Students Want to Know

Posted August 19th, 2010 by Josip Causic in Education

Students Want to Know

In this article, I will address some of the questions that I have received from students over the past few months. The topics are strike price selection, exiting short option positions and current market analysis.

Question 1

How do I know which is the correct strike to select?

First of all, the question must be a bit more specific than "which is the correct strike to select." It is not clear to me if you are a buyer or a seller of options. As a rule of thumb, when selling options, it is good to select strike prices that are OTM (out-of-the-money) and with the shortest amount of time to expiry. Again, precision of language is so essential. There are multiple OTM strike prices and which one an individual trader would select greatly depends on his or her definition of risk tolerance (aggressive, moderate, or conservative). Also, shortest amount of time to expiry could be kind of vague. If there are only two or three days left to the expiry, then there is very little premium left in the options and they are almost not worth selling. You may need to go to the next expiry period out. Again, a lot of option trading is really a matter of personal preference. Hence, define yourself clearly as a trader. Answer these questions: Which time frame am I trading? Days, weeks, or months. Am I a buyer or a seller of options? What is the current implied volatility on the underlying? Are the Bid and Ask strike prices on the individual options wide or tight? How liquid is the underlying and what is the open interest like on the individual strikes?

As another rule of the thumb, when buying options, it is wise to select strike prices that are deep in the money (0.70 cents of delta or even higher) with a minimum of 60 or more days to expiry. In short, there is so much more in the selection of strike price than what meets the eye at first glance.

The next question goes hand-in-hand with the previous one; only that this one is a bit more specific.

Question 2

I was looking at buying some puts as insurance on the stocks that I already own. I do know that if I have 3,000 shares, I need to divide them by 100 to get the number of contracts. I am just not sure which put strike to buy?

Personally, I buy the put (strike price) at the same level where I would put the stop loss if I just owned the equity without using options. The distance between the two points (the stock price and the purchased put) represents the risk that I am willing to absorb. Some option traders like to refer to that difference as the deductible, which is an insurance term. If the XYZ is at 112 and I am willing to place my stop (for equity trading) at 108, knowing that ATR (Average True Range) is $3.80, then as an option trader, I could buy a 108 put which protects me only if the stock price drops below 108.

After addressing the vertical dimension or price, the next dimension is time; how much time to buy? The more time is bought, the greater the cost will be; yet most (when compared to car insurance) buy the annual or semi-annual policies. It is up to the individual traders to select that dimension based on their trading plan which spells out how long they are planning to hold that particular stock.

Question 3

I am confused about my exit choices when selling options?

In reality there are only three choices that we as the sellers have. If the option that we have sold goes in the direction of our forecast, then we could either BTC (buy to close) for a fraction of the premium of what we had received, or let the sold options (the obligation) expire worthless. At Online Trading Academy, we suggest buying back your obligation. The third possibility is assignment, which by the way, should not be seen in a negative light. If a trader is willing to own the stock below the current price, then he or she could sell the put which would generate premium upfront. In this case, the stock could close higher, causing the put to expire worthless, or it could go lower and bring up the certainty of assignment and stock ownership. It is crucial to be willing to own the stock when selling the put. Depending on the drop of the stock price, the sold put could bring us a small discount which is better than the outright purchase of the stock.

The Last Question

It sounds to me that you are overly Bearish on the market due to the financials. Where do you think that we are going to go this summer and the rest of the year?

One can never tell with certainty and that is why all traders are classified as speculators by the rules and regulations of the trading industry. Every trader is entitled to his or her opinion and often there is disagreement between different traders. I consider looking at the charts as the way to obtain the factual opinion about the stock's/issue's past performance. Based on technical analysis, I observe multiple products/issues simultaneously and look for sync among them. If all twelve sectors are moving in one direction, then the broad market goes the same way.

As to the financials, the situation remains virtually unchanged as of the 8/10/2010 close. The Broker Dealers are the strongest industry in the sector, and the banks are the laggers. If we (the broad market) were to go higher, the financials would have to break out of the channel to the upside and more importantly, stay up for the remainder of the year.

In short, in this article I have answered four questions on various topics. Stay small in trading your size until it is clear which direction the market will go. Have green trading.

- Josip Causic

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