324

Hi guys, just have some basic options questions I was hoping you could help out on..

1. Should I never worry about how many options I am buying/selling, and whether that will effect me down the road as I try to sell and buy them back because market markers have to provide a liquid market? For example, I am worried about buying some vertical spreads as it seems like in even some pretty heavy volume stocks and ETFs, if I wanted to take on a $3,000(this is hypothetical as I am still in paper money) vertical spread. I could end up owning more volume then there is trading in the day. And sometimes own maybe a 8th of open interest, is this a problem?

2. As a follow up to the above question, does it make sense with spread positions to widen out your strikes. For instance, on the SKF I could buy a Mar 150/155 put spread that is trading at $2.00(4/10 ratio) or I could buy a Mar 150/160 put spread that is trading at $4.00(4/10 ratio again). With the latter spread I have a better break even price (150/160 is $156.00 and 150/155 is 153.00) pay half as much in commissions both ways, and hopefully could sell the spread a little quicker since I would have less options to move. Is there a downside that I am not seeing to this?

3. If you can tell by an option’s pricing that the market is already expecting a price decline, would you be better of shorting a stock then buying the options if you believe the stock will decline since a lot of the downside is already priced into the options(same theory applies to the upside as well)?

4. And just to check that I am on the right path, when you believe that a stock has upside potential but has a super high IV due to a recent decline, it would make more sense to buy the stock alone or the vertical call spreads right due to the vol. skew the calls will suffer from?

5. And also this is just somewhat of a philosophical question that probably has no right answer for all investors but I would be interested to see what you guys have to say. Do you believe that it would be better to master one stock/index/ or etf and trade all kinds of options strategies within that stock that you know so well, or would it be better to master a specific options strategy and try and trade that across all stocks and markets, or would you just say that it is better to have a combination of the two?

Thanks for all the answers you guys have been providing on this board as I have been reading just about every thread and is has certainly helped along with everything else I am doing.
 
Quote from user83248324:

Hi guys, just have some basic options questions I was hoping you could help out on..

Should I never worry about how many options I am buying/selling... as I try to sell and buy them back

if I wanted to take on a $3,000 vertical spread. I could end up owning more volume then there is trading in the day. And sometimes own maybe a 8th of open interest, is this a problem?

Yes you should worry about how many you buy and sell for RISK management.

If you trade a spread tha is $30 points wide, that would be very unusual. Reconsider. Especially if you want liquid options, go for something that's closer to the money than a 30-point wide spread.

Some thinly traded ETFs do not make good options trading vehicles. If you trade one with very low volume, you do have to consider how many you trade. But if you are talking about a 10-lot, don't worry about it.


does it make sense with spread positions to widen out your strikes. For instance, on the SKF I could buy a Mar 150/155 put spread that is trading at $2.00(4/10 ratio) or I could buy a Mar 150/160 put spread that is trading at $4.00(4/10 ratio again). With the latter spread I have a better break even price (150/160 is $156.00 and 150/155 is 153.00) pay half as much in commissions both ways, and hopefully could sell the spread a little quicker since I would have less options to move. Is there a downside that I am not seeing to this?

If you are going to worry about commissions and let them get in your way, you will not succeed. If broker too costly, find another.

You do NOT want to be selling naked options is SKF. This is a wild vehicle. 4 x 10 spreads can work very well, but the risk is much larger than it appears.

Yes, you want your so called break-even point to be at a price that makes you comfortable with the position.

If really trading 4 x 10, the 10-point spread is much, much, much better than the 5-point spread.


If you can tell by an option’s pricing that the market is already expecting a price decline, would you be better of shorting a stock then buying the options if you believe the stock will decline since a lot of the downside is already priced into the options(same theory applies to the upside as well)?

That's a very bad question. You are not ready to trade options with real money.

There are good reasons for paying a premium to buy puts rather than selling stock short. you must understand them.

Similarly, buying calls rather than stock is often a good idea.

Don't misunderstand. Im someone who never buys options as a directional play and I think the odds of success are poor. But you cannot seriously ask this question. Please start reading, studying etc.



And just to check that I am on the right path, when you believe that a stock has upside potential but has a super high IV due to a recent decline, it would make more sense to buy the stock alone or the vertical call spreads right due to the vol. skew the calls will suffer from?

Buying the call spread minimizes the fact that IV is high. But again, buying stock instead is a very different type of investment.

And also this is just somewhat of a philosophical question that probably has no right answer for all investors but I would be interested to see what you guys have to say. Do you believe that it would be better to master one stock/index/ or etf and trade all kinds of options strategies within that stock that you know so well, or would it be better to master a specific options strategy and try and trade that across all stocks and markets, or would you just say that it is better to have a combination of the two?

It take a very long time to 'master' a stock and the vast majority have no idea how to do that.

When trading options, strategy selection is important and you want to find one or two that make you comfortable to trade. But, far more important is risk management. Thus, if you manage your trades with skill and prevent large losses, any of several strategies will be ok for you. If you lack discipline, you have little chance of success.
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Mark
 
WAY..WAY..TOO Complicated!

A tip on doing a option spread would be wait for the last week before expiration, do a Credit spread that is at least 2 strikes OTM (to be safe).

Example of a good stock to do this with would be GOOGLE.(10 point between strikes) Idealy I would suggust not to do spreads unless you have at least $15K + in your account to be able to make it profitable
I used to do a credit spread every month during the last week of trading. Once expired I would just sit by and DO NOTHING until the last week came around again.

Try this on your "Paper Trading".
I would really suggust that if you are still "researching and testing"...keep it simple, or you will loose your shirt when you try real $$$. Complexity will kill your account quickly
 
As far as the stock buying vs option buying question, I am not quite sure why this was such a terrible question to ask. It seems from the little experience that I have that there should be times when you should use options and time when you should simply use the underlying. I understand the advantage that simply buying plain old options can give, they can give you more leverage with smaller amounts of capital and can allow IV to work in your favor if a drop occurs in price(on the call or put side) and that does not happen with stocks. But along with these positives they suffer from time decay and can suffer from large price drops if the IV drops. Now if you were bullish on a stock that just suffered a large decline, we will say you could either buy the underlying or buy a call. If the stock suffered a large drop the call would be difficult to make money off of as the IV would be so high that as soon as a recovery began to occur the options value would drop due to the vol. skew and you would also suffer from time decay. This would led me to believe that either buying the underlying or buying some sort of spread would be better. Now maybe there is something I am totally off base with here and do not get, but this seems fairly simple.

Now as far as buying the spreads I am not sure if I used the wrong term, but I thought that buying a put spread does not involve selling anything naked nor does it involve receiving a credit as the two repliers said. It is simply a bet that if I hold till expiration and the stock drops below whatever the lower strike is I will receive a full profit of the distance between the strikes.

So with the options I gave in my original post:

Buy SKF 150/155 MAR put spread:
Cost was $2.00, chance of success was 40%, you would pay twice as much in commissions, you would own more options possibly making them more difficult to sell. Break even price is 153.00
vs:
Buy SKF 150/160 MAR put spread:
Cost was $4.00, chance of success was 40%, you would pay half in commissions, you would own less options possibly making them easier to sell. Break even price is 156.00.

Now, I normally do not concern myself with commissions, and I simply concern myself with the trade. But with the above example it appeared that these trades were basically identical risk wise, except you had a better break even price, less options to buy and sell, and less payment in commissions with the wider strike trade. Now if I could essentially set up the same trades but receive better commissions and better break even prices why would I not want to at least possibly look at this? It's not as if I am looking at a completely different trade just for the sake of commissions. I am simply looking at what I believe would be an identical trade, risk wise, just with more things(break even price, commissions, number of options held) working in my favor.

Now, as far as my first question asking about whether I should worry about how many options I buy/sell and what effect this will have when I buy or sell back....I was just simply asking what would happen if I buy a far out of the money vertical spread, were this isn't a lot of volume traded or a lot of open interest, but I for some reason believed the stock was going to rise hard. I could end up buying spreads that are less than ten cents. For instance, if I thought the DOW ETF (DIA) was just due for a nice size rally up to around 83, this is not an outrageous number as we have seen the Dow trade in this range and do so very quickly. If I bought the 83/84 MAR call spread in the DIA, it would come to .08 cents. So if I wanted to risk an ok sized amount of $3,000 on this, I would have to buy 400 contracts. Now that is just a tad under what its volume has been today in both strikes. So if decided to buy in and then get out of this trade, would I have to worry about lowering my ask, because I would have such a relatively large supply for what the demand is, or would the market maker be forced to take care of this and cover my options at whatever the market ask is? Now if there isn’t a downside risk to my above question about spreading out your strikes but keeping the risk the same, I obviously would not do a 1 dollar spread in this trade, but am just using it here as a way to get my example across. Also note that I am by no means planning to take this trade in real money or paper money or anything,, I am just curious to learn how it would or wouldn’t work out.

And options4me, as far as waiting till the last week for selling credit spreads, it seems a little risky to me as the gamma risk you suffer from seems to be to large for the time decay you get. If I was looking at credit spreads I would usually try to avoid the last week especially in this crazy market. But then again what do I know.
 
Quote from options4me:

WAY..WAY..TOO Complicated!

A tip on doing a option spread would be wait for the last week before expiration, do a Credit spread that is at least 2 strikes OTM (to be safe).
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This is a good tip for how to go broke quickly.

I strongly advise doing everything just the opposite.

Open your spreads earlier and close them when two weeks remain.

There is absolutely nothing safe about 'two strikes OTM.' NOTHING

Mark

Mark
 
Quote from user83248324:

As far as the stock buying vs option buying question, I am not quite sure why this was such a terrible question to ask. It seems from the little experience that I have that there should be times when you should use options and time when you should simply use the underlying.

That's true in a simplistic way, but buying stock is a very bullish play with very significant risk. [And shorting is the mirror image.]

The whole idea behind buying or selling options is to reduce risk. Thus, IMHO, if you are thinking of using stock instead of options, you are not yet well enough educated about the versatility of options allows you to forget about using stock - except as a day trading vehicle.

ADDENDUM: After reading your entire post, I now see that you understand this stuff far better than your question suggested. I also note that you are asking these questions for good reason.


I understand the advantage that simply buying plain old options can give... But along with these positives they suffer from time decay and can suffer from large price drops if the IV drops.

Sure, if you limit yourself to the idea of only buying options. Over the longer term you will do much better if you learn to SELL options - but never naked and only with adequate protection.

Now if you were bullish on a stock that just suffered a large decline, we will say you could either buy the underlying or buy a call. If the stock suffered a large drop the call would be difficult to make money off of as the IV would be so high that as soon as a recovery began to occur the options value would drop due to the vol. skew and you would also suffer from time decay.

If you are sophisticated enough to understand that much, then you understand that you have a choice. You can buy stock, hoping the decline doesn't continue, or you can trade options by either buying a call spread or selling a put spread. Yes, profits are limited, but so are losses. In addition IV risk goes away and theta is not bad.

And I ask this: Would you buy OTM options where IV is certain to get crushed, or ITM options where an IV collapse would not hurt too much - especially if it occurs as the result of your options moving Deep ITM?

This would led me to believe that either buying the underlying or buying some sort of spread would be better. Now maybe there is something I am totally off base with here and do not get, but this seems fairly simple.

Yes. Spread much better. Stock okay too - but with much greater risk and reward potential.

Now as far as buying the spreads I am not sure if I used the wrong term, but I thought that buying a put spread does not involve selling anything naked nor does it involve receiving a credit as the two repliers said. It is simply a bet that if I hold till expiration and the stock drops below whatever the lower strike is I will receive a full profit of the distance between the strikes.

Buying a spread involves zero naked options.

You pay a debit and do not receive a credit. Correct.

Yes, max profit occurs if below lower strike at expiration. the question is: Will you hold that long?

So with the options I gave in my original post:

Buy SKF 150/155 MAR put spread:
Cost was $2.00, chance of success was 40%, you would pay twice as much in commissions, you would own more options possibly making them more difficult to sell. Break even price is 153.00

vs:

Buy SKF 150/160 MAR put spread:
Cost was $4.00, chance of success was 40%, you would pay half in commissions, you would own less options possibly making them easier to sell. Break even price is 156.00.

Unless you plan to buy a gaggle of options, isn't the volume in SKF enough? Looks like it trades enough that it should not concern you. You will have no trouble selling your position. the real question is how good will the price be? Do you follow the bid/ask spreads all day? Do you know if the customers must pay offer and sell bid? Or do they have a chance to trade near the midpoints? That's what really determines how easily you will be able to exit your trade.

When you posted earlier you wrote about 4x10. I assumed you meant that you would buy 4 and sell 10. If not, what did you mean. That 4 x 10 spread includes 6 naked options.

Now, I normally do not concern myself with commissions, and I simply concern myself with the trade. But with the above example it appeared that these trades were basically identical risk wise, except you had a better break even price, less options to buy and sell, and less payment in commissions with the wider strike trade.

If one spread costs $200, the double spread will not cost $400. One of those spreads is worth more than the other. If you can buy the 10-point spread @ $4 when the 5-point spread costs $2, then by all means pay $4. But those are not realistic prices.

Now if I could essentially set up the same trades but receive better commissions and better break even prices why would I not want to at least possibly look at this? It's not as if I am looking at a completely different trade just for the sake of commissions. I am simply looking at what I believe would be an identical trade, risk wise, just with more things(break even price, commissions, number of options held) working in my favor.

Put that way, you are correct. If commissions will not force you to take an inferior trade, then fine. You are doing it correctly.

Now, as far as my first question asking about whether I should worry about how many options I buy/sell and what effect this will have when I buy or sell back....I was just simply asking what would happen if I buy a far out of the money vertical spread, were this isn't a lot of volume traded or a lot of open interest, but I for some reason believed the stock was going to rise hard.

If FOTM, then the options usually aren't that costly. and buy a few naked longs would be a better choice. But not here. these options are expensive by any measure. Thus spreads become necessary.

If correct and those FOTM options become ATM or ITM, you will have no trouble trading because they will be the most active options.

I could end up buying spreads that are less than ten cents. For instance, if I thought the DOW ETF (DIA) was just due for a nice size rally up to around 83, this is not an outrageous number as we have seen the Dow trade in this range and do so very quickly. If I bought the 83/84 MAR call spread in the DIA, it would come to .08 cents. So if I wanted to risk an ok sized amount of $3,000 on this, I would have to buy 400 contracts. Now that is just a tad under what its volume has been today in both strikes. So if decided to buy in and then get out of this trade, would I have to worry about lowering my ask, because I would have such a relatively large supply for what the demand is, or would the market maker be forced to take care of this and cover my options at whatever the market ask is?

No. The MM does not have to buy 400. But, there is more than 1 MM and This index trades plenty of volume in near-term, ATM options. If these options go anywhere near the money, you should be able to get a fill.


Now if there isn’t a downside risk to my above question about spreading out your strikes but keeping the risk the same, I obviously would not do a 1 dollar spread in this trade, but am just using it here as a way to get my example across. Also note that I am by no means planning to take this trade in real money or paper money or anything,, I am just curious to learn how it would or wouldn’t work out.

Buying 400 @ 8 cents is a reasonable play. What I did not do was look for alternatives - assuming you already did that. You might prefer to pay 20 cents for some spread and buy only 50 spreads. That's an entirely different decision.

And options4me, as far as waiting till the last week for selling credit spreads, it seems a little risky to me as the gamma risk you suffer from seems to be to large for the time decay you get. If I was looking at credit spreads I would usually try to avoid the last week especially in this crazy market. But then again what do I know.

Your instincts for survival are right on. You know more that you admit!
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Mark
 
This may be tangential to the actual question, but can you actually trade SKF combos at the price the OP's paper trading system gave? The bid-ask spreads seem to be at least $1, possibly leading $4 or more slippage on a two-legged combo round trip.
 
Hi Mark, thanks for the reply and the kind words. At times it is a little difficult to tell how well I am progressing with all of this as I am only 19 and kind of isolated in my learning; its not like I can discuss and question the ins and outs of iron condors or unbalanced butterflies with many of college buddies for help. So I am just kind of taking in as much information in as I can, but cannot really gage how well I am progressing at times, so it was nice to get a little recognition that I am on the right track.

But anyways, in my first post I was trying to make things less confusing but I actually just made them more confusing. I was just trying to show an example of two vertical put spreads where you buy and sell the same amount of puts. I simply put the 4/10 ratio thing in there because I was trying to show that both vertical spreads were equal in pricing since one cost $2.00 when the strikes were $5.00 apart and one cost $4.00 when the spreads were $10.00 apart(so both spreads cost 40% or was at 4/10 of the max profit), again sorry for this as I realize now it just made things much more confusing.

So, just to go over it one more time. I was looking at:

Buy SKF 150/155 MAR put spread(buy and sell same number of puts, nothing naked):
Cost was $2.00 with max profit of $3.00, chance of success was 40%, you would pay twice as much in commissions, you would own more options possibly making them more difficult to sell. Break even price is 153.00.
vs:
Buy SKF 150/160 MAR put spread(buy and sell same number of puts, nothing naked):
Cost was $4.00 with max profit of $6.00, chance of success was 40%, you would pay half in commissions, you would own less options possibly making them easier to sell. Break even price is 156.00.

Now both of these prices are being quoted at the mid-price, but even if I have slippage wouldn’t it amount to an equal percentage amount on both trades, still leaving the advantages with the wider strike spread?

And as to your response about my DIA example where you would buy a 400 lot vertical spread, do you have any idea if say five trading days into the trade I realize, that the market isn’t going to rebound as quickly as I thought and I want to get out of the trade. The DIA has stayed flat at around 73-74, IV has dropped about five percent, and time decay has dropped the price to say, .04 cents. So, if I wanted to get out of my large position but my options were still far ATM, would this be to difficult to do as their would not be enough demand or would the market markers have to take them?

So as you can probably tell from my questions I am beginning to get what I feel is a solid base of knowledge of the market and options themselves, but where I am still confused is on the real world pricing of options and on the market maker side of the market and how it all comes together and whether supply and demand is as large of force as it is in other markets. This is obviously the fault with paper trading as it is difficult to understand real pricing if you are not able to get real pricing and this is of course why I will eventually need to move on. The only problem is at this point I still do not feel that I am quite ready, but I would still like to began to learn how to understand pricing. I am not sure if there is a forum post out their, or book or podcast or something, that really covers how pricing works in both the options and stock markets as a whole; But I still at this point have no idea at what prices I should be able to get filled at, how much risk there is of a sold option in a spread of getting exercised, if you go short is their anyway you can understand how likely a buy in is, or how much slippage will their be when buying a stock or options(i,e, if a stock is trading with a five cent spread but is very liquid, does it work like some options where you can get a mid price fill or not)?

Hopefully someone can shed some light on these questions and thanks again for all your help.
 
Quote from user83248324:

Buy SKF 150/155 MAR put spread(buy and sell same number of puts, nothing naked): Cost was $2.00 with max profit of $3.00, chance of success was 40%

vs:

Buy SKF 150/160 MAR put spread(buy and sell same number of puts, nothing naked):
Cost was $4.00 with max profit of $6.00, chance of success was 40%

Where do get the idea that the chance of success is 40%. That is not right, but I'd like to know why you believe it is. Is is because you can lose 2 and make 3? That has zero to do with the probability of earning a profit from this trade.

What is your definition of 'success' in the above?


Now both of these prices are being quoted at the mid-price, but even if I have slippage wouldn’t it amount to an equal percentage amount on both trades, still leaving the advantages with the wider strike spread?

Slippage is in cash, not in percentages.

Think about this: Assume you can buy the 155/150 P spread @ $2.

Why do you believe you can also buy the 160/155 P spread @ 2?

1) You know the second spread is worth more than the first, right?

2) Do you also recognize that buying both spreads for $2 each [this is abstract; you would never make these trades in real life] gives you the wider spread @ $4?

3) Regardless of mid-points, if the lower strike spread costs $2, the higher strike put spread will cost more.

And as to your response about my DIA example where you would buy a 400 lot vertical spread, do you have any idea if say five trading days into the trade I realize, that the market isn’t going to rebound as quickly as I thought and I want to get out of the trade. The DIA has stayed flat at around 73-74, IV has dropped about five percent, and time decay has dropped the price to say, .04 cents. So, if I wanted to get out of my large position but my options were still far ATM, would this be to difficult to do as their would not be enough demand or would the market markers have to take them?

Stop thinking in terms of 'the market makers have to take them.' I told you before that they do not have to take 400 of anything. Most actively traded options have markets that are guaranteed for a minimum size. that minimum can be as low as 10; but is usually higher.

But, that's at the BID price. That's at the ASK price. If you go between those prices, you are guaranteed zip. If trading FOTM options that trade at very low prices, you may or may not get a fill. It's just going to depend on whether the MMs want to take the other side.

I know this is theoretical, but buying very far OTM options is a losers game. Sure, you collect one big jackpot, then blow all your money waiting for it to happen again.

So as you can probably tell from my questions I am beginning to get what I feel is a solid base of knowledge of the market and options themselves, but where I am still confused is on the real world pricing of options and on the market maker side of the market and how it all comes together and whether supply and demand is as large of force as it is in other markets.

If options are trading actively, supply and demand matters less. But it matters. It also depends on a myriad of other factors - about which you will know nothing. Why? Because you never know what other orders are available for the MMs to hedge. If they know someone is selling a gaggle of Mar 70 calls, then it will be a lot easier for you - and everyone else - to buy the 75 calls. Demand won;t raise the price much, if at all, when the MMs can hedge by buying as many 70s as they want.

This is getting too lengthy and I cannot undertake your entire education, but other factors go into the pricing of options. So, if there is a sentiment swing, IV can move higher or lower - and that will override supply/demand. the answer is no - not as large a force because of hedging possibilities.


This is obviously the fault with paper trading as it is difficult to understand real pricing if you are not able to get real pricing and this is of course why I will eventually need to move on.

I believe IB gives real pricing and TOS lures you in with easy to get, but unrealistic fills.

The only problem is at this point I still do not feel that I am quite ready, but I would still like to began to learn how to understand pricing.

Paper trading a position give you something to watch closely. In fact open several positions: a credit spread, a debit spread, a naked long, an iron condor, a butterfly. In short, open as many as you want to watch.

Be aware of the greeks and see if options move as you anticipated. Get your feet wet - but do not use real money. not yet.

I am not sure if there is a forum post out their, or book or podcast or something, that really covers how pricing works in both the options and stock markets as a whole; But I still at this point have no idea at what prices I should be able to get filled at,

By entering a bunch of orders - one at a time - in a realistic paper account, you will get a better feel.

how much risk there is of a sold option in a spread of getting exercised,

For all intents and purposes, there is little chance of getting assigned prior to expiraion. Sure, there are exceptions, but why should you care. there is nothing to fear about being assigned [See:http://blog.mdwoptions.com/options_...-assigned-an-exercise-notice-no-big-deal.html]

if you go short is their anyway you can understand how likely a buy in is, or how much slippage will their be when buying a stock or options(i,e, if a stock is trading with a five cent spread but is very liquid, does it work like some options where you can get a mid price fill or not)?

depends on order flow. If there are many buyers, you may have to pay offer. But, if selling, you would do better than the bid.

Hopefully someone can shed some light on these questions and thanks again for all your help.

Details are good. But you really should try to understand the basic concepts of how options work in reality. I know you feel ok with theory, but understanding how to play with some specific spreads helps also. PLUG: My book should help: <u>The Rookie's Guide to Options</u>.
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Mark
 
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