Archive for September, 2009

Option, Option on the Wall…By Option Prophet

I would have to say that my favorite Option Strategy is the one that makes me the most amount of money, from a risk to reward standpoint, in the shortest amount of time with the least amount of risk – or – The one that allows me to participate in the markets no matter what the environment and continuously collect my profits while maintaining protection for my existing position – or – The one that …

Right! – “Ok, that’s G R E A T” you say, “But what the Hell does it all mean? 

There’s no meat on that bone.” “Details…. Details….” you ask.

Well, Option Strategies are not a one size fits all methodology.

It is a correlation of market conditions, your risk tolerance and most importantly your trading psychology and discipline depending on the current situation you are in or the one you are about to embark on.

There are many strategic ways to extract money from the Options Markets.

Just a few ways I enjoy using Options to do this are: (depending on current market conditions and the specifics of the underlying at the time I put the trade on)

 **Trading the Passage of Time:  

Theta: – Time decay – an Option’s arch enemy, if you happen to be on the wrong side of the trade.

In brief, this type of strategy requires that you sell an Option contract as the time value portion of the contract erodes.

You would want the Option contract you sold to expire worthless or at least drastically decrease in price by the Options expiration cycle (In theory to purchase it back at a cheaper price – Like Shorting a Stock) so you are able to collect and keep the difference in premium (Option Price) from the initial cost of the Option contract.

 There are many more variables to this strategy, but this is the basic idea. (Less commission costs – Not including mentions of Interest and Dividends – A.K.A Cost of Carry)

 **Trading Volatility:                                                                                                                                                                                                 Vega: – Volatility – As an Option’s volatility increases (not in every single case – there are always exceptions to the rules) usually the initial cost of the Option contract increases as well as the existing premium of that contract.

While an Option is trading at a lower I.V. (Implied Volatility) in anticipation of a volatility spike, you might want to be the owner of an Option contract and when the volatility of that Option contract has spiked, you would most likely want to sell it and collect the difference in premium. (Again – this is not the “only” way to implement this type of strategy, but it is one way)

 **Gamma Trading: 

Gamma: – The second Greek derivative – Gamma measures the rate of change of an Option’s Delta.

In brief, this fast paced style of trading is a great way to hedge Day Trading positions throughout the day while not being solely held to a directional bias of the underlying.

You’ll hold a flat Option Delta position (typically by way of owning a Straddle) against that specific stock you are trading, as you flip the underlying back and forth in accordance with the + / – Gamma indication while remaining  fully hedged throughout the entire trade.

All the time, your objective is to maintain a flat Delta or Delta Neutral position, by selling and buying back the stock against the pertaining Straddle.

One of the highlights of implementing this strategy is that you do not have to be directionally correct, whereas if you were Scalping or Day Trading naked you absolutely must be trading in the direction of the current movement.

You are trading on a specific measurement of Delta, derived by the Gamma calculation of that particular Option’s strike.

This type strategy can be traded in either direction, whether you are long or short Gamma. *(This strategy requires you thoroughly understand your Option Greeks and are extremely familiar with Synthetic positions)

 **Stock Replacement Strategy: 

 By replacing the underlying (Stock) with the appropriate Option you are able to mimic the Stock to a very high percentage for a directional position.

Using a Stock Replacement Strategy enables you to carry a position without having a parallel risk as if holding the underlying nakedly with or without a hard stop.

Utilizing this strategy not only enables you a soft stop loss as well as a predefined maximum projected loss, but a percentage wise unlimited potential gain.

Also the cost of carrying virtually the same size position is dramatically decreased as well as the risk.

**Just a quick note**

I have many years of Option Trading experience as well as a very prominent Options education. I have met with some very wild experiences; I have had some real wild rides in the Options markets and have prevailed to advance another day. There is no substitute for proper education and solid hands on approach.

*There are styles of Option Trading that are not for the faint of heart. Before attempting to take a poke at any style of Option trading while putting live capital at risk, I would highly recommend you best have a worthy Options education; a well defined Trading Plan and many hours of paper trading in, prior to purchasing that ticket to ride the rails of the great Option market.

I wish you all Good Fortune

Peace –

Option Prophet

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