| Risks of Option Writing |
Top
|
There are inherent risks associated with that investment. A solid understanding
of those risks does not preclude us from option writing. When you are a buyer
of an option your risk is strictly limited to the cost of an option. As an
option seller/writer your risk is unlimited. There are three ways to
offset option losses.
First, you can close out the position by buying back the option or options
sold. Second, is to roll the position or positions into higher or lower strike
prices to avoid potential losses or to mitigate those losses. Third,
a position can be rolled to a deferred month.
| Option Writing Play by Play |
Top
|
There are many different strategies available for the novice trader
but one of the most used strategies by some of the most savvy traders is the
sell strangle. We believe markets move sideways in
a saw-tooth pattern as much as 70% of the time. More importantly, we
feel that choosing where a market is not headed verses where a market will go
is a much easier task.
The Gold market is trading around $350 oz. You believe the market is going up
so you buy a 400 call option. The option cost $300 with about 40 days left
until it expires. Well, you were right, the market went up but it stalled at
$380 oz. What do you do now? Do you hold on and hope the market goes up
further? Do you cash it in and hopefully make a small profit? What if you
thought the market was going down? If this was the case, you buy a 300 put
option. The option cost $300 with about 40 days left till expiration and sure
enough the market goes down and reverses at 330. These two examples represent
some of the different parallels that directional option buyers fight with on
every trade. Let's not forget, one thing they do not have is time on their
side.
| The Intrinsic and Extrinsic Values |
Top
|
The premium of an option is made up of intrinsic and extrinsic
value. The intrinsic value of an option is the value the option would have, if
it were converted (exercised) to the futures contract and offset. For example,
if you had an option to buy a wheat futures contract (5,000 bushels) at $3.50
per bushel, and the futures price of wheat was $3.60, the option would have an
intrinsic value of $500.00 (5,000 bushels X 10 cents) or ten cents per bushel.
Other values in an option are called extrinsic value. Time value is the most
common of this. Time value refers to how many days are left in the option, such
as 30, 60, or 90 days. The more time till expiration, the more likely something
positive will happen to the price of the option and that is the reason the
value of the option is higher.
Volatility of the underlying commodity is another factor of
extrinsic value. Markets that have made wide and active price swings, indicated
higher volatility which suggests the chance is higher that the underlying price
of the futures market will move in favor of the option. High volatility makes
all options more expensive.
The demand for the option is really the last extrinsic value
component in option pricing. A market which has a skew to it, meaning a long
term up trend will have higher interest in buying calls so since demand is
higher, so must be price. Lower demand means lower priced options. In other
words, bear markets mean puts are more in demand therefore more expensive and
vice versa for bull markets.
| Delta and what this is
|
Top
|
Delta factor is the measure of the change in the price of an option
relative to a change in price of the underlying futures contract. Taking our
previous wheat example, assume you have purchased a wheat put because you
expect the price of wheat to fall. Since there is a relationship between how
much your put will make when the wheat market falls, you have an interest in
determining how much you will make. A trader cannot just assume his option will
make the same amount of money that a futures contract will if he is right about
the direction of the underlying futures market. What would that change in
option price be with the fall in the futures market? That is what the Delta
measures.
Understanding Delta is paramount to trading options. The higher the
Delta, the higher the potential is for price fluctuations as it relates to
the underlying futures contract.
| Why it is important to understand Delta |
Top
|
Tracking Delta is important as it shows if some options are increasing in value
faster than others.
| Why Do We Sell Options? |
Top
|
In each of the above examples, someone sold the options to the
wheat put and call buyer and to the crude oil put buyer. The odds are that both
the call and put will expire worthless to the buyers of those options and
return profits to the sellers of those puts and calls.
Most people speculate on the direction of the market by purchasing
a call or put. What we do is speculate on the direction the market is not going
to go by selling a call and/or put.
We feel it is much easier to identify where a market is not going
to trade, than where a market will trade. For instance, let's assume the
S&P 500 is now trading at 1050 for the December contract. Based on
technical and fundamental research, we feel that stocks and stock averages will
not exceed a 5% range either way from the current market. This means that, in
our opinion, over the course of the next 30 days the market should not trade
higher than 1102 (1050 x 5%) nor lower than 998 (1050 x 5%).
We expect this to be right, and if we are right, we will collect or
take into our account the premium collected by selling both an 1105
call and 995 put at the same time. This type of trade is referred to as a "sell
strangle". You can sell both sides of the market and take in or collect the
premium that the option buyer would have to pay to buy both sides of the
market.
A note of caution here, this trading has inherent limitations
to it. It is not without risk, in fact if this trading is attempted by those
who are not familiar with how to curb risk, this type of trading can be
disastrous to an account. The risk of loss exists in futures and options
trading.
|
American Futures and Options, Inc.
2180 Immokalee Rd.
Suite # 301
Naples, FL 34110
Phone: 1-800-228-7058
Fax: 239-514-4919
|
|
|