2010 Jan 17 - Sun

Option Trading Scenarios

Most option trading books discuss the mechanics and mathematics of option trading. Rarely do they offer up any sort of in-the-trenches useful guidelines for doing what when and how. Some recent reading has enlightened me on some useful option trading scenarios.

The first one provides the dual mechanism of obtaining income and optionally paying for protection on an underlying which is already in one's portfolio. The process involves selling a kind of straddle: selling an out of the money call and an out of the money put. For example, with TSL, as of Friday's close, is at $49.50. The Feb 55 Call is at $1.75 and the Feb 48 Put is at $3.25. Selling this results in $5.00 premium. If TSL stays within the range of $48 and $55 till Feb 19, the full premium is kept. If the price goes above $55, the underlying will probably be exercised to result in a $5.50 profit, which is the premium plus the amount the underlying goes to get to the strike price. If the price goes below $48, the Put will go into the money, most likely causing it to be exercised, and you'll end up buying the underlying at the Put strike price, which may be a good thing if you are expecting the price to rebound. On the protection side, the premium earned on the put and call sale could be use to purchase twice the number of puts at the next out-of-the money price, which in this case would be Feb 45 Put. This provides protection on the original underlying plus the shares gained when the buyer exercised the puts.

Another strategy requires maintenance of no underlying. For a stock that you think will go up due to some upcoming good news, such as an earnings announcement, one could sell an out of the money put and use the funds to buy and out of the money call. By careful selection of put and call strikes, the money gained by selling the put may fully cover the price of buying the call. The downside of this is if the price of the underlying goes below the put strike price. You may end up owning the underlying in this case, but at least it was obtained at a lower price.

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2009 Aug 29 - Sat

Options as Indicators

Optionetics has an interesting article called Using Options to Predict Stock Prices. The author, John Jeffery, writes that, in addition to the usual fundamental analysis and technical analysis methods of 'stock direction prediction', options can help indicate trade direction. Three useful indications include:

• Put/Call Ratio
• Implied Volatility
• Option Volumes

Put/Call Ratios: The most popular Put/Call Ratio is the one used for monitoring the sum total of option trades at the CBOE (Chicago Board of Trade). The same technique can be used for individual stocks as well. It is basically the ratio of the number of open call positions relative to the number of open put positions on a given stock at a given expiry. With experience, it can be used as a bullish/bearish indicator of the underlying stock. Street Authority has some further information on the Put/Call Ratio. Schaeffer's Investment Research indicates the general market is strongly bullish. They have a series of stock screeners.

Bullish Stock Screeners
• Stocks with a high put/call ratio
• Stocks with high short interest

Bearish Stock Screeners
• Stocks with a low put/call ratio
• Stocks with low short interest

A reference is made to an article by Pan and Poteshman called The Information of Option Volume for Future Stock Prices where they say that they "performed daily cross sectional analysis on 10 years of CBOE data to reveal that doing nothing more than buying stocks with low put/call ratios and selling stocks with high put/call ratios generated a return of 1% per week." You have to read the full abstract for some caveates though:

We present strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the Chicago Board Options Exchange, we construct put-call ratios from option volume initiated by buyers to open new positions. On a risk-adjusted basis, stocks with low put-call ratios outperform stocks with high put-call ratios by more than 40 basis points on the next day and more than 1% over the next week. Partitioning our option signals into components that are publicly and non-publicly observable, we find that the economic source of this predictability is non-public information possessed by option traders rather than market inefficiency. We also find greater predictability from option signals for stocks with higher concentrations of informed traders and from option contracts with greater leverage.

One of the authors has another paper entitled Investor Behavior in the Option Market. One of the interesting points from the abstract is the remark "none of the investor groups significantly increased their purchases of puts during the bubble period in order to overcome short sales constraints in the stock market." Taken the other way around, puts are an easy method of getting around short selling restrictions on equities.

In visiting a related author, there is a recent paper called Dynamic Trading with Predictable Returns and Transaction Costs which discusses some portfolio optimization with a mixture of short, medium, and long term mean reversion based trades. This has nothing to do with options, but is an interesting article in itself which I wanted to keep.

Implied Volatility: Implied Volatility is the expected volatility of an option's underlying asset up to the option expiry. This tool can be used for inter-day and intra-day trading calculations. In the article's example, where the underlying is moving sideways, an increasing Implied Volatility could indicate some major move in the underlying. Various other relationships can be established as well.

Option Volumes: When looking at option volumes across the whole series of an underlying's strike prices and expires, look for unusual activity in volume. This means comparing current traded volume with average daily traded volume. It may be possible to see where traders are seeing resistance or support levels, with the interpretation being whether the volume is in puts or calls. If there are no related news, earnings events, or government announcements, then someone may know something.

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