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):

550.00

CNMAJ.X

27.80

0.30

27.50

28.50

35

701

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):

510.00

GOPAU.X

21.00

2.20

20.80

21.00

681

4,751

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.