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April 25, 2011 by Leave a Comment

5 Tips for the Option Buyer

Tip 1:  Have an exit plan.

It seems very elementary, but some traders will spend numerous hours looking for opportunities to enter a market, but put no thought into how and when they are going to exit.  Whether you base your trading decisions technically or fundamentally, you will need to know when you are going to take profits and when you are going to cut your losses.  Just because you define your risk when purchasing options, this does not necessarily mean you have to risk it all.  Technical traders should look for the area on the chart that proves a change in the markets direction and a point on the chart to take your profit.  Fundamental traders should closely track the news that is driving the market and exit when these fundamentals change.  Just like you don’t jump in your car without a destination, you don’t want to jump into a trade without one.  Trading is emotional and your ability to articulate your trade parameters will only help your long term success as a trader.

Tip 2:  Buy the time you need.

The beauty of options is their flexibility.  Purchasing options allow for flexibility with the timing on your entry and the timing involved for the market to make its move.  That being said, we pay for that time and flexibility.  After all, the value of an option is derived from both its time value and its intrinsic value.  The more time on the option, the more we are going to pay for it.  So if we expect a market to rise or fall within the next few weeks, it does not make sense to buy an option that expires in 12 months.  On the flip side, if you are looking for an extended move in a market that could take place over several months, then you want to make sure you buy enough time to allow for that to happen.

Tip 3:  Don’t try to pick the tops and bottoms.

Don’t try to pick the tops and bottoms.  Like many things in life, markets will tend to follow the path of least resistance.  Just like a swimmer would prefer to swim with the current, a market prefers to follow its momentum.  From time to time, we might convince ourselves that a market can’t go any higher or lower, but we must resist this urge and stick to our trading plan.  Until there is a clear signal that the trend has ended, we must remain patient and wait for the reversal to be confirmed.  Anything outside of this is option roulette.

Tip 4:  Consider the market’s volatility.

An options premium is valued by its location relative to the underlying futures contract, the time left until expiration, and the market’s volatility.  As an option buyer, we want to purchase an option when volatility is low.  Increased volatility means that markets are going to trade in a much wider range.  That being said, options will be rapidly moving in and out of the money, causing a spike in the options premium.  Ideally, we will buy in times of low volatility to allow us to take advantage of the spike in premium if and when the volatility does increase.

Tip 5:  Consider your delta.

Your option’s delta should give you a good idea on how your option is going to react to a change in the underlying.  The lower the delta, the less the options value is going to fluctuate.  The higher the delta, the more closely your option will trade to the underlying futures contract.  An option’s delta will help you determine where you will want to be positioned based on the anticipated move.  For more on delta, please see my previous article:  Going Greek:  Understanding Your Option’s Delta.

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Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Strategies Tagged With: , , ,
March 12, 2011 by 1 Comment

Going Greek:  Understanding your Option’s Delta

Option traders are often speaking another language.  I want to help you understand how your option’s value is going to be affected by changes in the market.  We can calculate how our option is going to react to these changes by understanding the Option Greeks.  The Black-Scholes Model identifies 5 Option Greeks to help us forecast the value of our option (Delta, Gamma, Vega, Theta, and Rho).  These Greek’s will help identify our option’s reaction to changes in the price of the underlying futures contract, time decay, volatility, and interest rate.  In this article we are going to explore the Delta.

Exploring Delta

Delta is the measure of the degree to which an option is going to move relative to the underlying futures contract.  In other words, it is a measurement tool to find out the speed the option value will change in relation to a full point move in the underlying futures contract.

For example let’s look at crude oil:

If my option has a delta of 0.50, this means that for every $1.00 move in the crude oil futures, my option will go up or down by $0.50 (1.00*0.5=0.50).  In other words, my option’s value will fluctuate approximately half the rate of the actual futures contract.  So if crude oil were to move $3.00, my option value would change by roughly $1.50.

The higher the delta, the more sensitive the option is going to be to the underlying futures contract.  The options distance from the current market price, as well as the number of days left until expiration are two factors that will determine the options delta.

Call Option Delta

For call options, the delta can range from 0 to 1.  A one delta would mean that the option is going to fluctuate tick for tick with the futures.  A zero delta would mean that the options value is not going to be affected by the movement in the underlying futures contract.  That being said, the deeper in-the-money an option is and the less amount of time the option has until expiration, the closer the delta is going to be to one.  The further out of the money and the more time an option has until expiration, the closer the delta is going to be to zero.  An at-the-money option will have a delta of around 0.50 because there is a 50% chance the option can move in-the-money, and a 50% chance the option can move out-the-money.

Put Option Delta

Put options, on the other hand, will have a negative delta, but the same rules apply.  Deep in-the-money puts will have a delta closer to -1, and far out-the-money options will have a delta closer to 0.  At-the-money puts will have a delta around -0.50.

Every trade begins with an idea.  Whether you are hedging or speculating in the markets, understanding your positions delta will give you a clearer picture on how your trade is going to react to price fluctuations.  Your delta, accompanied with the rest of the option Greek’s will help you more accurately forecast your options value and properly manage your position.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Risk, Strategies Tagged With: , , , , , , , , , , ,