|
OPTION BASICS
I will first cover some basic information about options. If you have never traded options before it is really pretty simple. Once you have the idea down we will look at how you can use Tortoise Trades and the futures options market to control your risk. Many subscribers have mentioned that the trades from the Tortoise Trades system were too high of a risk to do. Using options will allow you to trade all the trades that this system generates. I will discuss how I would use options to do the trades. You will have to decide how this method best fits your trading goals.
Puts and Calls
A futures option is the right, but not the obligation, to buy or sell an underlying futures contract at a specified price during a specified period of time. The two types of options are the call and the put. A call option is the right to buy at the specified price on or before the option’s expiration date. You would purchase a call option if you expected a futures contract to rise. A put option is the right to sell; therefore, you would buy a put option if you expected prices to decline. We will only deal with buying calls and puts. You could sell a call or put or even spread them several different ways, but with the Tortoise Trades system we will only discuss the first method of simply buying a call (market goes up) or buying a put (market goes down). To offset the position you simply sell the call or put.
Option Premium
A premium is the value of an option, or the amount you would pay to own that option. There are two components that determine the amount of the premium. Premium = intrinsic
value + time value. The intrinsic value is easy to figure. It is the amount the option would be worth if it expired immediately. For example, if you owned a S&P option that gave you
the right to buy a S&P futures contract at 1280 and the S&P futures contract was trading at 1300, your intrinsic value would be 20 points (1300 – 1280 = 20).
The second part of an option premium is time value. The time value is harder to define than the intrinsic value and is essential the perceived risk of the seller (writer) of the option. It is a combination of the time left before the option expires, short term interest rates, and most important, volatility. If the market moves suddenly the premiums will jump higher than if the market slowly gets to the same price. This sudden increase in the time value is the volatility component. The days to expiration are always decreasing so there is often a decrease in the premium called the time decay. This time decay will dramatically increase in the last 30 days when the option expires.
Strike Price
The strike price is the price at which you may buy or sell the underlying futures contract. An at-the-money option has a strike price that is close to the price of the underlying futures contract. An in-the-money call (put) option has a strike price that is below (above) the current price of the underlying futures contract. An out-of-the-money call (put) option has a strike price that is above (below) the current price of the underlying futures contract. As the underlying futures contract price changes calls and puts may become in-the-money options while others become out-of-the-money. So as an option becomes more and more in-the-money the intrinsic value will increase.
Trading Options with Tortoise Trades
In case you are not familiar with trade alerts from Tortoise Trades, below is an example of the information you will get.
Sample:
Sell Mar. Dow Jones 10810 stop gtc. If filled, Protective stop is 10998. Profit price is 10591. Estimated risk depending on fill is $1,150 based on the Primary stop of a close above 10925. Dollar Value is $730
Now we check our Money Management System (MMS) and we see that this risk of $1150 is too high for the money we have in our trading account. What option would we now buy to do this trade? Below is a table that is close to what I get from my on-line broker.
March DOW JONES IND AVE OPTION Calls and Puts
Expiration Date: 03/17/05--Days Till Expiration: 63
|
|
CALLS |
|
|
|
STRIKE |
|
|
PUTS |
|
|
|
| Last |
Value |
Bid |
Ask |
Vol |
OI |
- |
Last |
Value |
Bid |
Ask |
Vol |
OI |
| 52.5 |
$5,250 |
55 |
0 |
1 |
73 |
10300 |
2 |
$200 |
3.25 |
0 |
72 |
118 |
| 43.2 |
$4,320 |
0 |
0 |
1 |
68 |
10400 |
2.8 |
$280 |
0 |
2.5 |
1 |
167 |
| 34.5 |
$3,450 |
0 |
25 |
1 |
113 |
10500 |
4 |
$400 |
0 |
0 |
1 |
76 |
| 26.3 |
$2,630 |
30 |
19.5 |
5 |
77 |
10600 |
5.8 |
$580 |
0 |
0 |
3 |
41 |
| 19 |
$1,900 |
0 |
7.25 |
33 |
264 |
10700 |
8.5 |
$850 |
8.75 |
8.25 |
6 |
162 |
| 12.75 |
$1,275 |
12.8 |
6.3 |
2 |
463 |
10800 |
12.2 |
$1,220 |
0 |
0 |
1 |
2 |
| 7.8 |
$780 |
8 |
6.5 |
81 |
388 |
10900 |
17.55 |
$1,755 |
0 |
0 |
0 |
0 |
| 4.4 |
$440 |
0 |
4 |
4 |
201 |
11000 |
23.8 |
$2,380 |
0 |
0 |
1 |
1 |
| 2.1 |
$210 |
4 |
0 |
18 |
236 |
11100 |
31.8 |
$3,180 |
0 |
0 |
0 |
0 |
| 1 |
$100 |
0 |
0 |
8 |
170 |
11200 |
40.65 |
$4,065 |
0 |
0 |
0 |
0 |
| 0.3 |
$30 |
0.75 |
7.5 |
11 |
173 |
11300 |
49.9 |
$4,990 |
0 |
0 |
0 |
0 |
We want to buy a put because the trade is to sell Mar Dow Jones. If we make the assumption that this trade will happen fairly quick, in the next several weeks, we can assume that the time value will not decay because of getting too close to the expiration date. We'll also assume the interest rates will be stable. The only unknown is the volatility. How much will it change and how fast? I am going to work with the puts that are out-of-the-money. Let's look at our trade again. Sell at 10810 and take profit at 10591. If we buy the 10600 put for 5.8 we would pay $580 for that option. The market is currently near 10810 where we want to get in and the option near in-the-money is 10800 and cost 12.2 or $1,220.
This will be a rough guess but what would the 10600 put be worth if the market moved close to that strike price? Probably close to what the 10800 put is now, $1,200. So now we could make an option trade base on the
futures trade of buying a 10600 put for $580 and if the futures trade hits its target, sell the 10600 put for about $1,200 for a profit of $620. Like I said, this will be close to what happens if the futures trade works.
Now let's ask what our risk is. If the futures trade goes bad we would get out at 10925, roughly the next strike price up. The market action would cause the 10600 strike to drop to about the value of the strike below it, 10500. What is the current value of the 10500 put? The current value is $400 so our risk would be $180 (580 - 400 = 180).
You now have an option trade that would risk about $180 to make $620. This now is a doable trade for a small account. If you move the trade closer to in-the-money options the risk and reward become higher. Using options that are fully in-the-money will be about as risky as the futures trade and the profit about the same. Using options you can now adjust your risk level to what ever you want, however there is a trade off the further away you get from the market. The time value will not increase as much when the market moves in your favor so try to stay as close to in-the-money as you can.
|
