No lack of OPTIONS

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Postby PebbleTrader » Wed Feb 27, 2013 12:12 am

We covered those already but I thought further explanation with illustrations would be helpful.
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Postby MightyOne » Wed Feb 27, 2013 5:16 am

PebbleTrader is doing such a fine job explaining things that I think I'll just kick my feet up ;)

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Postby rushN4 » Wed Feb 27, 2013 9:17 am

I found here something on Delta Trading. Maybe some will find it usefull

http://www.barchart.com/education/pdf/D ... Course.pdf

It is a reprint from "The Delta Trading Strategy" It was initially published in 1994 by The Ken Roberts Company

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Postby PebbleTrader » Wed Feb 27, 2013 2:44 pm

Great link,

I'm still working my way through it.

I'll try to post some highlights from it that expand on what we have already learned.
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Postby PebbleTrader » Wed Feb 27, 2013 3:17 pm

OPTIONS TRADING: BACK TO GOLD

Now that we have read through the basics, let's examine a few possible
trades. Suppose a few months ago we had suspected that Gold prices were
ready to move up, but we did not want to take the risk of entering a
futures contract trade. Gold was trading at $420 an ounce. We decided to
buy an option.

PUT AND CALL
First question: What would we want to buy, a PUT or a CALL?

We would, of course, wish to buy a CALL option. A CALL gives us the right
to buy the futures contract at a specific price, called the STRIKE PRICE. A
PUT would give us the right to sell at a specific price, and we would use a
PUT if we thought prices were going down. But we think they are going up.
So we purchase a CALL option. That was the easy question. The next two
questions are going to take a little more review and discussion.

STRIKE AND PREMIUM
Next question: What STRIKE PRICE should we purchase and how much
PREMIUM will we pay?

If we look in Investor's Business Daily or The Wall Street Journal, we see
there are many possible STRIKE PRICES, all with different prices, or
PREMIUMS. Which one do we want? There is a STRIKE PRICE every $20,
that is at 400, 420, 440, 460 an ounce and so on. The closer the STRIKE
PRICE is to the current trading price, the higher the PREMIUM and the more
the option costs (remember, the PREMIUM is the cost of the option). The
further the STRIKE PRICE is above the current price of Gold, the lower the
PREMIUM for buying the option. We might think of each STRIKE PRICE
option as a different commodity. While prices will move in similar
directions, each will behave a little differently.

Exactly how much each Gold option costs depends on how likely traders in
the market believe it is that the price of Gold will reach and exceed the
STRIKE PRICE of the option. If we purchase the 460 STRIKE Gold option
when Gold is trading at $420 an ounce, Gold will have to move up over $40
an ounce before our option would be worth using. There is no sense in
using our option to buy Gold at $460 an ounce if we can simply go out and
buy Gold on the market at a price less than that. But if Gold does move up,
say to $480 an ounce, we can profitably exercise the option. We have the
right to buy it at $460! We can exercise our option and buy the Gold at
$460 (our set STRIKE PRICE), and then if we wish, immediately sell it back
at the current market rate of $480. By doing this, we pocket a profit of $20
per ounce. Each Gold CALL option gives the right to buy one futures
contract of 100 ounces, so we would be able to make a quick $20 an ounce
on 100 ounces, or a total of $2,000 ($20 x 100 ounces)! To determine our
net profit on this transaction, we must deduct from the $2,000 we receive
at sale, the original cost or PREMIUM, we paid for the option.
Last edited by PebbleTrader on Wed Feb 27, 2013 3:28 pm, edited 1 time in total.
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Postby PebbleTrader » Wed Feb 27, 2013 3:18 pm

VOLATILITY

How much PREMIUM will we have to pay for our Gold CALL option?

Remember, to obtain the profit in the above example, the price of Gold had
to move from $420 per ounce to $480 per ounce, and this is a pretty big
move. So how much is that option with a 460 STRIKE going to cost us to
begin with? Well, that depends on how likely traders in the market think it
is that Gold will make a big move up. If the price of Gold has been rather
steady, and there have been few major moves, traders will figure the
chances of Gold making a big move upwards are rather small. It will not
cost very much to buy a Gold option with a STRIKE PRICE way beyond
what traders think it is likely to be worth during the life of the option. This
perception of how active a market is and how likely it is to make a big
move is called the "VOLATILITY" of the market the sixth word in our
glossary of option trading. When VOLATILITY in a market is low, it means
prices are very stable and big moves in price seem unlikely. When
VOLATILITY is high, the market is making big price moves.

Under circumstances where VOLATILITY is low, the person selling the
option to us figures it unlikely he will actually have to deliver on the option
he figures prices seem pretty stable and are not likely to go up above the
STRIKE PRICE, or not very much above the STRIKE PRICE. So if Gold is
selling for $420 an ounce and prices are stable (low VOLATILITY), we may
have to pay only a very small PREMIUM for the 460 STRIKE option, as little
as $50 or $100. The more active prices have been, and the more likely it
appears that Gold may move up to the $460 per ounce STRIKE PRICE of
our option, the more the option will cost.If prices have been very active,
that is, very VOLATILE, and moving upward, the option PREMIUM could be
several hundred dollars.

Either way, if prices actually do reach $480 an ounce, we can exercise our
option and pocket the $2,000. Our net profit on the trade is this amount,
$2,000, minus the PREMIUM we paid for the option. If we paid a low
PREMIUM of $100 for the option, our net profit was $1,900, twenty times
the capital we risked! If we paid a PREMIUM of $400, as we would have
during the Spring of 1987, when prices were VOLATILE, and the PREMIUMS
therefore higher, we still would have had a net profit of $1,600, or an
800% gain. In either case, if we had been wrong about the direction of the
price move, the most we could have lost was the PREMIUM we originally
paid.

Please note, you don't have to exercise your profitable option. You can sell
it to someone else for a nice profit.

So back to the first part of our question, what option STRIKE PRICE should
we buy?

The answer depends partly on how much we want to spend on the option
PREMIUM. The STRIKE PRICES closest to the current trading price of Gold
will always be the most expensive. These are the options most likely to pay
off. Some STRIKE PRICES will even be below the current price of Gold, for
example, a 400 strike option when Gold is at $420. These options that are
already "in-the-money" are the most expensive. The 400 STRIKE option
gives one the right to buy Gold at $400 an ounce when it is currently selling
for $420 an ounce. This option will cost at least as much as the $20 an
ounce it is already worth (its current "intrinsic value").

Generally it is best to buy the option with a STRIKE PRICE one or two steps
away from the current market price of the futures contract. In this case
when Gold is trading at $420 an ounce, it is probably best to buy the 440
STRIKE PRICE option. If VOLATILITY is high, we might want to consider the
460 STRIKE option, but we must always remember that the farther away
the option STRIKE PRICE is from the current price of Gold, the less likely it
is that we will make money on the option. When we buy a distant STRIKE
PRICE (a "far-out-of-the-money" strike), we pay less money, and have
less risk, but we usually also have a lower chance of making a profit.
Last edited by PebbleTrader on Wed Feb 27, 2013 3:32 pm, edited 1 time in total.
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Postby PebbleTrader » Wed Feb 27, 2013 3:19 pm

TIME IS MONEY

The third question: Which EXPIRATION time should we choose for our
option purchase?

In answering this question always remember: TIME IS MONEY! The more
distant the EXPIRATION DATE (the longer the period we have to exercise
the option), the more we will pay for the option (the higher the PREMIUM
will be). The reason for this is simple:No one knows, to the best of my
knowledge, what the future will bring. It is possible to make reasonable
guesses about the near future based on current circumstances, but about
more distant events we will always be ignorant. The farther into the future
our CALL option to buy Gold extends the more distant the EXPIRATION of
the option the more that option will cost.

The EXPIRATION DATE of each option is set by the exchange where it is
traded. Each futures contract has multiple different delivery months
throughout the year. Usually these are spaced one, two, or three months
apart, and we can trade options on any of these coming months. When
trading options, always discuss with the broker the exact EXPIRATION
DATE of the option. We must know how much time remains until
EXPIRATION, because this is our period of opportunity. We should note that
the option frequently will expire in the month before the futures delivery
date. For example, an option on February Gold futures will expire in
January. By selecting options on futures contracts with deliveries nearer or
further away in time, we can pick an EXPIRATION DATE for the options
contract that is anywhere from thirty or less days away, to many months
away.

FACTORS THAT AFFECT THE PREMIUM BEFORE EXPIRATION

Every day we own the option, chances increase that something will happen
to change the price of Gold. Given "enough" time be that months or even
years it is very likely something WILL happen to drive the price of Gold up
and make our option very lucrative. This is called the "TIME PREMIUM." A
large part of the PREMIUM we pay for an option consists of this "TIME
PREMIUM," the chance that something unknown and unexpected will
happen to change prices and make the option profitable. The more time
until EXPIRATION of the option, the more chance there is that
circumstances and prices will change. In purchasing an option, we pay the
person selling the option for his willingness to accept the risks of time and
those unknown events which may make the option a good investment for
us.

If nothing happens and prices stay the same, the person who sells us
the option wins and pockets all, or part of our money. We have lost the
PREMIUM we paid, but nothing more. If, however, things do change, and
prices move as we thought they might when we bought our option, then we
pocket the profits. That's why we bought the option in the first place!

The more VOLATILE the market, the more we will pay for time.
VOLATILITY implies there is a greater chance that things will change, given
enough time. So our PREMIUM will go up. When we buy an option, we are
truly buying time, and all the chances that time offers. The more time we
buy, the more we will pay. How much time to buy (how distant an
EXPIRATION) depends on our market strategy. With most trading
strategies, it is unwise to buy an option much more than 90 days long. The
PREMIUM paid for an option longer than this is usually just too high.
Sometimes, time does cost too much!

If only a few days remain until EXPIRATION, options with a STRIKE PRICE
far removed from the current trading price of the futures will be essentially
worthless. This happens when the STRIKE PRICE is so far away from the
current trading price that it is impossible, given current VOLATILITY, for
prices to move to or beyond the STRIKE PRICE in the option's remaining
time. As the EXPIRATION DATE of an option approaches, and the time
remaining to exercise the option decreases, the PREMIUM (cost) of the
option will usually decrease. When the time remaining until EXPIRATION is
short, there will be very little "time value" in the PREMIUM paid for the
option. When there is little "opportunity time" left in the option, we pay little
for it.

WHAT HAPPENS AS EXPIRATION APPROACHES

As the EXPIRATION DATE for the option approaches, the PREMIUM cost of
the option will reflect more and more the intrinsic value of the option. Time,
and the opportunity value of time, has wasted away. If the option is "far-
out-of-the-money" (the STRIKE PRICE is distant from the current price of
the futures), the PREMIUM will be very small. This happens when traders
decide there is very little chance prices will reach the STRIKE PRICE of the
option and give it value in the time remaining until EXPIRATION.

Some options will be "in-the-money" as EXPIRATION approaches. For a
CALL option, this means that the STRIKE PRICE is less than the current
trading price of the future. For example, a Gold option with a STRIKE
PRICE of 460 is "in the money" when Gold is trading at 480. In this
instance, the option is worth at least $20 an ounce, because it grants the
right to buy Gold at $460 an ounce (the STRIKE PRICE), $20 an ounce
below the current market price of Gold futures. This is called the intrinsic
value of the option the amount it is worth in cash if it is exercised. As
EXPIRATION nears, the PREMIUM of an "in-the-money" option will approach
its intrinsic value, and there will be no additional time value added to the
PREMIUM. At EXPIRATION, the value of the option is equal to its intrinsic
value. For an option which is "out-of-the-money," there is NO intrinsic
value. The value of the "out-of-the-money" option is based on its time, or
opportunity, value the chance that time will change prices and give it
intrinsic value. As time passes, the chance of this happening diminishes,
and this value disappears. At EXPIRATION, there is no time left, and the
"out-of-the-money" option is worthless. When trading options we must
always remember, TIME IS MONEY.

For each trading month of a futures contract, there will be a number of
options with different STRIKE PRICES. Each of these should be viewed as a
slightly different commodity. While they will all undergo changes in value
based on changes in the price of the futures, they will change at different
rates and in different amounts, depending on how close the STRIKE PRICE
of each is to the current trading price of the futures. Options on different
trading months of futures move differently in value because of differences
in their times until EXPIRATION. There are relationships between all the
options on a given futures contract since they all vary in a specific related
way with the futures prices, but it can take some time and study to
visualize these relations.
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Postby PebbleTrader » Wed Feb 27, 2013 3:41 pm

----------------------------------------------------------------------------------------

Great example to work through from the link RushN4 posted
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Postby PebbleTrader » Wed Feb 27, 2013 5:04 pm

HOW TO MAKE THREE TIMES MORE MONEY

Back to our example. Gold is trading at $480, and the April CALL options
with a 500 STRIKE PRICE have a PREMIUM of $4.50 an ounce, or $450 per
option ($4.50 per ounce x 100 ounces = $450). We examine the last two
days' prices on The Wall Street Journal, and calculate that the DELTA of
this April 500 Gold CALL option is 0.25 (its PREMIUM has been changing 25
cents for every dollar change in Gold prices). With our $2,000 we buy four
options, at a total cost of $1,800, and save the $200 change. The total
DELTA of our position is 1. We will initially make one dollar for every dollar
change in the price of Gold. (For the technically advanced student only:
These following calculations are made with a market VOLATILITY of 15%,
interest rates at 6%, and 60 days until EXPIRATION but don't worry about
these technical comments.)

The price of Gold begins to move up, as we hoped. It quickly reaches $490
an ounce let's say this happens in the next two weeks and our options now
have 45 days until EXPIRATION. As the price moves up, remember the
DELTA of our options is also increasing. At $490, the DELTA on each of our
options has increased to 0.35. We own four options, so the total DELTA of
our position is 1.40 (4 x 0.35 = 1.40).Now for every dollar increase in the
price of Gold, we will be making $1.40 on our option position!! And what
happens when the price hits $500 an ounce, the STRIKE PRICE of our
options? The DELTA on each option is now 0.5, and the total DELTA of our
position is 2 (4 x 0.5 = 2.0). We are now making $2 for every $1 increase
in the price of Gold, or twice as much as we would make had we bought a
futures contract!

As the price of Gold continues to rise, we make more and more for each
dollar move as the DELTA of our options increases. If the price reaches
$540, the DELTA of each option will be over 0.90, and our total position
DELTA will be 3.6. We will be making $3.60 for every $1 increase in the
price of Gold now we own the profit power of four-hundred ounces of Gold,
instead of the single one-hundred ounce futures contract we might have
been able to purchase using our original $2,000 as margin!

FUTURES VS DELTA OPTIONS POSITION
Image
EVERY PICTURE TELLS A STORY

Figure 2, above, shows the profit curve for this DELTA OPTIONS trade. The
line marked with the "+" indicates the profit/loss potential of a single
futures contract. Notice it is a straight line, for every dollar change in the
price of Gold, up or down, there is a $100 profit or loss. When the price
rises from $480 to $540, we make $6,000, or $60 per ounce on 100
ounces. When the price falls to $420, we lose $6,000.

Now notice the profit line of the DELTA OPTIONS trade. It is a curved line,
and a line curved in a very favorable way. As the price goes in the
direction of our trade, we make more and more. When the price moves
against the trade, downward, we lose incrementally less, until our
maximum loss of $1,800 the amount of our original investment is reached.
If the price of Gold moves up to $540, we will make over $14,000, well
over twice as much as with a single futures contract. When the market
drops suddenly, and against our expected projections, we lose a maximum
of $1,800, the amount of capital we chose to risk, and far less than we
might lose on a futures contract. There is never a chance of a margin
CALL. Our risk is defined and totally limited, and our profit potential,
depending on how far Gold prices move up, is doubled, tripled, or
ultimately, nearly quadrupled! A wizard once said that magic is simply
power discovered unexpectedly. Here resides the magic of DELTA:
Unexpected and unlimited power to pro fit, amazingly allied with total and
predictable control of risk. Used in the right way at the right time, this is a
magic that can make futures-trading "wizards" rich!

THE COST OF MAGIC

As you must see, this is a most powerful tool. Unfortunately, there is no
spell that produces gold from lead at least not one that I can share! This
strategy does have a cost, something is given away in return for the
power. Before using the DELTA OPTION approach, you must understand
this cost. Return to Figure 2 and examine the profit lines again. Can you
figure out what is given away in return for the power of a DELTA OPTION
trade? Notice that between 465 and 495 the DELTA OPTION profit line is
below the futures profit line.In our example trade, if Gold prices make a
small move, say from 480 to 490, with the DELTA OPTION trade we would
make a profit of $675. Had we purchased a Gold futures contract instead of
a DELTA OPTION position, we would have made $1,000 on this small move.

If prices stayed the same, that is, Gold continued to trade at $480 per
ounce, our futures position would be a break-even venture. We would
neither make nor lose money (excluding the broker's commission). Our
DELTA figure 2 option position would, however, lose money. As every day
passes, our options with a 500 STRIKE PRICE are losing TIME PREMIUM.
Remember, time is money! Indeed, if we held our position all the way until
EXPIRATION of the options, and prices did not move at all from 480, we
would lose our entire investment of $1,800. This is, of course, because our
500 strike options are out-of-the-money and will expire worthless.

The cost of a DELTA option position is this: If prices fail to move much one
way or the other, one makes slightly less or loses slightly more than he or
she would with a futures position. There are two clear advantages of a
DELTA option trade: If prices move dramatically in our favor, we make far
more than we would on an outright futures contract; and if prices move
strongly against us, we lose far less. Understanding these costs, we can
design a trading strategy that will use option DELTAS efficiently and
profitably. This is not the approach to take every time we trade. As with all
tools, it must be used properly to work properly.
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Postby PebbleTrader » Wed Feb 27, 2013 5:04 pm

Isn't that interesting! :)
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