Tuesday, January 17, 2006
So, you want to be an options trader?????
Do you really? Well, OK. I'm going to show how I do some very simple analysis of what I buy and sell. I'm going to assume that you have some basic options knowledge already... if you don't then start reading books... and I do mean a lot of them. I'm not actually taking any of these trades and I'm doing this only for demonstration purposes. Don't do these trades... just learn from this. I'm using extreme examples to make a point. I repeat, do not do these trades.
All of the prices I use are current prices but in the real world there are spreads to consider and commissions so you won't actually be able to trade at these prices. Also, all of these example are making several assumptions. The largest of which is that all else remains the same! Does this ever happen? NO! Of course not. That's why these are just examples and I wouldn't trade them. Prices change, volitilty changes and so do other things that are more complicated for these examples such as Delta, Theta, and Gamma. If you don't know these start reading. I'm not going to get into this here.
Nuff said? OK. The prices I'm using are from the cme.com site. On the right side under the current quotes hit "view all delayed quotes". On the left hit "cme equities", then "cme s&p 500" look to the right and select "pit traded options". They are sorted by calls, then puts by month.
First I'm going to show you the difference between and verticle spread and a calendar spread. Verticle spreads are using two different options strikes that are in the same month. My favorite is the Verticle Credit spreads. An example is Sell the Feb, 1325 for 3.50 and buy a Feb 1400 for .10. Its a credit because you take in more than you spend.. therefore you have a credit or you get paid at the start. Doesn't mean you keep it all but it's a nice idea. In this example if the market doesn't go to 1325 by the 3rd Friday of the month then you collect the difference between the two, which is 3.40. On the big S&P contracts the prices are multiplied by $250 to get the actual dollars involved. In this case it's 3.40*250= $850. Verticle spreads. Got it. Good cause we are moving on.
Horizontal spreads also know as Calendar spreads. Why... because you use the same strike price but you position them in different months. Example of a Horizontal Credit spread (what we sell is worth more than we buy so we get a credit) would be:
Buy an Feb 1375 call for .25 and sell a Mar 1375 call for 1.10.
Ok, we all want to know how much we make right? Let's figure it out. Just subtract the two like before and we have out profit right? WRONG! It's a little more complicated than this. Here's what you do. In theory your Feb 1375 goes to 0. Congratulations, you just had your first trading loss of .25 (in real dollars it's $62.50 right). Well it gets better. Your March contract also loses value... but how much. We are making the assumption that you will hold this position for a month. How much is it going to be worth in a month? I have no idea and neither do you but you can make a wild guess for this example. Where do we start? Well take a look at the Feb 1375 price of .25... it's the same strike price but only one month closer to expiration right? In a perfect world couldn't we assume that the March contract would be worth what the Feb contract is worth right now? Making the assumptions (remember what I said about assumptions... they are never correct) that all else remains equal we will assume that one month from now the March 1375 will be worth .25. Where does this leave us. We sold it for 1.10 and it's worth a month from now .25 so we made .85 (or $212.50). But remember that we lost .25 from the Feb option expiring worthless so our net profit would hopefully be .60 or $150.
I am rambling and not really checking my math so hopefully I will get this all right.
Now, lets get on with another type of Calender spread called the Debit calendar or horizontal spread. It's the same thing but you switch the buy and sell. Simple right? Here we go.
Sell the Feb 1310 call for 7.40 and buy the Mar 1310 call for 13.50.
How much do we make if the market stays below 1310. The Feb option would go to 0 and the Mar call would drop to 7.40 from 13.50. That's a loss of 6.10 and a gain of 7.40 for a net gain of 1.3 or $325. This a Debit spread because you have to pay money for it. I used an example very close to the market for demo purposes. I would never even think of trading something this close. Suicide! Don't do it.
OK, so now your asking what's the difference between the two. Well if you noticed the debit spreads can make you more but you are much closer to the market. The other advantage the debit spread will have is that you only have to pay for it. No margin required. That's in the cash market but I'm going to have to check the span margins for one of these because I've never done one in the futures market. I will do that soon just to make sure. The other thing you should consider is that the optimum market to do one of these in is one with little expected volitility. You don't want this thing to go up like crazy past your strike or it's going to hurt. I theory you would want these to go right up to your strike and expire there on the short leg expiration day. In theory.... we all know how often that happens.... never!
The Credit spreads may not make as much money but they are further from the market so a little safer. The do require margin but much less (usually only 1/3 of a verticle credit spread). How much depends on how close to the market you are. The closer you are to the market the higher the margin will be because you have more risk.
Rest assured... you can lose money on both of these trades. You will if you do it long enough, but you wanted to be an options trader didn't you????
The other thing to consider is that it is rare that I just do a call spread without a put spread at the same time since I strive to be Delta neutral as much as possible... don't always get there but I am usually working toward it. That way if the market is rallying and you have a call spread in trouble your put spread is most likely doing well, that is unless Vega (Volitility) is getting a little out of hand. That's a whole other story. Take it from me. I traded through Oct 87 and 9/11 and lived to tell about it. Not much fun!
Trader X
All of the prices I use are current prices but in the real world there are spreads to consider and commissions so you won't actually be able to trade at these prices. Also, all of these example are making several assumptions. The largest of which is that all else remains the same! Does this ever happen? NO! Of course not. That's why these are just examples and I wouldn't trade them. Prices change, volitilty changes and so do other things that are more complicated for these examples such as Delta, Theta, and Gamma. If you don't know these start reading. I'm not going to get into this here.
Nuff said? OK. The prices I'm using are from the cme.com site. On the right side under the current quotes hit "view all delayed quotes". On the left hit "cme equities", then "cme s&p 500" look to the right and select "pit traded options". They are sorted by calls, then puts by month.
First I'm going to show you the difference between and verticle spread and a calendar spread. Verticle spreads are using two different options strikes that are in the same month. My favorite is the Verticle Credit spreads. An example is Sell the Feb, 1325 for 3.50 and buy a Feb 1400 for .10. Its a credit because you take in more than you spend.. therefore you have a credit or you get paid at the start. Doesn't mean you keep it all but it's a nice idea. In this example if the market doesn't go to 1325 by the 3rd Friday of the month then you collect the difference between the two, which is 3.40. On the big S&P contracts the prices are multiplied by $250 to get the actual dollars involved. In this case it's 3.40*250= $850. Verticle spreads. Got it. Good cause we are moving on.
Horizontal spreads also know as Calendar spreads. Why... because you use the same strike price but you position them in different months. Example of a Horizontal Credit spread (what we sell is worth more than we buy so we get a credit) would be:
Buy an Feb 1375 call for .25 and sell a Mar 1375 call for 1.10.
Ok, we all want to know how much we make right? Let's figure it out. Just subtract the two like before and we have out profit right? WRONG! It's a little more complicated than this. Here's what you do. In theory your Feb 1375 goes to 0. Congratulations, you just had your first trading loss of .25 (in real dollars it's $62.50 right). Well it gets better. Your March contract also loses value... but how much. We are making the assumption that you will hold this position for a month. How much is it going to be worth in a month? I have no idea and neither do you but you can make a wild guess for this example. Where do we start? Well take a look at the Feb 1375 price of .25... it's the same strike price but only one month closer to expiration right? In a perfect world couldn't we assume that the March contract would be worth what the Feb contract is worth right now? Making the assumptions (remember what I said about assumptions... they are never correct) that all else remains equal we will assume that one month from now the March 1375 will be worth .25. Where does this leave us. We sold it for 1.10 and it's worth a month from now .25 so we made .85 (or $212.50). But remember that we lost .25 from the Feb option expiring worthless so our net profit would hopefully be .60 or $150.
I am rambling and not really checking my math so hopefully I will get this all right.
Now, lets get on with another type of Calender spread called the Debit calendar or horizontal spread. It's the same thing but you switch the buy and sell. Simple right? Here we go.
Sell the Feb 1310 call for 7.40 and buy the Mar 1310 call for 13.50.
How much do we make if the market stays below 1310. The Feb option would go to 0 and the Mar call would drop to 7.40 from 13.50. That's a loss of 6.10 and a gain of 7.40 for a net gain of 1.3 or $325. This a Debit spread because you have to pay money for it. I used an example very close to the market for demo purposes. I would never even think of trading something this close. Suicide! Don't do it.
OK, so now your asking what's the difference between the two. Well if you noticed the debit spreads can make you more but you are much closer to the market. The other advantage the debit spread will have is that you only have to pay for it. No margin required. That's in the cash market but I'm going to have to check the span margins for one of these because I've never done one in the futures market. I will do that soon just to make sure. The other thing you should consider is that the optimum market to do one of these in is one with little expected volitility. You don't want this thing to go up like crazy past your strike or it's going to hurt. I theory you would want these to go right up to your strike and expire there on the short leg expiration day. In theory.... we all know how often that happens.... never!
The Credit spreads may not make as much money but they are further from the market so a little safer. The do require margin but much less (usually only 1/3 of a verticle credit spread). How much depends on how close to the market you are. The closer you are to the market the higher the margin will be because you have more risk.
Rest assured... you can lose money on both of these trades. You will if you do it long enough, but you wanted to be an options trader didn't you????
The other thing to consider is that it is rare that I just do a call spread without a put spread at the same time since I strive to be Delta neutral as much as possible... don't always get there but I am usually working toward it. That way if the market is rallying and you have a call spread in trouble your put spread is most likely doing well, that is unless Vega (Volitility) is getting a little out of hand. That's a whole other story. Take it from me. I traded through Oct 87 and 9/11 and lived to tell about it. Not much fun!
Trader X
