Trading Options for a Living

Option Trading Topic: This is meant to throw a bit of a scare into those of you option traders out there aspiring to make a living trading options full time. Happy Halloween!

Dear Options Trading FAQ:

What percentage of option trades expire worthless? What is the number for professional traders? I ask because I hope to become a full time options trader and want to know the odds of being able to support myself doing it.

About to Quit my Job to Chase Options

Dear Options Trading FAQ:

This is sort of a personal inquiry about my hopes for options trading. I know it's risky to trade options, but I seem to really love trading. I dream about becoming a professional options trader - working at home and supporting myself just by trading and then if I’m successful, managing money for others. I am a psych doctoral student with a spouse and young child and will graduate next year.

I can find some research or company job if I want to, for about 40k$/yr or more, but I want to be my own boss if possible. I used to want to become a professor with a stable $50k or so salary, but my mind is now caught on the idea of trading options for a living.

My questions is: Can I feed myself and my family with this kind of "job"? My husband and I are dreaming of building wealth by trading, and to work at home. Right now we are doing stocks and options, and I would like go into financial futures and commodities later on. We are not very successful yet but we feel hopeful that we will start to see the sunshine. I wish for great success as an options trader.

Optimistic About the Future of Option Trading

Dear Aspiring Option Traders:

I get many letters such as these from folks hoping to become full time option traders. I am touched by the earnestness and hopefulness that is apparent. Sometimes the naiveté shown just strikes something within me that really tugs at my heart, triggering such bittersweet memories of my own initial hopes and dreams about Wall Street.

So let me say this as gently and supportively as possible: It is an extremely difficult proposition at best. As trading guru William Eng writes in his upcoming book (excerpts appeared recently on misc.invest.stocks), you are up against the smartest minds in the world. When you get to the core of it, the essence of trading is outsmarting the next guy to take his money. Professional institutional traders have the backing of tremendous resources behind them. The at-home trader with his 15 minute delayed TV tape and deep discount order clerk is quite outclassed.

Trading for personal income is VERY, VERY difficult. Even for the Wall Street pros. The best traders in the world can do their best when IT IS NOT THEIR OWN MONEY. When the money means something to you, it becomes mostly a psychological matter. (Maybe the psych major in the above letter will have an edge. I have often said to myself that if I go back for a Ph.D., it will be in the field of psychology, specializing in group behavior/ herd mentality.)

The public is usually not aware of the rigid rules set in place for the pros on Wall Street. They are designed to cut out the psychological pressures that bedevil the rest of us. For example, how many of us can really limit our losses to a reasonable level? Not many, I daresay. In theory, we can set an arbitrary stop-loss level but it is so difficult to keep.

Let’s say you open a $10,000 account with the idea of closing down the whole thing if the equity drops to $7,000. You fool around a bit and find yourself below that level one day. Do you now offset all your positions and call it a career? Do you pick up your marbles and go home? Can you face up to your losses? It isn’t easy. You’ve been telling your wife about the wins but not the losses. How do you ‘fess up now? Haven’t you been hanging your ego on this trading thing? How about leaving the money in and trading out of the situation? Yeah! Bingo! Sound like a scenario from a major Japanese bank? These feelings are only human and plague all of us.

On Wall Street, the trading rules are set as simply as possible. A system is designed that, if followed strictly, should bring in a certain amount of profit each week, each month and, each year. Pro traders might have bad days or even bad weeks, but, in the long run, they have to be profitable to keep their jobs.

The secret to letting the trading system work is in the management of losses. The specific numbers change but they go something like this. Let’s say that you are allowed to goof up and lose a maximum of 10% a month with a generous overall max loss of 30% before you get booted out the back door. It will be structured like this: Once you hit your max loss for the month (regardless of time, whether it be trading day #20 or on the first of the month), you get a stern lecture and are forced to sit out the rest of the month without trading. Oh, don’t worry, you won’t be idle - the rest of the guys will need their coffee and donuts. For the gunslingers on Wall Street, this down time is pure torture. Come the new month, you can start up again but be careful of how you trade, everyone will be watching. A couple of these forced trading stops and you are history.

The point is that there is a strict structure in place to keep the junior traders away from their worst enemy - themselves. When the head traders start monkeying around and get into creative ways of hiding the embarrassment of bad trades, you get the likes of Barings and Daiwa Securities.

To hope to support a family on your own trading may be a pipedream. Household bills come with amazing regularity. Profits on Wall Street seem to have their own schedule. Also, keep in mind that what you generate in the account is not all yours. Uncle Sam needs his share of last year’s winnings and won’t care that you blew it on a bad trade before the April 15 deadline. Somehow when your employer withholds the taxes from your payroll, it sticks around as a credit to your taxbill. Pretty neat.

The abovementioned trading hopeful mentioned a 40k or 50k job. Accounting for expenses, taxes, and such. this is equivalent of clearing 100k trading profits her first year out. Hmmm. Doesn’t sound so easy does it? The $3,000 loss carry-forward is little solace should things not work out.

Having said the above, I’ll relate an amazing trading story. One of our clients, an anesthesiologist hopelessly addicted to the thrills of option trading, ran his account from 10k to 900k in just six weeks. What makes it really incredible was that it was not from riding any easy trend, or not just a few lucky hits. He adroitly traded in and out of both calls and puts on a large number of different securities. Of course, he caused quite a sensation as the number of contracts pyramided up. Casually placing 1,000 lot orders to the floor was a thrill I’ll not soon forget. Anyway, that remains the most unusual run I’ve seen on Wall Street. Oh, by the way, he lost the entire amount even more quickly than he made it. But that is another tale!

The more common story is that of traders coming in again and again with trading stakes carefully saved up and carelessly traded. It seems that upticks and downticks in the market don’t seem like money to people. If you misplace a $20 bill in your house, you’ll spend a good amount of time walking back and forth looking for it. Yet, folks will sit and watch much larger chunks of their equity fly by with each tick and nary bat an eye.

If you are hell bent on pursuing your trading interests, at least get a solid education. Here is a partial list of must-read trading books. Technical Analysis of Stock Trends by Edwards and MaGee. Options as a Strategic Investment by Larry McMillan Market Wizards and New Market Wizards by Schwager. And as an eye opener, try the Gene Marcial (he writes the Inside Wall St column in Business Week) book, Secrets of the Street. An excellent trader's magazine is Technical Analysis of Stocks and Commodities. And of course a good set of chart books are essential.

It is not easy, as the statistics show. The first reader mentioned asked for the percentage of options that lose money. I happened to see a post on this very matter. I quote from a recent post from www.interaccess.com : "...OCC economists estimate that 30%-33% of stock and index options expire worthless, and perhaps as much as another 20%-33% are offset at a loss." Let's add that up. That seems to be up to 66% losers. The edge seems to then go to the option seller, not the buyer.

Indeed, premium selling strategies are preferred by pro traders. The favorable margin requirements allow them to steadily collect small gains over and over again. Long side shooting is left to the public speculators who find the naked requirements too exclusive. With the cards stacked this way, it is difficult to try to trade for a living.

Many readers may write to say that it can be done. I will admit that for some it may be a reasonable proposition. Some may have the discipline, the gumption and the capital to pursue it successfully. If you have plenty of risk capital, personal discipline to stick to a winning system, a rock solid grasp of money management and the personal freedom and time to devote to it, then you may want to try it out on a small scale. DO NOT THINK ABOUT IT if you have dependents riding on your trading success. This is not responsible action. I have personally been witness to family breakup, marital strife and even suicide on Wall Street. The market is a head game and I must say that not many of us should take peeks into those heads of ours. We may not like what we see.
Happy Halloween.

Parting options trading advice: Try not to invest too much of your psyche into your trades. The sad part about a losing trade is the deflating effect on one’s spirit. Letting the market trounce your wallet is one thing, letting it ravage your soul is another.

From one trading fool to another: Good Luck. Be Strong.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order, Stock Market Trading, Professional Trader

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use. Think about your options.

Option Exercise Assignment

Options Trading Topic: More about option exercise and option assignment

Dear Options Trading FAQ:

I love to trade options. I was interested to see your letter about exercise and assignment of options as I am a seller of options myself (buy-writes against stock). I’m still a little foggy on it so I thought I’d write. BTW can I be put on your e-mail list?

OK, let's flip the question a little bit. I have 300 shares of ABC and I wrote 5 November call options at 100 for 7/8. The stock price is now 100 and the call options are worth around 3 1/4. From what you've said, these calls (probably) won't be exercised because they're worth more on the open market. However, if the stock moves up, these calls are going to appreciate accordingly as well since they are in the money. In the most extreme case, wouldn't these calls be worth more as options as long as they are in the money? On the day of expiration, will they expire worthless or will they be automatically exercised if they're still in the money?

Optioned Out Option Strategist

Dear Down but Never Out:

Sure, you can be put on the Options Trading FAQ list. Good thing you asked while there are still openings! But seriously, there’s really nothing to getting on the list. I’m proud to say that it has become very popular and critically acclaimed among option traders. With some journalists and financial writers, it is considered a must read option primer. Welcome and enjoy!

As for your options question, everything seems OK with what you wrote until the end. Yes, the in-the-money option will move lock-step with the common stock. Yes, the calls will be worth more as options and that is why they don’t get assigned right away. BUT, that may change as expiration nears and as they get deeper in the money. That is, during expiration week, they may lose all the time and volatility premium and reflect only intrinsic worth. When they trade towards parity like this, they have a much higher likelihood of getting exercised.

At times the price of the call option may dip below the intrinsic value (trading at a discount). When this happens, the option holders will have to exercise the option to realize more than a straight open market sale and you will receive the assignment notice. If you don’t get assigned, as in your scenario, the options will go all the way to expiration day. At the close of that day, the exercise will be automatically done if the call option is in the money.

As I mentioned in a previous letter, you can also be assigned if the stock lands exactly on the strike price or even if it closes below the strike (making the call theoretically worthless).

The timing of dividends can influence assignments as well as any type of inside information. Also we can see seemingly strange assignments or non-assignments at times. I’ve gotten a few letters that sketch out stories of assignments that don’t seem to make any sense. Oh well, the vagaries of option trading.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Exercise, Options Assignment

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use. Think about your options.

Country Index Options

Options Trading FAQ Topic: Oh Canada, Oh, Canada! And other options on country indexes.

Dear Options Trading FAQ:

Canadian markets are facing lots of turbulence and fear-inspired downward pressure as we approach Monday's referendum vote that could lead to the secession of Quebec from the rest of Canada. Though I live in Canada, I have never played their markets. For a variety of reasons (I'd be happy to send along my arguments if you like), I am convinced that the vote will be "non"; that Canada will remain whole. Therefore, I expect a strong upward breakout Tuesday morning when the results are known. My question: how would you play this on the option side?

Are there TSE 300 index options? If there are, I was thinking of buying calls on Friday. I don't play currencies, but I am changing some of my US $s to CAN$s this week. Do you follow and play options on Canadian markets?

Loyal Canadian Options Trader

Dear North of the Border:

With your grasp of the situation, you should be on public television! We stick mostly with US issues here at my office. We get the occasional client order for Canadian securities, and they are usually restricted to shares of junior mining companies. So with our exposure to Canadian shares so low, no one here has developed any sort of personal interest. Sorry. No , I don't know of any index option plays for Canada. Maybe the readership can suggest something. Other countries do have index options available.

For a list of specialized indexes, check with the exchanges. Some of the more popular country indexes are the MEX (Mexico) and JPN (Japan). New ones include the LTX (Latin) and ISX (Isreali). A trick with some of these is that of the difference in time zones. The JPN price, for example, is posted just once at the beginning of the day while the MEX is constantly updated. With the static ones you have the additional challange of trading in anticipation of the index moving a certain amount. That's a little weird when you are used to the option premium being priced off a real-time index.

Other less popular country indexes are NIK (Nikkei 300), HKO (Hong Kong), XIS (Isareal), MXY (Mexico) and coming soon the MEX-30, an index based off of 30 Mexican stocks (MEX and MXY are based off of ADRs). Also I do believe options trade on the Nikei 225 futures, but i'm not sure. There are both TSE 35 and TSE 100 index options available on the TSE. I beleive they are American style options but I'm not 100% sure. Settlement is the same OEX and other index options, $100 a point. The TSE 35 has NOV,DEC,March and Jun expiry months currently offered with srikes from $220 to $247.50 (listed yesterday). Yesterdays TSE 35 value close was $226.79 ... Strikes are 2.5 each way ...

In regards to Japan, the Nikkei futures trade at the Merc in Chicago, and are what most market makers in the JPN index watch and hedge with. So you have a real time hedge and thus real time index. The JPN implied future closely mirrors the Nikkei.

BTW the TSE35 is an index of major 35 companies in the TSE 300. The TSE35 options seem to have more liquidity than the TSE100 options.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Trading Cheap Options

Topic: More Plays on Cheap Options

Dear Options Trading FAQ:

Ok, here is a question for the Options Trading FAQ. Right now a lot of technology companies are reporting and it seems a lot are coming out with earnings well above analyst’s estimates. SUNW, MSFT, INTL to name a few.

What do you think about buying calls well out of the money on a list of say 10 technology companies that you think might do well? For example, companies that would benefit from Windows 95 such as memory manufacturers, modem manufacturers, and software companies that write utilities for Windows 95.

You would have to get a list of companies that have not reported earnings yet and find options that sell for VERY cheap. Optimally I would buy calls where the bid is 0 and ask is 1/8. If the earning are even with estimates or bad you lose all. If the earnings are good, I think the bid would at least go to 1/8 and you would get your investment back. If the earnings are very good you could easily double or triple your money. If the earnings are GREAT you could walk away with a sizable sum.

This is a gamble with little downside, a lot upside, and with 10 companies you might get lucky and hit one real winner. What do you think?

Cheap Option Fan

Dear Cheap Chap:

It's not enough for the earnings to come out great, they have to come out great with very little public expectation for it to do so. Otherwise, all the public option speculation (and there is plenty at the price range you're talking about) won't allow you to find a reasonable option at 1/8.

Yes, when there is a surprise like that, you can make a killing with the cheap options. Buy enough of these longshots and some will come through. The question is will this strategy work out in the long run? The successes have to more than pay for all the failures. A detailed study of this would be informative.
Let's suggest this as a thesis project for an investment/finance MBA candidate.

Warning note: In the vast majority of cases, options with no bid or a 1/16 bid are worth just that and never move up but, rather, go straight to zero.

How about this as a strategy? (I like fooling around with this one now and again.) Wait for a high flying tech stock to announce bad news. The more scary, the better. Hopefully, the stock will halt trading and then gap way down. At the opening price (order is entered while the stock is still halted), I'm a buyer of a now cheap call option. I play this for a quick bounce. If you buy the option for 1/8 or 1/4, it may double right away on the bounce. Have the sell order placed on the floor right away so that you get out as soon as possible. After that first bounce, all bets are off. This is a strict day trade (minute trade is more like it).

What do you think about that sort of play as opposed to the method you proposed? Let's throw it out to the rest of the option traders forum for comment.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Strategy, Options Pricing

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Stock Split Effect on Options

Topic: How do stock dividends and splits affect the stock options?

Dear Options Trading FAQ:

I have purchased calls on a stock that has announced a stock dividend of 3 for 2. I purchased the call options before the record date. I may exercise the options between the record date and the time the stock dividend is allocated.

How will this affect my options? I am not exactly sure what the difference is (if any) between a stock dividend and a stock split. In a stock dividend does the extra share for every two come from the shares held by the company? Or is it the same as a split where the number of all shares is increased and the price appropriately adjusted? Please respond soon because my options expire this Friday! Of course I could just sell the calls for a profit, but I would like to own the stock with the stock dividend.

Too Many Options, Not Enough Time

Dear 3 for 2 Split:

Let me answer in a practical sense first, then I'll go into some financial mumble jumbo. Not all the details are apparent in your example, but I suggest that you check very carefully whether "adjustments" to the option terms have been made yet. (Is the stock now trading at the "usual" price, or the post-dividend price? That's how you'll know if the options have been adjusted).

When you call to sell or exercise the option on Friday, have the rep check the account to see how the option is listed. Make sure you sell the right option.

Here's an example of how traders have been tricked in the past: In some cases, there are instances of simultaneous listings of both "old" and "new" options. e.g. if ABC splits 3:2, the outstanding options will be adjusted to new terms (lower strike price with fractional values and more underlying shares). They will then sport the ABZ option symbol to indicate the change. Then new options may be introduced with the regular ABC designation. These will trade with the usual terms (100 share multiple and usual strikes) under the regular ABC symbol.

New option buyers will go for these, but the "old" option holders may get tricked and sell the wrong option, not knowing that their option has been adjusted and now has a new symbol. A holder may call up to sell the ABC option instead. He'll then be long the ABZ and short the ABC!

Anyway, that is just something to be aware of but that will apply only in cases where the split has occurred a while ago and there are both new and adjusted options to worry about. In your case, the option has yet to be adjusted and with the expiration so close, it probably won't be. So your concern is whether to sell it outright or to exercise. Adherents to efficient market and arbitrage theory will say that on this level, it doesn't make any difference. If you exercise, you'll have stock that is entitled to the dividend, but so will any stock that is bought at any time before the payout. The premium at this point should be at parity with the intrinsic value, so there is no advantage there.

I like to tell people to just sell the options for a profit. I do so for several reasons. A stock split/dividend situation is often "messy" with waiting for the posting of new shares, selling out the right amount etc. Also, there is the question of the margining of a stock purchase rather than continuing to play the options with much less. Another advantage to trading out rather than an exercise is that you can try to time your moves. Sell the options on an upmove and wait for the next pull back to buy some stock or to roll into later month options. You'll have more flexibility. Of course, you won't have ownership over the weekend unless you exercise. If the stock gets taken over Friday night, you won't profit if you sold the option outright. As you see, there are many concerns to consider.

Now for the dry part. The new stock comes from treasury supply. As for why a company will issue a stock dividend versus a stock split, it is largely a matter of corporate book keeping. For the individual trader, we can think of dividends and splits in the same way. Whether, in an accounting sense, one is dilutive towards earnings, I'll pass that along to the bean counters.

As for your statement that you bought the option before the record date, that doesn't matter. As I've explained with the term adjustments, a option buyer can assume the rights at any time with a simple purchase. As a matter of fact, if you sell out on Friday, the buyer who takes it from you will exercise it under the same terms available to you when you were the owner.


Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Cheap Option Contracts That Will Double - NOT!

Topic: Find Me a Cheap Option That Will Double!

Dear Options Trading FAQ:

This Friday 10/20/95 I will purchase my first set of option contracts. For the past 2 months I have been buying and selling options on "paper" and have done fairly well. I have decided to take the plunge! I am not a large investor and my plan is never to invest more than I can afford to lose. I am looking to double my investment and then sell the option. I do not intend to get "greedy". I have researched and researched options trading and strategies but I am still very nervous about laying it on the line.

I have some stock options in mind but I am wondering what some of your picks might be? Something selling between 1/8 and 1/4 per contract but no higher. ANY suggestions would be appreciated and I understand about no guarantee. Thank you for your time.

Hopeful Option Trader

Dear Abandon All Hope Ye Who Enter Here:

My hope is to dissuade you from your intended course of option trading. Or to deflect it slightly anyhow. What you are proposing to do is quite difficult, to say the least. Finding options at an eighth to make money on is discouragingly difficult. Doing it with limited capital reserves your first time out makes it near impossible.

Further, the date that you propose is an options expiration day. Do you intend to buy an expiring option? That would make it a pure crapshoot. It is rare that an option gets rescued on the last trading day.

One can make significant profits from very little money in the option market but not from buying worthless options. They are priced at 1/8 because they will likely go to zero.

Here’s how I did it once. After a hiatus from personal trading, I set out to prove that a significant amount can be made from buying a one-lot. I picked an OEX call option trading for 3 1/2 anticipating a significant upside breakout. The trend turned out to be real. Ordinarily, I would have taken a quick profit, but because I only had one contract instead of the usual 10 or more, I held on. I sold this contract on a pullback for 7 1/2 and rolled the proceeds into 5 less expensive contracts on the next push. This turned out to be one of the first bull legs in the push to Dow highs and I wound up turning the $350 into $4700 or so after a nice series of trades. A rather nice return from a one-lot!

These opportunities are rare but a strong trend makes it possible. This current tech rally saw plenty of $2 and $3 options go up plenty in just a few days.
I would take the same amount of money that you intend for the cheap options and carefully wait for that next runaway market. The 1/8, 1/4 options do sometimes explode but like at the track, you must be willing to face the more common occurance: A worthless bet.

Bottom Line: Buy less option contracts that are worth more.

PS. In your paper option trading, keep track of what the bid/asks of the options are. You cannot go by what the paper lists as the last sale of the option contract. That does not reflect reality and often misleads paper option traders!

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Strategy, Options Pricing

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Valuation 101

Topic: Option Valuation 101

Note: My replies to points as they arise are in brackets [ ].

Dear Options Trading FAQ:

I'm a big time options trader. Please correct me if I'm wrong: [With a question this long, I don’t care how wrong you are - you definitely get partial credit!]

I understand that options have (at least) three contributing factors to their current price:
- intrinsic value
- time premium
- volatility premium

[What about fine tuning with riskless rate of return, historical volatility, etc.? See the Black Scholes Formula for options valuation.]

1. Option price = Intrinsic value + time premium + volatility premium, but cannot be negative.

[On a general basis, the above factors do contribute to the current price of an option but see the classic option valuation model for the mathematical formula]

2. Intrinsic value of an option can be positive or negative. It changes with time, and is the difference between the strike price and the current value of the underlying stock or index.

[An option is either worth something intrinsically or not, there is no penalty (negative value) for being out-of-the-money. So intrinsic value is a positive value or zero. Other wise an option can be worth less than zero. Maybe a money penalty like that would keep me out of my more stupid option purchases!]

3. The time premium of an option can be positive or zero, but not negative. It decreases from being most positive at the start down to zero at expiration.

[Time waits for no one...(Mick Jagger)]

4. The volatility premium of an option can be positive or zero, but not negative. It is greater with greater volatility in the underlying stock or index, and is smaller with smaller volatility in the underlying stock or index.

[The volatility factor in the Black Scholes Option Valuation Model is the trickiest part. A historical figure is usually assigned. This assumption does not account for up-to-the-minute jumps. Hence the pros use the current trading price to back out a value for volatility through the Black Scholes. This is the famous Implied Volatility reading. Watch for sudden jumps in the i.v.]

Assuming that the above statements are correct (and we all know what happens when you ass-u-me ), I have the following questions for you:

1. How does the time premium vary as one gets closer to the option expiration date? Is it linear or (as I'm guessing) some other shape? Does it look something like the below graph, which starts out flat, but decreases sharply as the expiration date approaches?

^ Time ----------------\ Premium --------\ ----\ --\ -\ \ +-----------------------------------------> Time ^ Expiration Date

[above chart may get wacked out by e-mailing]

[Good approximation. Option premium sellers look to ride down the premium during that area towards the end when decay is most drastic.]

2. Which has more effect on the ultimate price of an option, the time premium or the volatility premium? If the graph above is at all correct, it would seem that when option expiration is far off (in time), the time premium would be the over-riding effect. But as you get closer to expiration, and the time premium decreases, the volatility premium could become an increasing factor to the point that it's effect over-rides that of the time premium. What are typical values for time and volatility premiums on the options?

[Here is a drastic example of what the volatility factor can do for the option premium: In the aftermath of the Crash of 87, call options on the OEX 60 points out of the money still were trading over $1. The swell in volatility was so great that it accounted for most of the option’s premium. See the option valuation model for the math relationships. In a more normal setting, volatility doesn’t usually spike up to make up for steady loss in time value. If you are an option buyer, volatility is your friend and if you are an option seller, time decay is your favorite companion.]

3. What happens to the price of an option who's intrinsic value is so negative (i.e. it is so out of the money) that no time premium or volatility premium could ever make up for it? Obviously, the price can't be negative. Is it just never sold, and the holder is forced to keep it until it either becomes in the money, or expires worthless?

[There are no restrictions on such an option. It can always be sold for a loss unless there is no bid. This situation is not at all uncommon. As a matter of fact, most options expire worthless. The option wars exact many casualties.]

I appreciate any response that you can give me. I realize that these can be categorized as "beginner" questions, but I am trying to learn all that I can before entering the options market. In addition, I am trying to make an overall options pricing model that disregards the volatility (over the short-term).

[You must do some reading on theoretical option valuation. Warning: Do not ignore volatility. It is the most crucial component of option valuation. The key to using options to forecast upcoming stock moves is to watch for unexplained jumps in implied volatility!]

Thanks in advance, Just Beginning Options Trading

Dear Option Beginner:

Wow! I’d hate to see the questions you send after you bone up on the option textbook theory. (If you start asking about the Greeks - i.e. delta, vega, gamma, I’m quitting!)

Seriously, read McMillan’s Options as a Strategic Investment as well as the educational materials from the option exchanges.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Theory, Options Pricing, Options Valuation

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Limit Orders vs. Market Orders

Topic: Limit Orders vs. Market Orders on Options

Dear Options Trading FAQ:

Here is my first option question for this great option trading resource:

Up to now, I have always had my option trades executed as market orders. Is there anyway to get a price between the bid and ask? I am comfortable using limit orders when trading stocks on the NASDAQ to get a price between the bid and the ask, but with high volatility in the option markets I hesitate to use limit orders.

Any ideas? Thanks,

"Sick of the Spread"

Dear Sick of Options (I hope you feel better after reading this answer):

Like you, most professional traders use market orders. This is the only order that guarantees an execution in a fast moving market. If you are watching the market tick by tick and are sure of wanting to jump on an emerging trend, do use a market order.

The popular psychology is to avoid market orders, however. There are a few factors behind this. Some feel that a market order gives the floor a license to steal, while others don't want to pay the going price in any situation. These traders may feel secure only when placing a buy order on or below the bid.

But here is a question: When the price does go down to your limit, don't you think it'll continue lower? Oh, I see, the market will dip down for you to get in at a great price and then rocket up to that wonderful profit you envision ;) Seriously, some nervous buyers go so far as to continually lower their bids when the option starts coming their way. (In the order room, that is called "going the wrong way") Perhaps subconsciously, these traders realize that if the option goes down to your price, you really don't want it!

As for my own option trading, I now force myself to use market orders after too much frustration with unexecuted limit orders. In the old days, I , too, was uncomfortable with "paying up" for an option - especially when it starts trading at higher prices (After all I've been watching it trade for hours at the lower levels). But how many times have I missed on a limit order and watched the option fly away in price never to return? Too many to count. However I do notice an alarming correlation: When I miss with a limit, the trade would have turned out a big winner, but when I jump in with a market order, the price promptly turns around - leaving me with having paid the high option contract price of the day! Why is that?

Anyhow, folks, here is my recommendation on the matter. In a flat, ranging, lazy type of market, you may, if you wish, use buy limit orders at the bid or in between the bid and the ask. There will probably be several chances to get an execution on your options. Asking your broker to "book" an OEX or SPX option order may increase your probability of execution, by the way.

In an emerging trend market, try to use market orders if you think the breakout is for real. If it really is a legitimate move, the "higher" price you pay will seem like a bargain before long. You'll be ahead of all those who were unwilling to pay up on the initial move and be better off psychologically to withstand the inevitable pull-back. Speaking of psychology, one trick super-traders use is to commit to trends in set lots. Buy the first bunch of option contracts on the initial movement, the second on confirmation that it is a real move, and another on the retracement. If the first lot turns out bad, you'll have only committed a small portion of your wad.

Here's a tip that we like to mention to our option clients: Use an "Or Better" order. I'll devote a future letter to that subject, but here is the essence of it. An option is quoted 1 1/16 to 1 1/8 and starts to move up quickly. You don't want to use a market order (maybe you need to cap the amount of funds committed to this position) but you don't want to miss the opportunity either. So, being the savvy Options Trading FAQ reader that you are, you enter a limit order at 1 1/4 or better. That is, you'll accept a price as high as 1 1/4 but hopefully the execution will come back at a lower price. You are giving some room for a fill but at the same time limiting the maximum price possible. A good compromise when trading options.

Thanks for a stimulating question. As order entry preferences are highly personal, I expect quite a response from the readership on this subject. We'd all love to hear stories about types of orders used and why one likes them.

PS - You should really also consider the trading volume in the option. If it's a thinly traded option you should most likely consider a market order, this is because it's unlikely your order will be taken out by paper on the other side. It will only be filled if the market moves. On the other hand in the OEX, you have a good chance of being filled against paper with the market not moving at all. Then again the OEX moves around more as well, but it is the most liquid options pit in the world. Again, though if you are trying to fill as back month OEX option the trading volume will be low, and it will be unlikely your order will be filled with another customer order. So in addition to trend analysis, consider option volume analysis as well in your decision.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Prices Listed in Newspaper

Dear Options Trading FAQ:

How come my broker says I can't go by the option prices listed in the newspaper? I call him asking for a fill based on the price I see on the option but am told no fill. Why?

Getting No Satisfaction from My Option Trades

Dear Getting None:

Sorry, your broker is absolutely right. Until your paper starts listing the closing BID prices, it's not much help to you. What you see listed is the last traded price for the option contract. This may be from earlier in the day (before your order was placed) or from days ago! This always fools naked option sellers who are looking to sell these "inflated" values. They then are disappointed to find out that the real price is much lower. Remember, there is no free lunch on Wall Street (those luncheons are hosted by firms looking for your money) - if something looks too good to be true, it is. This is especially true when it comes to trading options.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Timing of Option Exercise and Assignments

Topic: Timing of Option Exercise/Assignment

Dear Options Trading FAQ:

I've sold some put options on some stocks because I wanted to buy the underlying stock. The stock has moved significantly below the strike price but the puts still have not been exercised. Why is this?

In addition, I have written some covered call options on other stocks as well. Can you explain why the calls would not be exercised if the strike price is reached? In both cases, I was told that they will be exercised but during option expiration week. Can you explain this please?

Potential Assignee

Dear Potential Option Strategist:

Look at it from the option owner's point of view. His puts have a time and volatility premium above the intrinsic value. That is, he can sell those options in the open market for more than it would be worth if he were to exercise it. For example, let's say I'm long a 60 put on a stock trading at 58. That means I'm in the money by 2 points. But the premium of the option will be higher than that depending on the time of month and volatility of the stock. Let's say in this case the option is bid at 2 7/8. I could either sell it for that price or I could exercise it to realize the 2 point intrinsic value. Which would you choose? Would you take more money or less?

During options expiration week, the time value of the option is reduced to the point that it may make sense to exercise it rather than to sell it in the option market. If the option premium falls to a discount, you should expect an assignment. (This is a case where one would make more $ by exercising rather than selling the option itself.)

Also, other factors include, advance (inside) information on the stock, late breaking news, and timing of ex-dividends.

Keep in mind too, that many option holders never have any intention to exercise their options. It may be insufficient margin for the transaction or just a lack of desire to get involved with the actual stock. To each his own!

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Strategy Big Swing Expiration

Dear Options Trading FAQ:

Thanks for your last reply on OEX option expiration week strategies. Do you have any thoughts on the following? Wait until Thursday and put in a buy order for both a call and put of the same strike for a pre-determined price. If filled, ignore the market and let it settle on Saturday. If the order is unfilled because the OEX moves to another strike price zone, reset the combination order around that new strike price. The trick is to determine the price of the combination, one which results in the narrowest "loss band" and has a decent chance of being filled.

Thanks,

Option Expiration Fanatic

Dear Fanatical Option Trader:

Sounds interesting. I'd like to see how such an approach works out over time. With the volatility on expiration Thursdays and Fridays, I could see some interesting plays using this system on a trading basis (taking a quick profit on the early swings rather than going all the way to Saturday). The beauty of this system is not having to "forecast" the direction of expiration swings. But keep in mind that many expirations are not "wild" at all. If not, option premium buying strategies such as this one can see a steady erosion of value all the way to zero by Friday's close.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Strategy, Options Expiration

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Options as Wolf Detectors for Stock Takeovers

Topic: Options as "Wolf Detectors" to Find Takeovers

Dear Options Trading FAQ:

'Nuff already with that mumbo-jumbo exercise/assignment/settlement jazz. Say something I can unnerstand. Gimme a sure thing in the daily double and I'll buy ya lunch.

New to this Options Stuff

Dear Nouveau Poor:

Alright already. Read on my good options man...

Dear Options Trading FAQ:

There has been much speculation about the possible takeover of a certain airline. What would you say about buying a straddle (both calls and puts) on this one?

Up in the Air

Dear Frequent Flyer:

I'd say that at this point the options must fully reflect the possibility of any takeover action. That means that unless the deal does occur (and at a great price), it would be hard to make money on a long straddle. In fact, many professionals may elect at this point to short that same straddle, betting on the non-occurence of the deal or, at least, a delay so as to collect from the time decay. It is rather difficult to play takeovers with such inflated options. It becomes a real crapshoot when everyone uses the calls to bet on a buy-out. Smart stock players do it just the other way around. That is, they scan for interesting action in equity options to point out good stock plays. Called "wolf detectors" this unusual action in the options can often tip off impending takeover action in the stock.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Valuation, Options Pricing, Options Strategy

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Maximum Loss on OEX Options Credit Spreads

Topic: Maximum loss on an OEX options credit spread may be more than you think

Warning: Unless you know or care about option credit spreads, you may find this letter very long and very boring!

Dear Options Trading FAQ:

In your last post, you mention that the max loss on an OEX option credit spread may be greater than what my broker tells me. I thought it was the difference in strikes less the premium generated. So what are you thinking of?

Don't know who to believe

Dear Unbeliever:

Here is an article for an option column back in the spring. I'm too lazy to update the strike prices in this example, but the principle remains the same.

OEX SPREADS: THE HIDDEN DANGER

Did you ever have your carefully planned OEX (S&P 100 Index) options spread position obliterated by an early assignment? Scrambling to re-establish the strategy after your broker calls you with the notice is bad enough, but do you realize the hidden danger in this cute trap?

With spreads on American-style (early assignment feature) Index options, there is the risk of losing a great deal more than you thought possible. Here is what can happen.

Let's say right now you are bearish for the near-term and sell 10 OEX May 485 Call options for 3 1/2 and buy 10 OEX May 490 Calls for 1 1/2. The net credit (3 1/2 minus 1 1/2) is a realized gain of $2,000 if the OEX closes anywhere below 485 at the May expiry. The maximum potential loss, so you think, is the difference between the strike prices and that net credit (5 minus 2 = 3, or $3,000). But that is true only for European-style options where early assignment is not allowed. In our scenario, your broker calls you on expiration morning to inform you that your 10 short OEX 485 Calls have been assigned at last night's close. With the OEX at 495, that means a debit to your account of $10,000 (OEX 495 minus your strike of 485), leaving only just the 10 long OEX 490 Calls.

Unfortunately for you, the market opens sharply lower and your calls open way down. You sell them at $2, off three points from yesterday's close, which turns out to be the high of the day and they are offered only 1/16 at the bell. Your total loss in the position is now $6,000 (original credit of $2,000, less assignment debit of $10,000, plus long side sale of $2000). This is twice what seemed to be the maximum loss possible.

Of course, had you not sold the long side, holding them until the close, the loss could have been $8,000!

Many people assume that you can respond to the assignment notice by exercising the long side of the spread. This is incorrect in that you would be too late to be entitled to yesterday's closing OEX value. An exercise at this point would be settled according to the current day's level.

Of course, the OEX could open higher instead of lower, but it doesn't often work that way. In fact, this past February saw the largest number of call assignments for a single day in the history of the OEX. That occurred after the close on the Thursday before expiration day. The market did open down substantially the next morning to trap plenty of OEX spread traders.

How to avoid this hazard? Bernie Schaffer of Investment Research Institute suggests trading the SPX (S&P 500 Index) options which, with its European-style feature, cannot be exercised early. Why doesn't everyone do this? Michael Evans of Evans Economics, who also uses the SPX, points out that the spreads on the S&P 500 are wider than on the OEX and that those eights and quarters can add up if one is not careful. Entering and exiting a spread trade could mean a 1/2 point sacrifice if one loses an extra eighth on each side.

Actually, you could spread the OEX and avoid an early exercise if you keep a close watch on your short option. As long as that option retains some time value over its intrinsic worth, early assignment is unlikely. If late in any day, it is trading at a discount to its intrinsic value, you should consider closing the position and rolling to a higher strike or a later month. Also keep in mind that the danger of early assignment increases greatly as an option gets deeper in the money and as it approaches expiration day.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Expiration, Options Spreads, Options Strategy

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Credit Spreads

Topic: 2 Way and 4 Way Credit Spreads

Dear Options Trading FAQ:

Can you go over what the difference (max gain and loss) for this option strategy: a 2 way spread and a 4 way spread on the OEX Index? Let's use the same strike price and expiration on the 2 way as in the 4 way (the other half of the 4 way can obviously be at a different strike price). I can't seem to find a software package that will help me on this.

Thanks,

Spreading ‘em in South Carolina

Dear Spread’em:

Let’s assume that all the readers know what a regular 2 leg credit spread is (e.g. With the OEX Index at 554, Buy an OEX Oct 575 Call for 1/2 and Sell the OEX Oct 570 Call for 1, resulting in a 1/2 credit. You then hope for the OEX to expire this month under 570 so that you can keep that 1/2 credit.) A 4 way would also involve the put side of this example - that is, also buy the OEX Oct 535 Put for 1 7/8 and sell the OEX Oct 540 Put for 2 1/2 resulting in a put credit of 5/8. The total premium collected for this 4 way is 1 1/8. You would collect the entire amount if the OEX settles between 570 and 540.

The max loss for the OEX call spread is usually considered to be the difference in strikes less the premium - in this case, 5 minus 1/2 equals 4 1/2 max loss. On the 4 way it would be that plus the requirement on the put side - 5 minus 5/8 equals 4 3/8. In other words, you risk a total of 8 7/8 to make 1 1/8 with a width of 30 points in the OEX.

Notes: In strongly trending rallies (like the market we’ve been in) YOU WILL GET KILLED IN THIS OPTION STRATEGY. Month after month you will get hit on one side - sometimes all the way to the max loss. This is a strategy for tight range markets (like before the bust out a year ago).

In the OEX, which is an American style exercise, YOU CAN LOSE MORE THAN THE DIFFERENCE IN STRIKES LESS THE CREDIT. This is due to early assignment where the spread is broken on you and the long side you are left with gets tanked. Use European style exercise options like the SPX. This is a complex issue which very few traders realize. I will address it in a future letter.
Send for free literature on spread trading from the CBOE at (800) OPTIONS.

A reader replies:

You said

>>On the 4 way it would be the spread requirement of the call side PLUS
the requirement on the put side (also the difference in the strikes less the credit). In other words, you risk a total of 8 7/8 to make 1 1/8 with a width of 30 points in the OEX.

>This confuses me. I would expect that if it is about 570, the puts are
worthless, and vice versa, so that you're actually only risking 5 - (1/2 + 5/8), which seems much more reasonable.

>Though, as you note later, early assignment can mess you up if the market
reverses.

The Options Trading FAQ replies:

Good thought. In theory, the OEX settlement leaves one side of the 4 way out-of-the-money if the other side is hit. If so, then why does the exchange require margin for both spreads and not just one? The answer is the risk of a highly volatile market. Let’s say the market jumps for a couple of days, you get nervous about the upside risk, and so close down the call spread for a 3 1/2 point loss (you took that loss to avoid it becoming the maximum upside loss of 4 1/2).

According to the options margin man, at this point, one CANNOT assume that the other side is totally out of danger (in real life, barring a real disaster it is -assuming your spread is wide enough.) He envisions the following scenario: As soon as you close out the call spread, the market crashes and the put side becomes in danger. That’s why the margin is for both spreads - they are worried that you won’t hold on until expiration but get cruelly whipsawed instead.
In fact, as you note, the occurrence of an early assignment may really throw things out of kilter, forcing you to take an early loss and not giving you the option of a play clear through to settlement.

Same reader further notes:

Options Trading FAQ wrote

>> In strongly trending rallies (like the market we’ve been in) YOU WILL
GET KILLED IN THIS STRATEGY. Month after month you will get hit on one side - sometimes all the way to the max loss.

>If strongly trending, wouldn't the loss be only in one direction, and
thus the smaller amount I calculated? Or have I misunderstood trending?

Options Trading FAQ reply:

You are right. The loss is on one side only. The tragedy in this type of market is the extent of that loss and its frequency. Even on the one side, you are risking 4 1/2 to make 1. If you let the loss go to the max, the winning side premium (in this case the put spread) made you only a 1/2 giving you a total loss of 4 points. Here is the implication: On a successful month, you make a point or so. In a flat market, these points will steadily add up to a great annual return. In a year when the market trends one way strongly, a string of bad months will occur. A max hit of 4 points puts you 4 months behind (if you're only bringing in about a point each month.) If you get hit another time (back to back), that’s 8 months to make up. Your year is shot. This strategy works great in the long run but in the current type of market, there’s hell to pay.

GENERAL NOTE: I congratulate everyone on the depth of the option strategy questions and comments I get regarding these posts. I truly enjoy and appreciate the careful thought behind questions such as this one.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Strategy, Options Exercise, Options Spreads

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Strategy on Options Expiration Day

Today's Topic: Option Expiration Strategies

Dear Options Trading FAQ:

Do you have any favorite OEX Index Option strategies to take advantage of the increased volatility during expiration week, especially the last few days when the option premiums start to rapidly decay?

Expiration Day Player

Dear Options Expiration Fan:

Ahh, options expiration day.... When month-old dreams struggle till the closing minutes to stay alive. When out-of-the-money OEX options are eagerly sought out at 3:45 with the release of market-on-close indications. What excitement, what sadness.

Option expiration day is when the true option enthusiast comes out to play. One very popular OEX play is to watch the out-of-the-monies at the end of the day for a long side buy with the hope of a closing run-up. These players start their buying at 3:45 with the release of MOC indications. This is risky in that these out-of-the-monies will certainly collapse totally when it becomes apparent that there will not be a run-up.

The more conservative play is to buy in anticipation of positive indications and then to sell into the resulting rally (not sticking around for the after market run). Note: most months this strategy will result in a total loss of the premium. The fans of this approach say that with proper choosing of months in which to try this, the spectacular successes will outweigh the long dry spells.

The option trading pros like to “fade” the MOC blips. That is , market insiders will gladly sell the out-of-the-monies to the public in hopes of collecting all the premium. Of course, most of the time this will work out for them, but once in a while, there will be hell to play. A stop-loss buy is a must in these short positions. Private investors like to try this on a smaller scale but naked margin requirements make it difficult to do enough to make it a good proposition.

Option sellers like to establish positions a week or so before expiration to take advantage of the great decay in time value during that last week end before expiration. This is particularly appealing to short spread traders using as a hedge in-the-money current month options or, more conservatively, next month’s options. The short spread approach is an excellent idea for most expirations, but one must be willing to close it down to take one’s profit before the close if one feels the possibility of expiration fireworks.

Option day traders are in hog heaven during expiration week with the increased volatility. A good indicator for a choppy, ranging expiration week include the RSI (Relative Strength Indicator) Chart. Use plenty of stops whether trading long or short.

I could go on and on but I don’t know if I’m getting in too deep for the rest of the forum. Others can let me know or send me questions.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Expiration, Options Strategy

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Options Pricing Leads Stock Price

Topic: Options lead stocks? Dorfman says so / Getting the opening price for your option trade

Dear Options Trading FAQ:

Re yesterday’s post: So stock traders sometimes look to options for cues? I thought it was only the other way around! (this might make another good question for your column)

Being the suspicious type of options trader --well, let's say "interested in the *magic* of options", I see this and wonder if some kind of manipulation is going on...

Getting Jaded

Dear Jaded Options Trader:

Welcome to the world of Dan Dorfman! If you watch him regularly, you know that his “sources” often tip him as to “interesting” option prices leading the stock prices. **** Option Trader Name Withheld**** also is on the leading edge of this kind of work. His daily screens point to situations where unusual option prices or volume indicate probable jumps in the underlying stock price.

The theory goes like this: High Option Volume - premise is that smart money moves first in the option market. Overpriced Options - where the option contracts are highly overvalued by traditional modeling. A jump in implied volatility for the options may indicate a coming sharp, sudden change in the stock. Non-Validation Signal - generated when a stock’s options do not confirm the move in the stock. We would believe the options over the stock. The subject is complex. I’ll elaborate in future questions.

Dear Options Trading FAQ:

Yesterday you wrote about an option’s opening rotation. I sent for information from the CBOE options exchange on it but let me ask you this: When do I have to get my order in to my broker to be entitled to the opening price?

Early Bird Gets the Worm

Dear Worm Enthusiast:

It depends on how busy things are on the floor. On a normal day, 10 - 15 minutes before the NYSE opening should be fine. Some days (in very volatile market periods) the CBOE floor will call “upstairs” to tell us that opening rotation option orders must be in to them by a certain time (like 1/2 an hour before the New York opening bell).

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order, Options Pricing, Options Valuation

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.

Option Pricing and its Underlying Stock

Dear Options Trading FAQ:

I saw very very strange and unusual options pricing this morning. A heavily traded NASDAQ stock opened at $63 and moved about one point downside in the first ten minutes of trading. After another ten minutes, it was still down about -3/4. Five minutes later, it was still down, about 1/2. After another five, it was down only 1/8. The total time we're looking at is about 25 minutes.

Ever the hopeful options trader, I was looking at the 65 current month calls. At 8:40, they were 1 7/16--1 11/16. This was when the underlying stock reached it's lowest, down about 1 1/4 points. Ten minutes later, when the stock had risen half a point to around -7/8, the option was at 1 3/8 bid to 1 5/8 ask. Five minutes later, when the stock was down -3/8, the option was at 2 1/8 to 2 3/8.

This seemed to be a **radically** higher price, way disproportionate to the underlying equity. Volume was only 110 contracts. What causes these kinds of huge option price swings?

Swinging in the Rain

Dear Swinger:

We loves a fat, juicy option trading question! I wish you had included certain details, but I’ll give it a whirl anyway. First of all, I’ll assume that your option quotes are on time and that the “lag” that seems to exist between the stock and the options in your story isn’t due to delayed transmission of quotes. Also that there is no news on the stock (or is there?).

Basically your scenario asks a few questions: “When the stock regained 1/2 a point to down 7/8, the option was at about the same price as when the stock was at the low. Why?”

I wish I was watching this one myself - to see if the opening rotation had anything to do with the perceived price jumps. This is how an opening rotation sequence works: Option series are opened up for trading in a certain order. Prices are determined for each month’s strikes in turn. As they go from option to option, the opening “rotation” prices are left on the machine (the quote you see).

If the underlying stock is plunging or flying up, there will be a “jump” in the bid-asks of the options rotated “early on”, after the rotation process is completed (a jump to the “real” price ala the current underlying stock price). In our case, the first quote you mention 1 7/16 to 1 11/16 may be artificially high from the rotation. Did this quote fall quickly from there a few minutes after they started trading?

“But what about the rush up in the options after that?” Ahh, the magic of options. You mentioned that the stock involved is a heavily traded NASDAQ stock.. That means that we have plenty of guys looking at the options (both puts and calls) at the same time as the stock. How did the put options react in all that? As a guess, I would say they opened near their highs and then collapsed. Anyway, what the option hotshots do is to jump on the calls as a “bargain” if they see the stock catching support. The call option premium will swell as they do this to an “unexpected” proportion. Is this what is happening at the end of your scenario?

By the way, when this happens with the call options, the stock traders are heartened and will be encouraged to buy (they would consider the swelling call premium “smart” money). The calls are giving a buy signal.

Again I don’t know if these are factors or not, as I don’t have enough info at hand - but I hope I’ve given you enough to chew on.

P.S. One needs to try to find out how the options “usually” trade. They probably always have a fat premium which makes the valuation swing less dramatic. If it sprang right back to “normal” levels, then folks are saying that all is “OK” for the stock.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Valuation, Options Pricing

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

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