Option plays on swing trades

[brownsfan019]

Per my idea here, I thought a thread on option strategies would be useful. I haven't played options in quite awhile, so hopefully we have some experienced option traders that can start with the basics...

[brownsfan019]

Here was something in the recent Futures Magazine about a possible option play. I actually liked it so much that I made a copy. I didn't realize they also post the articles online as well. The idea is simple, which I like.

http://www.futuresmag.com/cms/future...trategyJohnson

Stock Replacement Strategy
10/1/2007
By BILL JOHNSON

Most stock investors firmly believe that options are high-risk investments, only suitable for unrefined traders. But holding expensive stocks through turbulent markets can prove to be an even less civilized approach. October has historically been a dangerous month for equity investors and several analysts say this October may be historic in that regard. Using options, namely the stock replacement strategy, can tame the wildest of risks.

Before we describe the stock replacement strategy you must understand one critical point: Options represent tradeoffs in risk and reward. They are not superior or inferior to stock, they present a different set of risks and rewards and it is up to each investor to determine which is right for him.

This strategy is designed as a substitute for purchasing shares. It provides nearly the same profit if the stock price rises but only exposes you to a fraction of the downside risk. To understand the tradeoffs, you must understand the risks and rewards of each strategy.

Assume you are bullish on Chevron-Texaco (CVX), which is trading at $90. If you purchase 100 shares of stock, it will cost $9,000 and you will earn dollar-for-dollar if the stock rises but lose dollar-for-dollar if it falls.

The important point is that the profit and loss profile for a long stock position is a straight line. It shows that you continue to profit as the stock price rises but accept a large, unknown downside risk for that opportunity. While it’s true that the maximum loss is $9,000 at a stock price of zero, the chance of that happening is remote. So aside from that one known value we don’t really know what your losses could be. You’re investing in the face of uncertainty.

We can improve the risk-reward profile by using the stock replacement strategy. This strategy buys a deep-in-the-money call with a delta in the range of 0.80 to 0.85.

An option’s delta shows how sensitive an option’s price is for the next dollar move in the underlying stock. If you buy an 80-delta call for $10 and the stock immediately rises $1, the call will be worth $10.80.

Delta does not stay constant though. If the stock continues to rise or as expiration nears, the delta eventually rises to one, which means the option eventually behaves like shares of stock. But right now, you’re capturing 80% of the stock price increase. You have nearly “replaced� the upside potential of the stock with an option. However, your downside exposure is greatly reduced.

Let’s assume the March ’08 $75 call (239 days until expiration) is trading for $17.10 and has a delta of 0.80. This call gives you the right to purchase 100 shares of Chevron-Texaco for $75 at any time through expiration. Because it controls 100 shares of stock, you will pay $17.10 * 100 = $1,710 to buy the option. This is certainly much less than the $9,000 you must pay to buy the shares. By purchasing this call, your profit and loss profile looks much different as shown by the red line in “A better way.�

For all stock prices above $75 at expiration, the profit and loss diagrams for both strategies run parallel and nearly overlap; they are separated by the small amount of time premium paid for the option. There is virtually no difference between the two strategies if the stock price is above $75.

But look at the difference in risk for all stock prices below $75. As the stock price falls, the long stock position continues to lose but the option’s maximum loss remains at $1,710. You have sacrificed a small amount of potential profit in exchange for a fixed maximum loss. It’s a sensible tradeoff in risk and reward.

What about dividends? Chevron pays 58¢ per quarter so the stock buyer collects $174 over the next eight months. By using the stock replacement strategy, you have only spent $1,710 rather than $9,000, which means you have $7,290 sitting safely in cash. At 3% interest, you’d earn $145 through the same period. Although less than $174, you didn’t spend $9,000 to get it. This strategy can therefore create synthetic dividends � even if the stock doesn’t pay one.

Risk creates fear, which paralyzes decisions. To improve your investment results, you must tame the risk. The stock replacement strategy is just one of many option strategies that allow your fears to escape. And this may be a particularly good time to employ added downside protection.

[TinGull]

Good article. Also, an important thing to consider is getting out of any option plays a week or so before expiry. Gamma exposure that late in the game can drive the delta way higher/lower therefor increasing your risk exposure if something terrible were to happen to the underlying.

Gamma basically is the strength of the delta. Delta tells you how much your option is going to move in accordance to the underlying instrument. When the gamma is bigger, the delta will move in accordance. Bigger delta, bigger move in the option when the underlying moves.

I got nailed on gamma exposure during Oct 2006 expiry and lost a good amount of money. Granted, I was on the wrong side of the trades to begin with (novice) and had I closed out the position a week earlier...my life would be a bit different right now.

[brownsfan019]

Good stuff Tin. You should start an 'Option Trading 101' thread. Seriously. If we are going to discuss the greeks, IV, etc. then a thread where all this is explained would be useful for all, myself included.

[brownsfan019]

Option question - so let's say we find a good underlying to play. How/where are you going to look for the option info? Just straight from your broker, the charting software or a separate website? Where are you going to find the IV, greeks, etc.?

[brownsfan019]

Here's the graph that corresponds with the above article:

[TinGull]

	Quote:	brownsfan019
	Option question - so let's say we find a good underlying to play. How/where are you going to look for the option info? Just straight from your broker, the charting software or a separate website? Where are you going to find the IV, greeks, etc.?

I get it right from my thinkorswim platform. They've got it all laid out really nicely along with the greeks for your whole portfolio, so you can see if you're ultra short theta and collecting lots of premium, or if you've got a big gamma exposure over your entire portfolio. For instance...




So i can see in an instant where my achilles heel is. In that software you can also plot your greeks against a stock or index. Beta weighting it. So for every dollar DJX moves, my BHI position will increase xxxxx theoretically.

We can certainly start another thread discussing all that is the greeks.

[TinGull]

Oh, also...I didn't really answer your whole question. If you've got a software that has access to the option chains, then it should be able to plot implied vol for that particular instrument. ToS does this right on the chart:

[brownsfan019]

Tin - can't you just use TOS charts then? Why do you need a separate charting platform?

[TinGull]

I use it to scan, not necessarily chart.