The Concept of Options Trading

Free Options Software How to Develop Your Own, Unique Options Trading Strategy There are many different option trading ideas, strategies and even more variants of these strategies, the whole idea is based on the nature of the options premium pricing formula, that’s a formula with many variables, and while you can just follow the path of experienced traders and their well established and well known generic concepts, there’s nothing stopping you from developing your own unique trading strategy. In order to develop your own, unique and secret trading strategy you have to look at the options premium pricing formula, and bear in mind that despite all the complexity it poses, you can still simplify things a great deal by applying the following rule: When developing a new trading idea, you can just deal with only one formula variable at a time, while keeping all the rest fixed! More to the point: We know that options premiums pricing formula has the following, option contract-based variables (or parameters): The Delta is used to measure the sensitivity of an option premium’s intrinsic value when compared to the stock. In other words it tells you how much that intrinsic value will move for every one point move in the stock. If you have a delta of 50 that means your option’s intrinsic value will move $.5 for every move in the security, this is used to establish the dollar-for-dollar relationship between the stock in question and the intrinsic part of the option’s premium as and when it gets In-The-Money. Because the Delta is measured for every $1 increase in price, calls will have a positive delta and puts will have a negative delta. The Gamma measures the rate of change of the delta, for instance if the Gamma is 1.1 then for every favorable $1 move in the underlying stock the Delta will move up 1.1 vice versa. So if the delta is 50 and the stock moves up $1 the delta should now be 51.1. You can see that this relationship is not linear, neither symmetrical, it is possible to pick options that can make money if the expected happens, and they will lose much less if the unexpected happens! The Theta measures the effect of time decay on an option. It measures how much value an option premium’s extrinsic value will lose for every 1 day that the option gets closer to expiration. If you have a theta of 3 then for every day that passes the option loses $.03. Theta is much bigger for shorter time periods. An option 20 days away from expiration will have a theta many times the size of a theta on an option 3 months out. Note that Time-Value and Extrinsic Value are really the same thing, but it is affected by volatility as well, not just the passage of time, therefore the term ‘Extrinsic Value’ is better suited.

The Vega measures how much an option premium’s extrinsic value will change for every 1 percentage point change in implied volatility. If volatility goes up so will the price of the option and vice versa. These are the most important on the option contract, then of course there’s the Beta parameter, and the technical chart status of the stock itself. The general concept behind every trading strategy is that you only deal with one parameter at a time, so you can pick stocks, you can look at their implied volatilities, historical volatilities and price direction and expectations, then you can look for overlooked opportunities, these are usually asymmetrical patterns upon these parameters. For example: One Call option contract has favorable Delta and Gamma so if the stock moves, and the option becomes In-The-Money, it becomes somewhat profitable right away, while a Put option on the same stock, having the same Delta and Gamma, contract term, and everything else being equal, will also be just as profitable if the stock does the exact opposite than you expect! The only thing that’s left to chance here is volatility, because you are buyer on both sides, volatility will only work in your favor if the stock drops, so you make sure you buy AtThe-Money options, both the Put and Call, or the most affordable In-The-Money ones and you also buy on a day where volatility is in your favor, you avoid buying OTM options so as to limit the effect of volatility. This strategy is used when a huge breakout is expected, usually at technical converging trend lines, just before earnings release week, or just before economic indicator release days, where we don’t know which direction the markets will go, we just know they will move by big magnitude in one direction. We need the intrinsic value to be symmetrical, no matter what happens, so Delta and Gamma have to be equal, here we attempt to profit from intrinsic and not extrinsic value, we want our options premiums to contain as little extrinsic value as possible, so that volatility will not have much of an effect. The only parameters that matter most here are the Delta and Gamma, you expect a breakout move on the stock, so that the winning option will move more in the money, and so will Delta, it will rise and tend to become 1, at the same, the losing option contract can be closed on breakout day, but even if it is left open, its Delta will fall and will overall yield a smaller loss than the winning option’s profit. Up to this point we don’t have to confuse our minds with the other parameters, we can entirely start our idea, dealing with one parameter at a time

Developing your own unique option trading plan By analyzing all the interesting data on the stock market, scanning for particular stocks, looking at their Beta, looking at various sectors or industries and identifying leading and

lagging stocks, and by analyzing the status of these stocks on the technical charts, you can infer a lot of inspiring information as to what option ideas can be implemented. So first we have to focus on the stock, and its status relative to the rest of the market. Then we have to find the most appropriate strategy, we have to decide if it makes sense to trade with intrinsic or extrinsic value objectives, and find the right options contracts that can do it. For more sophisticated ideas, simple optical observation may not be enough, that’s why many brokers and option trading mentoring websites such as Analyzetrade.com have made available not just screening and scanning market tools, but also trade simulation tools that can put your option trading idea to the test, using real market data from the past, this enables serious options traders to really scrutinize their ideas and leave nothing to chance. Free Option Software Links to popular option websites: http://cboe.com/LearnCenter/default.aspx http://www.optionseducation.org/