Sunday, February 28, 2010

Options and such


***Disclaimer***
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (the "ODD"). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes. In order to simplify the computations, commissions, fees, and margin interest and taxes have not bee in included in the examples used in this presentation. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. No statement within this presentation should be construed as a recommendation to buy or sell a security or to provide investment advice.


I can't help but to feel relieved that the first week of option trading has just ended.  For some reasons, I have problems putting on trades this week.  Obviously, I have thoroughly understood the study materials and have even done up a "re-usable" spreadsheet for trade planning purposes.  But I find myself hesitating when it comes to which trades to put on.  Finally, I managed to put on my first 5 contracts on Tuesday, 5 more contracts on Wednesday and the next 5 contracts on Thursday.  I even bought some "tail" put for margin and protection on Friday.


Part of the hesitation came from the fact that I was trying to "improve" on what I did last month.  The ratio spread trades were a lot easier for me last month.  I put on my first trade primarily based on the parameters provided by Jay after I've given him my perspective on the TA.  The second and third batch of contracts were really conservative ones just to get a feel for how these ratio spreads work under trading conditions.


Back to last Monday, I was trying to trade 1:3 instead of 1:2 ratio spreads as part of the improvement.  There were two reasons for that.  First, I was not getting the kind of credits that I would like for the 1:2 ratio spreads (even though we understand that getting a credit is not the main focus of the game).  Second, with the 1:3 ratio spread, I can increase my spread from a $15 to $20 spread, effectively increasing the size of my "mouse trap".  I realized, however, that the greeks for 1:3 ratio spreads are not as well balanced as compared to the 1:2 ratio spreads.


Look at the row that says "Net P/L vs. movement".  This is part of the "what if" analysis that finds out what happens to your position if the underlying makes an immediate moves +- 5 strikes.  There will be a $2.55 "paper loss" if $OEX moves immediately to $480.  Everything noted here is on a "per share basis". If you're trading 10 contracts, that will be $2,550 (10 contracts x 100 multiplier).  That was my major area of discomfort even though I know that in reality, it is improbable to happen.  We are asking S&P500 or S&P100 to drop close to 5% immediately which will not happen unless a catastrophe happened.


The greeks for the 1:2 ratio spreads, on the other hand, are well balanced.  The two lower strikes that you sell usually offsets the strike that you buy.  Nevertheless, I decided to put the trades on but reduced my positions to maximum of 5 contracts for each night. 


By the end of the first trading week, the underlying $OEX hardly moved.  It put in a high of 510.11 and a low of 498.51 and closed the week at 506.06.  But the "hardly any movement" with time passed on has helped my ratio spread positions.


In general, when trading ratio spreads, time passes on without any underlying movement actually helps the trader gain "paper" profits.  This is due to the normal distribution of the probably curve.  The short strikes are further Out-of-the-money than the long strikes (which are Out-of-the-money).  Therefore, as time moves toward expiration, the normal distribution of the probably curve "shrinks", as the FOTM short strikes have a lesser and lesser chance of having an intrinsic value at expiration.


You can look at the premium offered for the same strike but different month as an illustration:


$OEX March 10 500 strike is last traded at $6.00
$OEX April 10 500 strike is last traded at $10.60


This means that if you buy the $OEX 500 strike for $10.60 and one month elapses without any underlying movement, you can expect your $OEX 500 strike to be worth only $6.00.


Now, I need $OEX to start moving down for better profits over the next two weeks or so.


On C, I took profit on the short strangle position that I have on since 24th of December 2009.  There was a combined $0.06 left to be made on that position and I decided that it is a waste of margin.  I re-strangle C for June expiration.


on GS, I sold the March covered call at 170 strike and did a 1:2 ratio spread with strikes 145 and 135.  I quickly dismantled it by selling away the 145 put when I realized that Congress threw out the "Volcker's rule".  I will offset the 135 puts in the coming week.

2 comments:

stevegee58 said...

Hey guys, I've been following BWBs myself. I've been paper trading them for about a month and I'll probably start small with real $$$ next month.

I noticed that you chose OEX and QQQQ. I think SPY might be better than QQQQ since strikes are about 1% apart but the Q's are about 3% apart.

randomjaywalking said...

Hi SteveGee,

I compared various indexes in the beginning (DJX, QQQQ, OEX) but I found that the OEX provided better risk/reward ratios. If you are undercapitalized, then the suggestion is a lower value index e.g. DJX, MNX, QQQQ, or SPY

The OEX has $5 strike increments so max profit is greater and the wider the increment between the long and short strikes means a wider "mouse trap". $5 strike increments also represents 1% movement in the underlying between strikes.

Hope this clarifies.
-randomjaywalking