finance article No.8530
Maximizing Option Trading Profits With Fast Puts And Calls
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In today's chaotic stock market, the ability to make a profit trading long Option positions (Puts and Calls) depends on being able to capitalize on shortterm moves in the price of a stock or index. Stocks are up one day, and down the next - and it's anybody's guess as to what the long-term outlook is. With the price action occurring on a daily basis being more or less a guessing game, the ability to make profits with long option positions depends on being able to buy options that can gain value quickly with a minimum amount of price movement in the underlying security. In the past, figuring out which option might move the most quickly has been a guessing game. For every equity with options there are several options for each expiration month. In the case of options on Indices, such as SPY or DIA, there are literally dozens of option choices for each month. Clearly, figuring our which of those options will reach a particular target gain on your initial investment, just by looking at the list of choices, is basically a guessing game The key to a winning Option Trading Strategy it to be able to sort out the relative behavior of all of those options, and find the ones that can make your target investment gain (50%, 100%, etc.) with the least amount of price movement in the stock. The availability of a new Spreadsheet that can analyze and display the behavior of the various option choices, and show clearly which options can provide the desired gains with the least amount of price movement in the stock, eliminates the guesswork. This analytical spreadsheet provides a number of useful Metrics for characterizing the behavior and future value of options, but the most important are the price gain data in the Matrix displays, which give a visual impression of the rate at which the different options will gain value as the price of the stock or Index changes. This provides the tool for finding the options which gain value at the fastest rate. The spreadsheet provides two Matrix displays: The first shows the behavior of
the options based entirely on the effects of Delta and Gamma, which determine how the price of the options change as the Stock price changes. This set of calculations is most relevant when you expect a very quick move in the stock price - a situation in which time decay (Theta) does not play a significant role. The second Matrix adds to the Delta and Gamma effects calculations of the influence of both Time Decay, and Volatility (Vega). These two variables can be changed independently of each other. The results of these calculations are illustrated below in two tables. The data in the tables are for Dollar Tree Calls. The first set of values shows the amount that each call will gain based on the increase in the value of DLTR stock shown in the top line of the table (DLTR Price Gain). To make the relative behavior of the different Options clear, each line of the Table shows only the two price gains which bracket the increase in the option Bid price that will allow each option to be sold for double the original price paid, (the Ask price). (The target value can be set to any desired multiple of the initial cost, not just 2x, as in this example): DLTR @ $35.42, Price changes needed to Double the value of a Call: Matrix 1 - Delta & Gamma only price gains: DLTR Price Gain:___ $2.00__$3.00__$4.00__$5.00__$6.00__$7.00__$8.00 DQO CU_______________$1.48___$2.09 DQO CH_______________$1.09___$1.56 DQO CV_________$0.47__$0.76 DQO CI_________$0.31__$0.51 ----------------------------------DQO EH_______________________$1.89___$2.45 DQO EV_______________________$1.56___$2.04 DQO EI________________$0.91___$1.28 DQO EW_______________$0.73___$1.03 (These tables are greatly abridged for publication, and many data columns are not shown.)
The second Matrix shows how these same options will behave at some time in the future and, optionally, with a change from the present value of Volatility (Vega). The number of days into the future, and the change in Volatility, are determined by user input, which allows the exploration of many different "what if?" scenarios: Matrix 2 - Price Gains after 35 Days and with Volatility at 85% of current value: DLTR Price Gain:____$2.00__$3.00__$4.00___$5.00___$6.00___$7.00__$8.00 DQO CU__________________* * *___* * *__$1.65___$2.53 DQO CH__________________* * *___* * *__$0.52___$1.28 DQO CV__________* * *____* * *__________________$0.43__$0.76 DQO C___________* * *____* * *__________________$0.18__$0.37 ----------------------------------DQO EH_________________________* * *____ * * *___$1.58___$2.30 DQO EV_________________________* * *____* * *__________$1.50___$2.15 DQO EI___________________* * *___* * *__________$0.66___$1.06 DQO EW_________________ * * * ___* * *__________________$0.72___$1.06 In this second Matrix, the positions occupied by price gain data appearing in Matrix One are represented with asterisks (if they differ from the new positions), providing a clear visualization of the way in which the Options' gains in value have been changed by the effects of Time and Volatility. The Tables above show how an analysis of multiple options can be used to make choosing the fastest option to purchase for a trade a more systematic process. If we anticipate that DLTR is going to make a quick move upward in price over the next couple of days (perhaps because of an earnings announcement), then using the data from the top table we would buy either the
DQO CV Calls, or the DQO CI Calls. In cases like this, where there are two choices for an option based on the fastest rate of price gain, there are other metrics, such as price gain to achieve break-even, which can be used to narrow the choice further. Based on the results of the analysis, these two Calls should double in value if the price of DLTR stock rises by $2.00 - $3.00 over the next few days, as of the time this data was current (early February 2009). The DQO CU and DQO CH options, by contrast, won't double unless the price of DLTR rises by $3.00 $4.00. If we were expecting the stock to drop, then we would perform a similar analysis using the Puts for DLTR. This example illustrates the power of this strategy: Buying one of the two fastest options cold result in a 100% profit, after the price of the stock has risen by less than 9%! On the other hand, if we expect that DLTR will rise gradually over the next several weeks, then we would use the calculations in the second Matrix. Setting the number of days to the expected interval for the trade (in this case, 35 days) and allowing for the likelihood of a 15% decrease in volatility for these options, the best choices for Call options to buy would then be either the DQO CU, or the DQO CH Calls. Note that these March calls will still provide a faster return than the longer expiration options (the the May calls), even though the elapsed time is 35 days. This is not always the case, however. One of the advantages of the way this data is presented is that anomalies in Option pricing "jump out" at the user very clearly. In the second Matrix, notice that the price gain data for the DQO EI Calls are displaced one position to the left, relative to the DQO EW and DQO EV Calls. This indicates that the DQO EI calls have an advantage over the others under these conditions, and will produce a faster return. The use of a trading strategy that takes advantage of analytical tools (like the price gain velocity analysis shown here) provides an opportunity to make trading decisions that are based on analytical data, rather than "gut instincts". This provides Option Traders with a more systematic way to make choices when devising an Option trading strategy, and taking an Option position.
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