Friday, November 24, 2006

When Forrest Gump met Dummy

Based on some recent feedback from SimplyOptions (who subtly pointed out to me that I had mistaken her as a "him" - colour me embarrased!), I believe now is a good time to share what I have learned about options trading.
There is still so much I don't know about options. What's a Gamma? When is it appropriate to execute a butterfly? That is why I try to trade like Forrest Gump - my lack of knowledge in options trading is hopefully compensated by the simplicity of my approach.

Approach #1 - Select an option that is liquid
For options, liquidity is defined by high volume and Open Interest.
If an option has low open interest, not only is the bid ask spread very wide, but it may be difficult to exit your position if the underlying stock moves against you.
For example, look at CME Jan07 550 calls (barely ITM as of Nov 24/06):

550.00CNMAJ.X27.80Up 0.3027.5028.5035701
The last number represents open Interest, 2nd last number was the trade volume, and the next two represents the bid/ask. Note the bid/ask spread is $1 !!

Now look at GOOG Jan07 510 calls (barely OTM as of Nov 24/06):
510.00GOPAU.X21.00Down 2.2020.8021.006814,751

Both open Interest and trade volume are an order of magnitude bigger than CME. Consequently, the bid/ask spread is also more narrow, which means I can get out of these options easily.
Though there are exceptions, but in general, the highly liquid options are found in the highly popular popular stocks. I stick with the popular suspects like GOOG, AKAM, RIMM, BIDU, AAPL, etc.

Approach #2: Buy Well Behaved, High Probability Setups
I have reviewed my options trades (plus a few more that I did not manage to post here), and I find that I have the greatest success rate when I buy options on stocks that follow the high probability chart patterns that I have identified. I noticed that my options trades failed (ie. I lost money on them) when I bought when the underlying stock was at resistance, or when it was going sideways, OR thrashing around alot (ie. misbehaving) with no clear direction. I have used the pullback pattern with a great degree of success. The breakout pattern I have had some success with, but sometimes breakouts fail, esp. in the current choppy market environment. The dummy spot pattern, I haven't yet tried (because I don't come across dummy candles too often in the group of stocks that I watch for placing option trades), but I am confident that it will also yield a good degree of success. I do remember one time buying some call options based on the hammer reversal pattern of the underlying, and had success with that option trade.
Options add "juice" to these high probability chart patterns.

Approach #3 - Hold for a short time
My time horizon for holding an option is typically 0 to 3 days. I have never held any option for longer than a week and see no reason to do so (with the exception of MNCS, stocks do not keep going up for over a week without pulling back). Because options are highly leveraged instruments, even an orderly pullback in the underlying stock can cause excessive weeping and gnashing of teeth for the option holder. The other problem with holding options is that of time decay, or what they call Theta. Say you buy an option for $5 when the underlying stock is $100. The stock pullsback to $97 and 1 week passes by before it climbs back up to $100. Well guess what, just because the underlying is back at $100, that does not mean that the option will climb back up to $5, esp. if the option that you are holding is close to its expiration date. Holding the $5 option for those few days cost you.
The Phantom of the Pits's Rule #1 is very appropriate here: I only hold options for the time that it goes up and I am gone as soon as it stops going up - there's no reason (in options trading) to wait until you are proven wrong.

Approach #4: Keep it Simple, Dummy
I don't know how to execute an Iron Condor or a Butterfly. And while the concept of a straddle is an interesting play on pending earnings announcement, I just prefer to keep things simple. Wait for the high probability setups. Buy calls when the stock goes up. Buy puts when the stock goes down.

There are obviously still a few unanswered issues. For instance, is it possible to risk the same amount each time in an options trade? I am still trying to experiment with appropriate position sizing. I also don't have a rule for how to select which option for the trade (1month out, 2 months out, or 3 months out? ITM or OTM, and how far ITM/OTM?). However, I have a tendency to select options that are 2 months out, OTM but within one or two ATR's of the underlying stock price. Example: If I were to make a play on GOOG's potential continuation move, I would look for Jan07 520 calls.

Well, that pretty much captures how I trade options. Hope this helps those who are considering trading options, or want to try new approaches to option trading.


Tyro said...

So you're using options in a strictly speculative fashion, as a replacement for stocks? I'd guess that you just buy puts or calls.

This seems like a real shame, given the power of options. Why not get a couple books and start trying out a couple spreads. These may reduce your risk and the cost of establishing the position while only reducing the max potential profit - probably not a problem for very short term trades.

BTW: how are things on the job front going?

Tyro said...

Man, that sounded so pejorative. I don't know squat about money and have lost almost every dime that I spent on options. I shouldn't be talking at all, but I'm enjoying learning from you. Sorry man, didn't mean to sound like such a jerk.

Phileo said...

Hi Tyro,

No worries, the issues that you raised are legitimate.
Yes, that is an accurate description - I am currently using options as a replacement for stock. The main difference being that my time horizon is 0-3 days. Not really attempting to swing trade options at all. In and out for a quick profit.
I have thought about using spreads. However, selling calls require that you either own the underlying stock, or have enough equity to afford the increased margin requirements. A big chunk of your equity/margin is tied up in that spread, so that limits your ability to make other trades for the duration that you hold the spread, unless I am very well capitalized (which I am not). Plus, there may be slippage costs with the additional calls to setup the spread.
So far, I am having more than enough success with my simple approach - my equity is up 50% ever since I made that second attempt at the Google Call trade back on Monday Oct. 23, 2006.
Most traders have mentioned this as well - focus on doing one thing consistently well first, and only then consider expanding your repertoire. I have not yet felt the need to tweak my approach yet with these other options strategies. However, I remain open to adding additional strategies to my approach - in due time.

Job search? It's coming along slow. I've started applying to a few companies, and next week will probably be working with a recruiter who got me a previous job. If you know of any leads, don't hesitate to contact me for a resume - my email is in my profile.

Tyro said...

You should be able to put on the spread without any additional capital since the long call will act as the equity needed to short the call. Should the stock ever move high enough that the short call goes in the money and keep going up, the addition profits in your long call will match the losses in your short call. Call the broker, this margin shouldn't be a problem.

I talked to the g/f's brother who is working in hardware chip design. He's not sure if there are openings, but is keeping his eye out.

Good luck with the hunt. You seem to be handling the additional stress well.

Phileo said...

Hi Tyro,

Thanks for the explanation about spreads - you obviously know more about options than I do!
Sounds like spreads can address the issue of controlling the amount risked in a trade. I will give it some further "hmmm......" as to how I can incorporate it into my options trading approach.

Cal said...

I've made some very nice gains in Google, and Apple options, I am also a daytrader of Nasdaq stocks, check me out.

P.S. Also check out this guy, he's an awesome options trader, and recently won a huge contest to take a trip to Chicago

Phileo said...

Hi Cal,

Thanks for taking the time to visit!
Yeah, Goog and AAPL have been pretty good lately, just wondering when this ride will be coming to an end.
Thanks for the link to 1Option's site, I will check his articles for sure. Thanks for dropping by!