Option Investor
Educational Article

How about a review\?

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After being away from the market for awhile, it's always good to review some basics. If any of you out there have a newborn and work from home like I do, then you have to know how hard it is to do anything, let alone sit in front of the computer during market hours watching your real-time quote vendor. It's almost impossible! If you've read Marty Schwartz's book, "Pit Bull", he sums it up pretty well: "... don't trade too heavily the month before and two months after your wife gives birth." It's so true!

What should you have in your arsenal before you actually put on a trade? First off, you should definitely have some kind of options calculator that will compute fair value. The CBOE has a useful calculator on their website that you can use for free. You should also have access to either delayed or real-time quotes. If you are a more active investor/trader, you might want to pay up for a streaming datafeed. When deciding on a data vendor, make sure they have good volatility data in their option chains. The next step is to find a good options broker with decent commissions. This may take some time and you might want to open a few small accounts to see which one you like the best. Many traders will argue for their favorite, but I look for a brokerage that allows option spread trading online.

Now that you've got your datafeed, software, and brokerage account set up, what's next? Do some research and find an option to trade. Start with the well-researched picks within this newsletter. There is definitely a potential trade for all types of strategies and scenarios. Once you've keyed on a trade, you can do further research if you like.

I want to expand on a few subjects which are the most vital to me before I place any trade. My number one criteria is to check the historical and implied volatilites of the underlying stock and options. If any of you have read some of my previous articles, you know that I view volatility as a key ingredient to option trading success. Check the archives of this site under the "options 101" section. To re-cap, there are a few types of volatilities. "Historical volatility" is a number that measures the magnitude of the underlying stock's movement over some period in the past. The movement can be in both directions. The standard time periods that are widely measured by the trading community are 20-day, 50 or 60-day, 90 or 100-day,etc. You can measure any period you want. Some believe that you should measure a time frame that coincides with the amount of time to expiration of your option. The more erratic the underlying stock has been, the higher the volatility reading will be.

"Implied volatility" is a number that is derived from the option itself. You can solve for this number by working backwards thru the Black-Scholes model by inputting the option's current price instead of a volatility guess. Implied volatility is a guess by the market participants of what the future range of the stock will be before expiration of the option. The market players are in a sense telling you what the historical volatility is going to be before it becomes history. Get it? The higher the IV, the fatter the option premiums will be. An erratic stock will have bigger premiums and a stable "Old Economy" stock will have paltry option premiums.

In most cases, HV and IV will be different. Since everyone has a different idea of what the stock's volatility should be and because everyone's time frame may be different, this is what can lead to trading opportunities. The way to use HV and IV to your advantage is to look at its past behavior. Looking at historical HV and IV charts is a good way to tell whether your stock's option premiums are at the high or low end of its range. The historical HV and IV charts will usually move in tandem with each other but either one can be higher or lower than the other at any point in time. You'll want to stick with option buying strategies when the volatility is at its low end and look for option selling strategies when volatility is at its high end. This is extremely important. If you buy options when volatility is high, the odds are greatly against you. Not only will your directional bias have to be correct, but the timing and magnitude of the move will have to be even more precise.

The other concepts that play an integral part in determining which option trades to make are the option's "delta" and its "probability of profit". These two items can really give you a heads up on the chances of you making some money on your trade. The delta of an option tells you how much the premium will go up or down in response to a $1 move in the underlying. An at-the- money option typically has a delta of .50. This means that if the underlying stock moves up or down $1 in price, your call or put option will gain or lose approximately $.50 (all other factors being equal). The delta can also be looked at the "chance of your option being in-the-money at expiration." An option with a .50 delta tells you that you have approximately a 50% chance of your option finishing ITM (in-the-money). Now that doesn't mean you'll automatically have a profit if your option is ITM. If you bought a $40 call option for $5, and the stock closes at $41 on expiration day, you'll still lose money even though the $40 call closed ITM.

That brings me to my next concept - probability of profit. This little number is a better way of knowing your chances of success before you put on a trade. But in order to know your chances, you'll need to run the numbers through a simple probability calculator. It's a simple tool that can tell you the chances of the underlying security being below, at, or above a certain threshold by a specified date. The threshold levels that you use are going to be your breakeven points. This will tell you exactly your chances of finishing at breakeven or for a profit. Just remember, based on statistical theory, your chances of finishing with a profit if you buy options, will never be higher than 50%. That's because on any given expiration day, the stock could close higher or lower than the strike price. Most likely, your option buying success will fall in the range of 20-35%. Try to aim for the higher probability number if you're going to buy options. This is why the sellers of options are usually the winners, because their probability of profit is the opposite of the buyers. Always subtract from 100% and you'll get the sellers probability. Example: If you are buying a call option with a 15% probability of profit, the seller's probability of winning will be 85%. Yes, buying options can lead to unlimited profits, but the odds are not always that great. Yes, the seller has unlimited risk (unless doing spreads), but the odds are totally in his/her favor. I hope this article has given you a few ideas of how to get your- self up and running with your options trading business. Remember, always do a little volatility analysis and probability calculations, and you'll increase your chances of success.

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