Selling Options

In the last two posts, I have discussed about buying options, both call options and put options.  Today, I want to discuss the opposite : Selling Options.

For the Options (Put or Call) buyer, we have limited risk (the premium we paid) with unlimited potential rewards.  For the Options (Put or Call) seller, we have limited reward (the premium we received) with unlimited risk.

It is for this unlimited risk that most traders avoid options selling.

If you avoid options selling, you will miss out the unique features of Options trading.  And, thus, the advantages of using Options in trading.

Unlike other products (Stock, Futures, Forex, etc)  for trading, Options has an unique feature called Time Decay.  All Options lose time value every day.  It loses time value at a faster rate as you get closer to the expiry date.

The other unique feature is Expiration.  Option becomes worthless when it expired, regardless whether it still has any intrinsic value or not.  Say, you bought a Call Options, it has an intrinsic value of $5.00 on the last day of trading.  You forgot to close your position, by selling your Call Options.  The next day, it becomes worthless, even it has an intrinsic value of $5.00.

When we buy Options, time is working against us.  When we sell Options, time is working for us.  It is this unique feature that give seller the advantage and edge in trading options.

When we buy Options, say Call Options, we need not only be right in our direction (price rise in future), we need to be right before expiration.  Not only price need to rise, it need to rise by a sufficient amount to offset the time decay for us to make a profit, before expiration.

For Options seller, say Put Options, we just need to be right that price didn't drop a lot.  We will make a profit 4 out of 5 scenario below:

1. Stay flat (win)
2. Rise a little (win)
3. Rise a lot (win)
4. Drop a little (win)
5. Drop a lot (loss)

Say, we have established a bullish view on Ford Motor (F) stock.  On 20 August, price closed at 16.31 above the support at 16.00.  We believe that the retracement has stopped.  Price should went back up to test the last swing high at 17.67.  However, if our bullish view is wrong, we are prepared to stop loss at the next support at 15.18.

Thus, we sold 10 contracts of F Oct19'13 15 Put @0.30.  We received $300 (excluding commission) for the premium.

From 20 August to 19 October, F stock price can stay flat, rise a little, rise a lot or drop a little (above the Strike Price of 15.00), we will get to keep the full $300 (excluding commission).

Price close at 17.05 on 27 September.  Let's review it again in mid October or when it expired.

Similarly, for selling Call Options, we will make profit 4 out of the 5 scenario below:
1. Stay flat (win)
2. Rise a little (win)
3. Rise a lot (loss)
4. Drop a little (win)
5. Drop a lot (win)

It is this unique advantage and edge as a seller that got me interested in Options Trading, on top of my Futures and Forex trading.  Options selling is effectively an 80% (4 out of 5) winning system.

Buying Put Options

The next simple strategy we shall consider is : Buying Put Options.  Similar to Buying Call Options, it is simple because we can relate it to Shorting Stocks or Futures or Forex.  It is also attractive to beginners because maximum profit potential is unlimited while maximum loss potential is limited to premium paid.

Even though Buying Put Options is similar to Shorting Stocks or Futures or Forex when you have a bearish view on the Stocks or Futures or Forex, there is a one very big difference.  For Stocks or Futures or Forex, you are Shorting, means you are Selling.  For Put Options, you are actually Buying.

So, when you have established a bearish view on XYZ stock.  You will Short/Sell the XYZ stock.  If you use Put Options, you will instead Long/Buy the Put Options.

Call Options give the Buyer the right to Buy the underlying Stock at Strike Price.
Put Options give the Buyer the right to Sell the underlying Stock at Strike Price.

Let me use an example to illustrate.  KO is trading at 38.63 after it failed to break the resistance at 39.60.  And it fell below the downtrend line.  We are bearish on KO.  We can Short/Sell KO at current price 38.63 with a stop above the resistance line 39.60, say at 40.00.

To implement that in KO Put Options, I will use the same guideline established in Buying Call Options (see the post here):
1. Underlying Stock : KO
2. Expiration : at least 2 months
3. Strike Price : ITM and Stop Loss price
4. Call or Put : Put
5. Price :

So, I will buy KO Dec20'13 40 Put @ 2.12 (yesterday close).   Using Options Calculator, the theoretical Options price is about 1.94 when KO is at 38.63 and about 1.13 when KO is at 40.  The potential lost is about $81 (1.94-1.13 * 100).  The theoretical price is different from (lower than) the actual market price.  I hope the difference is about the same.

Buying Call Options

We shall continue with the simplest strategy : Buying Call Options.  This is the simplest strategy because it is very similar to Buying Stocks or Futures or Forex.  It is easy to follow.  It is also attractive to most beginners because maximum profit potential is unlimited while maximum loss potential is limited to premium paid.

After we have established a Stop Loss method, the next question is : What is the Entry?  For Options, it is more of What Options to buy.

Say we have established a bullish view on XYZ stock.  We want to buy XYZ Options.  They are many Options available for XYZ stock.  Which one to buy?  There are 5 pieces of information you need before you can buy:
1. Underlying Stock : assume we have already decided on a bullish stock XYZ
2. Expiration Month/Dates
3. Strike Price
4. Call or Put : it will be Call since we are using Buying Call Options strategy
5. Price :

Expiration : at least 2 months
Time is a critical factor in Buying Call Options strategy.  Every day that we hold an Option, the time value of our Option will decrease.  And it will decrease at an increasing rate as we approach the expiry date.

So, we should not be buying Call Options that is expiring in near term, say in the current month.  Not only there is very little time for the price of the underlying Stock to increase for our bullish strategy to work out, the time value is going to decrease at an increasing rate as we approach the expiry date.

We are playing against time.  The price of the underlying stock needs to increase by a sufficient amount before the expiry date for us to make a profit.

Therefore, for a start, I am only going to buy Call Options that have at least 2 months till expiration.


Strike Price : In The Money (ITM) and Stop Loss price
When the Strike Price is higher than the Stock Price, our Call Options is Out of The Money (OTM).  The premium we pay for the Call Options are all Time Value.  If the Stock Price didn't increase above the Strike Price at the expiry, the Call Options time value will become zero.  The Call Options will expire worthless.  We will loss all the premium.  The Stock Price need to increase sufficiently above the Strike Price to firstly offset the premium we paid for the Option.  And need to increase even further to make profit.

When the Strike Price is the same as the Stock Price, our Call Option is At The Money (ATM).  Similarly, the premium we pay for the Call Options are all Time Value.  It will be almost the same as OTM.

Therefore, I will only buy Call Options that is In The Money (ITM) which the Strike Price is lower than the Stock Price.  In fact, I will choose the Strike Price to be the Stop Loss price where the trade is no longer valid.

In conclusion, I will only buy Call Options that will expire at least 2 months away and it is ITM with Strike Price same/close to my Stop Loss price.

How do I determine Stop Loss

The first question I have when I started to explore into Options Trading is : How do I determine Stop Loss?  

Coming from Futures/Forex trading background, to manage my risk via Stop Loss is number one priority.  For every trade I enter, I need to know where is my Stop Loss before I open any position.  In both Futures and Forex, I have Charts for the Futures contract or the Forex pairs that you are trading.  From the Charts, I will be able to determine that the opinion of my trade (be it up or down) is no longer valid.  I need to cut loss and exit the trade.

I don't use Hard Stop, which you use a place a stop loss a fixed number of ticks/pips from your entry price.  I only use Logical Stop, where the Price Action tells me that the opinion of my trade is no longer valid.

Although Options are derivatives like Futures and derive their value from their underlying Stock/ETF, there is no Charts for Options, unlike Futures.

If I buy XYZ Dec20'13 80 Call @ $3.70, how will I know my opinion of this bullish trade is no longer valid?I cannot see from the Options Charts (there is no chart).  When the price drop to $1.70 is the trade still valid?  I also cannot use the price drop since I don't use Hard Stop.

This leaves me with no choice but to use Stock Price Based solution.

Let me use a example to illustrate.  WDR is trading at 49.13 off its support level (47.20-47.62).  I am bullish that WDR will go back to test its previous high at 55.

So, I buy WDR Dec20'13 45 Call @ 5.60.  Using Stock Price Based method, I will hold on to this Call Options contract as long as WDR stay above the support level 47.20.  If WDR fell below 47, I will exit this trade.  Using Options Calculator, assuming all other variables remains constant, the theoretical Options price is about 4.20 when WDR Stock price is 47.00.  I will exit this trade with a potential loss of $140 (5.60-4.20 * 100).

This Stock Price Based method seems ok for now.  It provides me a method to cut loss and exit my Options trade when the trade is no longer favourable/valid.  However, I am also aware of some complications.  Option price may change even when Stock Price remains the same.

Complications:
Besides Stock price, Option price can change due to other variables such as Volatility and Time Decay.  As volatility increases, option premiums increase; as volatility decreases, option premiums decrease.

For example, assume we purchased XYZ Dec20'13 80 Call @ 3.70 when XYZ was trading at $82.00 per share yesterday.  Today, it is a quiet market, XYZ traded in a narrow range of $2 ($81.50 to $83.50), compare with a typical range of $10.  It close unchanged at $82.00.  However, our Option is trading for $2.70, a drop of $1.00.  The decrease in implied volatility cause the option price to drop $1.00.

I do not have a solution for these complications yet.  If you know of any, please share with me.  Thanks.

First Blog, First Post

Today, I finally created a first blog, this blog about my Options Journey.  And this is the first post of my blog.  Please bear with me as I totally new in blogging.  I will learn along the way as I go through this journey of learning Options Trading.  Comments, suggestions on how to make it better are most welcome.