Option Investor
Educational Article

Giving Something Back

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One of the most rewarding parts of writing about the financial markets in this forum is the variety of other traders I have the opportunity to correspond with. In fact, I have readers that regularly write to me from each of the 6 continents (I'm not yet aware of any readers in Antarctica, but if you're out there, by all means drop me a line!). Some are relatively new to the newsletter and some have been writing to me since I started contributing to OIN back in late 1999. While I love all the variety, by far my favorite group are the new traders.

You know who I'm talking about, as we've all been there. There may be some familiarity with trading in general (or even quite a bit of experience), but they're new to the world of option trading. We've all been there, and if you think back on your own learning curve, isn't it amazing how much you've learned since getting started in the world of options?

I obviously can't spend much time with every new reader that comes along or I'd never have time to trade or write these articles (GRIN), but every once in awhile, a new reader comes along that shows a genuine interest and willingness to learn how to win at the options trading game. Over the past few weeks, I've been corresponding with a fairly new reader, we'll call Jerry. Jerry's fairly experienced at trading stocks, but brand spanking new to the world of options. Based on the discussions we've had up to this point, Jerry appears to be doing things right in terms of research, proper money management and at the same time trying to fine tune his business plan.

I can tell he's working on that business plan by the most recent question he posed. He's had a couple of small losses in his early option trades, and is naturally comparing that performance to what he knows is possible in the world of just trading equities. From that flowed the pivotal question, which gives us our topic for the day.

When I do all my calculations on IVolitality.com and consider my strike price and my expiration date and all, and I see that an option is only going to run, say, sixty-four cents for every dollar of movement in the underlying stock, and I know that my option is going to be losing time value every day that the stock doesn't move so I've got to be real good at judging time, I find myself wondering-- what is the advantage of trading options as opposed to just doing the straight-up stock trade. Apart from controlling risk-- like knowing the maximum amount one can lose going in to the trade-- and apart from being able to 'control' more shares for a lot less capital outlay than I would in a straight stock play, what are the advantages to options trading v.s. stock trading?

You see, Jerry started out by devouring all the information I could point him at with respect to option pricing and how an option will move relative to the underlying stock -- you know, the Greeks. You see, he's entering a new endeavor and looking to relate what he knows (stocks) to what he's trying to learn (options). Alright, let's leave Jerry's learning curve aside for awhile and just deal with the question at hand.

Unless deep in the money, an option will never move dollar-for-dollar with respect to the underlying stock. As I've covered in detail in the past, the amount the option moves with respect to the underlying stock is determined by the Greek, Delta. An ATM option will have a Delta of 50, meaning that for every $1 move in the stock, the option will move $0.50. So we know we're going to need a decent move to make our trade worthwhile. Additionally, the clock is always against us, as buyers of options. Mike Parnos' cadre of CPTI students know this fact all too well and are more than happy to take the other side of the trade, selling premium in well-considered trades.

But let's stick with the idea of buying premium. If we're going to do it, we need a target that not only has the capacity for a large movement, but we also need that movement to happen in a short space of time, RELATIVE TO THE EXPIRATION of the option we choose. If I buy an option that expires in two weeks, I need a big move and I need it to happen RIGHT NOW! If however, I purchase a 2-year LEAP, I have the luxury of time on my side. I can wait for the move to take place as the impact of time decay will be very slight over the next year. But we're not just interested in NOT LOSING, we want to MAKE MONEY, right? For that, we need a stock that moves, and will likely do so in a short period of time relative to expiration.

The problem with that qualifier is determining when a move is likely to take place and then allowing enough time by selecting the right expiration month. When I first started trading options, I had a pretty simple rule of thumb. I picked trades that I thought had the potential to move at least $2 for every $1 of risk, and that I thought would start their move some time in the next 2 weeks. But the key is that I never bought an option with less than 60 (preferably closer to 90) days until expiration. That gave me time to be right. I've fine-tuned that process over the years, but I still think it is an excellent place to start for new options traders.

I actually wrote a couple articles last year that I think are germane to this issue. In case you missed them, I think you'll find them instructive on the twin topics of which strike price should I use (relative to where the stock is currently trading) and how much time should I buy?

Which Option Should I Buy?
Which Option Should I Buy? -- Part Deux

We still have the underlying question that Jerry posed though. What inherent advantage does option trading have over stock trading. Simply put, leverage. You see, it takes a real home-run to net a 100% return on a stock trade. If long, the price of the stock needs to double to provide that return, and if short, the price of the stock needs to go to zero. By contrast, it really doesn't take that large a move in an ATM option to generate a 100% return.

Let's look at a quick example to demonstrate the point. In the middle of January, shares of AIG looked like they were going to tip over below the 200-dma, in a continuation of the long string of lower highs that commenced in the fall of 2001. At the time the stock was starting to roll over from the $63 level, with both daily and weekly Stochastics looking weak. The PnF chart was already on a Sell signal, with a bearish price target of $47. That looked pretty favorable at the time, with upside risk limited to the bearish resistance line at $64. So positions entered at say $62, had $2-3 worth of upside risk and $15 of potential reward to the downside.

I don't want to spend a lot of time on the technicals of the trade setup, but instead want to focus on the potential for return. Let's assume that we're just trading the stock. If AIG were to fall all the way to the $47 price target (which it did), that would represent a gain of $15 from the $62 entry point. Doing some quick math, that equates to a gain of 24%. Given that the whole move only took 3 weeks, that is really quite a respectable trade, even just trading the shares. But let's compare it to what would have transpired with if we had chosen the March $60 put (AIG-OL) as our trading vehicle. Let's assume our entry into the trade would have taken place on January 17th, which would have given exactly 2 months until expiration. A bit close to the 60-day threshold, but close enough.

My chart service doesn't show any trading for that option prior to January 21st, so to err on the side of caution, we'll use the close on that day (when AIG closed at $61.40) as our reference point. On 1/21, AIG-OL closed the day at $2.55. A few short weeks later, as AIG was beginning to recover off its low near $46, this option was fetching a very respectable $11.80 on February 13th! That wasn't the peak price, but performing the same simple division produces a gain of 363%! That is precisely the advantage that option trading holds over stock trading. Certainly this is an extreme example, but I think it clearly demonstrates what we, as options traders are endeavoring to capture.

Here are a few examples of recent (over the past few months) moves that set up nicely on the charts and would have delivered handsomely to traders that had a handful of puts:

AZO - 1/07 - 1/27
CYMI - 1/14 - 1/28
EXPE - 1/16 - 2/04
LPNT - 12/22 - 1/10

Each of these moves would have produced respectable gains for stock traders, but option traders would have netted fat triple-digit percentage gains. This is at the very core of what option trading can provide, that stock trading can't.

I know there are many traders that will trade options on a stock, looking for a move of $3-5 over a relatively short period of time. That's all well and good, but it doesn't fit my style. In my opinion, it doesn't make sense to take the risk on an options trade (time decay, bid/ask spread, volatility changes) for a move of less than $5, and my preferred target is for a move of $8-10. I know what you're thinking -- there haven't been very many of those lately! Bingo! No matter what your trading vehicle, the current market is a perilous place to be. Aside from surprise news events, it is hard to find a stock that has moved more than $5-7 in the past month. Take IBM and MSFT for example. Since 1/21, IBM has been confined to a volatile $76-81 range, with a trend being very elusive. How about MSFT? Since 1/27, this institutional favorite has been confined to an even tighter range, from $23-25. It's tough to make a buck out of that kind of action, unless you have a much longer time horizon.

So while options have distinct advantages over stock trading, we must allow sufficient time for the move to take place and the corollary to that statement is that we want to trade options on a stock that is either in the midst of a trend move or we think is ready to get started on one. Determining what are viable targets and when, is at the core of what technical analysis attempts to determine. It is as much art as science, but the pursuit of that Holy Grail will likely persist as long as there are markets to trade. Hopefully this rambling discussion will help you (as well as Jerry) to see where the relative advantages and disadvantages lie between trading stocks and trading options. If so, I'll feel that in my own small way, I am giving something back to the system that has been so good to me.

Questions are always welcome.

Mark



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