The Options Advantage

[TradingAdmin]

This discussion topic is motivated by a friend..- well, we have not actually met yet, we got acquainted via email, currently he is on a mission away from home for 3 months, but with lots of questions on his mind.  For you, my friend - something to keep you busy through the lonely afternoons.  For anyone else following this, you are of course most welcome to participate...

I'll use this discussion topic to show a couple of trades involving trading in the straight futures - (such as what anyone who got involved in currency trading for example, would be very familiar with) - versus trading with various different options positions.  You then judge which is the more risky approach?

First off, I'll use two graphs from out of the Options Explorer on all these posts, as follows:



The graph on the LEFT is a profit / loss graph.  It shows us the profit / loss that you will make on the left axis, versus the price of the commodity (or instrument) that you are trading in on the bottom axis.  The RED LINE will be the profit / loss situation on the day that the futures instrument expires - in this example 21 days from today.  The BLUE LINE is the profit / loss situation on the day that you entered the position (in other words today).  The PURPLE LINE is the profit / loss line on an arbitrary date into the future - in this case it is 9 days into the trade.  Thus the profit / loss line is time dependant (naturally, since the price of the commodity will change over time).  The vertical bars are the prices at which we entered individual positions.  The solid vertical line represents the price on the day that we are analysing - in this case day 9, the price is at 145, you can read the profit from out of our graph on this day from the purple line.

The graph on the RIGHT presents exactly the same information, but in this case it super-imposes the profit loss in our trade position on top of a line chart of the daily closing price of the underlying commodity (price chart in GREEN).  Our profit / loss lines are drawn in YELLOW.  The thick (bold) yellow line is our break-even lines (in this case, between the two thick yellow lines we are making a profit, outside that area we are making a loss - note sometimes this will be reversed, and sometimes there will only be one line.  The feint yellow lines tells you on which side of the break-even line we are in trouble, obviously on the other side we are in profit).  The two feint yellow lines represent loss lines - in this case a $500 loss and a $1000 loss respectively.  Futures price on the left axis, days left until the futures expires on the bottom axis.  We are able to simulate price action on this graph - I have added nine days on this graph, keeping the price constant at 145.  Thus this graph shows we are in profit (9 days in if the price stays level) and the graph on the left shows us how big that profit is (about $700 - pink line at a price of 145)

These graphs shows you the underlying risk in a trade situation - how much money can you make and how much can you loose, and what does the price of the instrument you are trading in have to do for you to make a profit, versus for you to make a loss.  (In the example above (USD/GBP) it should be clear that we are expecting the price to stay level - if that happens we will be making a profit.)

Study and familiarise yourself with these graphs - we will be using them to describe different positions.

[TradingAdmin]

As our first trade, let us look at a FUTURES Trade.  We go LONG the currency at the current price....

What does this mean?  It is a straightforward currency trade - we BUY the exchange rate, on whatever platform you use.  The risk profile looks like this:



Your expectation is that the price will increase.  If it does, you make money.  Your potential profit is unlimited.  If you are wrong, you loose money, your loss is also potentially unlimited.  There is only one line on our profit/loss graph - your profit/loss is the same the day that you enter than 5 days from now than 20 days from now, it depends only on whether the price goes up or not.

Your risk graph shows the break-even line (bold yellow) as a horizontal line at the price that you traded.  If the price goes above this line, you make money, if it drops below this line, you loose money, as simple as that.  The two feint yellow lines show where you will be taking a $500 loss and a $1000 loss respectively, trading only one single contract.

If you look at the daily price graph, you will see for days 52, 35-34, 32, that there are potentially large price changes in a day, average price change is about, or slightly more than 1 point in the currency.  You can take a $1000 loss in a day, but risk on average is just more than $500 per day.  This is quite a risky trade.

This is the kind of risk you take on on ANY of the many different trading platforms trading in the Currencies.  You cannot afford to take your eyes of this trade - if you get it wrong, you can loose big-time, and you can loose fast.  You need to be wide awake, you need to be glued to your computer screen, you need to be very quick in your reactions, get out at the smallest indication that something is not right, or you can very easily and very quickly loose a substantial amount of money.  Welcome to the world of trading in the Currencies!

Note: To the Currency Trader, on any of a number of different platforms, and extremely aggressively marketed on social media and via many different trading advertisements and seminars and stuff.. - this is the only option you have for trading the markets, this is the only trade you can make.  You can either buy and hope the price will increase, or sell and hope the price will decrease (SHORT position in the markets depicted below - you'll see it is the same thing, except you make money if the market drops).



Tomorrow, we'll look at trading the same situation, but with an OPTION...

[TradingAdmin]

Today we take exactly the same situation, but we trade it with an Option instead.  We BUY a CALL OPTION. 

Now note:  When you do this you are not actually entering the market - in other words you are not subject to the price fluctuations in the market.  You have a contract (a guarantee) by which you may enter the market if you choose to and when you choose to, at a pre-determined price - regardless of where the actual market is trading - as long as you do it before your contract expires.  You are basically sitting on the side-line, watching what the market does and if the market turns in your favour, then you enter and take your profit.  If it does not, you keep sitting on the side-line, waiting..



Soo..- we BUY a CALL OPTION at a strike price of 146!

Thus, we may enter the market at a futures price of 146 (long the futures, or buy the futures - exactly the same as our first trade) at any time from this point forward until expiry, 21 days from today.  At a price of 146 - regardless of where the actual market is trading.  Yes even if the market is trading at 150, we may still enter at 146 - our option guarantee's us an entry at 146!!

What happened to our RISK in this trade?  Well, first off, our profit is still potentially unlimited.  Our risk (downside of the trade) however is now limited TO A MAXIMUM LOSS of $700.  This is the most profound change - we CANNOT loose more than $700 on this trade!  With the futures, our downside risk was unlimited, we could easily loose $1000 or more.  No more!  With this trade the absolute maximum loss is $700.  If you take a look at the risk graph, the two feint yellow lines shows you where you will take a $500 loss and a $699 loss respectively.

Compare this to your straight currency trade.  There you would have taken a $500 loss at a price of approximately 144.3 and a $1000 loss at a price of 143.6.  With our options trade, you will only take a $500 loss at a price of 142.5; you cannot take a $1000 loss, the maximum loss possible is $700!

What did the option do for us?  It bought us the right to be wrong about the market direction!!  It safeguards us against the market moving in the wrong direction...

What is the price that we have to pay for this?
Of course one cannot expect such a favourable position for nothing - there must be a downside!  You can see the downside in your break-even line.  With the futures, the break-even line were horizontal at 145.2.  With our option, the break-even line starts at 145.2, but then slopes upward to just above 147.  In other words, before - with the futures - we would have made money the moment that the price of our currency pair increased.  With our option the price increase has to follow at least the rate of our break-even line, otherwise we will loose.  Also, our loss lines are no longer fixed, they also slope up towards our break-even line.  In other words time has become an enemy - the more time goes by, the more critical it becomes that the currency pair does increase in value.  That's the price we had to pay for reducing our downside risk!

But risk-wise, we are much better off than with our futures trade!


So now the question - is it possible for us to reduce the risk in our trade (like we did here) while simultaneously also turning that break-even line into OUR favour...?

[TradingAdmin]

So now the question - is it possible for us to reduce the risk in our trade (like we did here) while simultaneously also turning that break-even line into OUR favour...?

You mean, like this...?


(Those two loss lines, as in the previous example, again at $500 and $700 respectively.)

Thus to answer the question - YES IT IS!!  We ARE able to:

• Drastically reduce the downside risk - versus our futures trade, while simultaneously
• Shift our break-even profit line hugely into our favour!!

HOW DID WE DO THIS!?

In this case, we SOLD an Option!  That's right we SHORTED a PUT Option.  The net result is like below:



There are some changes here:

• Someone somewhere PAID US money to take this position.  That is 100% right - instead of us forking out money for this trade, someone else paid money into our trading account for us to take this trade - $500 to be exact.  When we entered this trade, we received $500 into our trading accounts for us being willing to take this risk.  And we will keep this money - the transaction is concluded, the money is ours, we will never give it back
• Our downside risk, as was the case for trading in the futures, is again potentially unlimited.  HOWEVER, the price level at which we will take that loss has shifted down significantly! While with the futures we would have taken a loss of $500 at 144.3 and a loss of $1000 at 143.6; we will now take a loss of $500 only at 143.2 and $700 loss at 142.7  - in other words we have much more room to realise we are wrong and get out of that trade
• Our loss lines decreases over time!! - That is as time goes by, the currency has to drop more and more before we will take a loss - in roughly two weeks from the day we entered, the $500 loss mark shifts down further from 143.2 to 142!
• Our profit potential however is now LIMITED.  It is limited to the $500 we have received beforehand - we no longer have an unlimited profit making potential
• Our break-even line however slopes sharply downwards.  Not only will we make a profit if we are right and the price goes up, we will now also make our money if the price stays level, or even if the price drops, as long as it does not drop too quickly!!

This extremely favourable position was brought about by us willing to limit our profit potential in the trade.  By not being greedy, by being willing to settle for a maximum of $500 in profit, the market rewarded us with a very favourable position - one where we are even allowed to be wrong on the market direction and still make a profit!

[TradingAdmin]

It's been a while....

OK, so we saw that not only can we reduce the risk in a trade by trading an option (instead of the futures), we are also able to shift the break-even line into our favour - in other words we are able to buy space for ourselves to be wrong about a trade. (This the case when we Sell an option)

What I want to show you here, is the relationship between the strike price at which we sell our option and the risk that we are taking.  First the picture:



Try to not get confused here - there are three different options strategies depicted here, all three on the same graphs in order to compare them.  The three cases are for selling a PUT option at a Strike Price of 146, 144 and 142 respectively (P146 means Put @ strike of 146). So now:

• First, note that our currency is currently trading at a price of just over 145 !!  Our currency (GBP) has a point value of $625.  Thus for each 1 point that the futures move, the contract that you are trading in will gain or loose $625!!  To be clear, if you bought the currency at 145 and the price moves up to 146, you will make $625 in profit, likewise if the price drops to 144 you will loose $625.
• We are selling PUT options here.  A PUT option will give the owner of the option - the person to whom we are selling these options - the right to go SHORT the currency, in other words if the option owner decides to exercise, he / she will SELL the currency at the option's strike price.  The option owner expects the price to go down, so that he / she can profit from it
• We on the other hand want the price to move up, in which case exercising the option will make no sense to the option owner and we will keep the premium that we received for selling the option
• The first option we sell is a P146.  The strike price is ABOVE the futures current trading price!  In other words, there is immediately VALUE in this option - the owner (of the option) may SELL GBP at 146 and immediately buy it at 145.2 (the current price), realising a profit or (146 - 145.2)*625 = $500.  BUT, the buyer has to pay us $1200 for this option!!  Thus immediately exercising the option does not make sense.  However, let's not focus on the buyer, let's focus on ourselves.  We will receive $1200 for this option.
• Also shown is a P144 option (144 strike), for which we will get $620 and a P142, for which we will receive $285.  Thus, the further we move away from the current price of the futures, the less money we will be paid for the option - it makes sense, the further away me move from the price, the less the risk that the futures will hit our price, the less a customer is willing to pay for insurance to protect against such a price move.  (and selling options is nothing more than selling insurance premiums)

On the risk side:

• Looking at our risk graph (right side), the further we go from the price (the lower the strike price) the steeper the break-even line gets.  Considering that we are thinking that price will move UP, the steeper down the break-even line, the more chance we buy ourselves to be wrong and still make a profit!  Look at the P142 - the break-even line curves really sharply down.  Price not only needs to go down, it needs to go very sharply down before we will be making a loss!!  We have to be absolutely completely wrong about the future price direction for us to make a loss!
• This is also illustrated on our profit loss graph (left-hand graph).  Look at the red lines.  A price anywhere above 142 on expiry day (21 days from today) and we will keep the $285 for the P142.  Compare this to the P146:  Although we will make more money, price have to be above 146 for us to keep that money!
• The blue lines depicts the situation on entry day.  If the price should drop to 144 on entry day, then with the P142 we will be down (loss) of -$180.  With the P146 we will be down -$400!  And from there it turns down sharply!

So what can we say about all of this?  It is all about YOUR APPETITE FOR RISK!!  If you are absolutely 100% certain that the price will move up, then go for the P146.  Or just long the futures.  It gives you the highest possible return.  BUT, if you are wrong, you are going to loose a lot and you are going to loose it fast.  If you are more conservative, and willing to make less money, then the further away you trade from the price action, the more chance you have of making a profit.  Even if you are wrong, you may still be able to get out of the trade with a small profit!

It is all about RISK versus GREED.  If you are GREEDY, take more risk, you may make more money when you are right, but you will loose more every time that you are wrong.  If you are risk averse, a safer bet may be to stay far away from the price action, take less profit at a time, but loose less when you are wrong!

Of course I have to ask the question:  Would you rather trade one contract with a P146, earning $1200 for the contract, but only if the price closes above $146, OR, trade four (4) contracts of the P142, earning $1,140 and keep that money as long as price stays above $142 ?

[TradingAdmin]

In the previous post we highlighted an important factor - the RISK in the trade..  Today we explore that risk...

Here are two of the trades above, on separate graphs - the P146 and the P142:

Shown on the graph is the break-even line as well as the lines for a -$500 and a -$1000 loss respectively.
You will notice that with the P142 (right), the price at which you will take a -$500 loss is less than where on the P146 (left) you would have already taken a -$1000 loss!

What is risk? 
It does not matter what trade position you try to take, there is always the "chance that you will be wrong".  And when you are wrong, you will loose money.  How much money you loose is entirely up to you - it depends on how long you want to stay in before taking your loss.
(This by the way is where most traders fail, or loose the plot.  They fall for all the marketing crap about how easy it is to make money from home, trading the Forex markets.  They try a few trades and they make a few bucks.  Then one day they run into a loosing trade, but they have never learned when to get out, thus they incur a loss.  But they stay in, hoping the currency will turn around and the loss becomes a big loss.  Then they argue that:  "if I get out now, I will realise that loss.  It is better I hang on, the currency have to correct, go the other way, then when the loss is smaller, then I'll get out".  Then the currency does correct and the loss is smaller, but then they say "OK, finally things are going my way..- just a little bit more and I'll be able to get out with no loss..- just a little bit more".  They stay in, the currency turns around and goes back the other way.  Now suddenly the big loss of before turns into an even bigger loss.  At this point, most traders suddenly find faith in the Lord - because for the first time in their lives they actually find they are praying to the Lord - something like "Please Lord, let it just go back to where it was before, PLEASE, I promise I will go out then, I cannot take this massive loss, please Lord".  And...  well, sometimes the Lord listens, but the trader does not get out, sometimes the Lord does not listen.  Regardless of whether the Lord listens or not, invariably the trader takes a massive loss and he is done with trading - this does not work for him.., well for the next year - then he thinks about it and how stupid he was not getting out, and then he decides this time it will be different and then he tries his hand at the Forex game again...)

Risk is the chance that you will be wrong.  But risk is more than that, it is also how much you will loose when you are wrong.  Now how much you will loose is quantified for you in the two graphs above.  You can see that for the P142 you will loose less at any specific price level than what you will loose with the P146 - provided you get out of course.

The chance that you will be wrong
No one can predict (accurately) what the markets will do - if we could (1) we would have been millionaires and (2) we would not have shared that knowledge with anyone - for this reason, the moment that someone tells you they have found the holy grail of methods - here is a method to make a guaranteed income out of the market..- RUN!

There are two things that influences the chance that you will be wrong:

• TIME:  The more time you give a particular market to reach your break-even point, the point from where you will be incurring a loss, the higher the chance that the market will get there.  A lot of things can happen in a 100 days!  If you give the market 100 days to reach your break-even point, the chance is quite high that something will happen and the market will give you a loss.  However if you only give the market 5 days to react - it is a bit difficult.  Un upwards moving market cannot just stop and rocket down for nothing - it needs time to make a change!
• DISTANCE from the Price Action: It should make sense that the further away you are from the current price action, the further the market has to move to get you into trouble, the less the chance that that will happen and therefore the less the risk!

This is what is depicted above!  For the P146, you are trading at a price of 146, which is above the current price level of the market.  Just a small move down and you are into trouble.  With the P142 you are trading at a price that is waayyy down on the price chart - you are far away from the price action - the market has to move substantially down before you are getting into trouble.

You also see an element of time here.  With the P142 you are really putting pressure on the market - not only does it have to move down to get you into trouble, it has to keep on moving down, every single day to keep you into trouble!!  We are asking a lot of the market in this position - we are almost trying to force the market's hand (if the market wants to get us in trouble)

And so now the choice:  Do you take $1200 out of the market and take the risk for the P146, or are you happy with only $285 and take the risk for the P142?  And if you really would like the $1200, why not rather take 4 of the P142 trades - same kind of profit, but much less risk?

Conclusion
There are two things that should be clear:

• Stay away as far as possible from the price action
• Squeeze the market for time!

Next time we will look at one way to do this..

[Cecil]

Got a question, received via email, from Jim:

You stressed the importance taking less risk deep out of the money options to taking more risky deep in the money options for more money (premium). You made an example of the premium of $1200 on the deep in the money option, and maybe four options at $285 each for a lesser risk (deep out of the money options) - which added together still comes to almost $1200 that you get from the more risky option.

My question to this way of thinking: how much margin will you have to put aside for one option that has the potential of giving you $1200? And also how much margin will you need to put aside for four options that are less a risk, and has the potential of giving you about &1200 all combined? Will the margin be the same.

Wont the exchange demand a bigger margin for less risky four options - because they are four?  Please explain.

[TradingAdmin]

Hi Jim,

(The correct terminology used in the options world is: "deep in the money", "in the money", "at the money", "out of the money", and "far out the money" - referring to where the strike price is relative to the futures price)

You are quite correct.  The MARGIN we need to put down to sell an option is the same, regardless of whether that option is in the money or out of the money.  Thus yes, the strategy of four options versus one will require four times the margin than only the one option.  For the British Pound (GBP) - the commodity used in this example the margin requirement is low however ($1650 per contract).  Thus to short four options and realise the smaller risk, will require (4x$1,650 = $6,600) in margin.  For something like Crude Oil, where the margin is close to $9,000 per contract it does become significant.

[When I sell an option - and I do not take any remedial action, we'll get to that later - in other words I only sold the option, then we call that a "naked option".  The exchange look at the naked option and evaluate that you are open to unlimited loss, if the price should suddenly melt down completely.  Thus they do not take the strike price, or the proximity of the strike price to the futures price, into account.  They simply say that, if the price should drop to zero (for put options) or shoot to infinity (for calls) then you are exposed to the maximum risk, and therefore the margin requirements are what it is - regardless of the strike price.  And therefor for each option in our example, you pay the full margin]

I guess then putting the example into perspective, your choices are:

• Short 1 x In the Money option, you have a chance of making $1,200 on an investment of $1,650 - great return, but at high risk to yourself, or
• Short 4 x Far Out of the Money options, you have a chance of making $1,140 on an investment of $6,600 - at much lower risk

[Selvage]

Got a question, received via email, from Jim:

You made the most out of these weight loss pills for men and stressed the importance taking less risk deep out of the money options to taking more risky deep in the money options for more money (premium). You made an example of the premium of $1200 on the deep in the money option, and maybe four options at $285 each for a lesser risk (deep out of the money options) - which added together still comes to almost $1200 that you get from the more risky option.

My question to this way of thinking: how much margin will you have to put aside for one option that has the potential of giving you $1200? And also how much margin will you need to put aside for four options that are less a risk, and has the potential of giving you about &1200 all combined? Will the margin be the same.

Wont the exchange demand a bigger margin for less risky four options - because they are four?  Please explain.

Option 2 sounds a lot more appealing to me. The risk in the option 1 seems just too high for my taste. What do you think?

[TradingAdmin]

It boils down to your personal make-up, your ability to handle the psychological stresses in trading.  How far are you willing to let it slip before you get out...

Remember that you entered this trade thinking that the commodity will move up.  If it does not move up, it moves sideways instead, or worse, it moves down; then you are wrong about the trade and you should get out!!  What is the key to success as a trader..?  Keep your losses small ?

If you are wrong, and this commodity moves down in price, how long do you wait before you admit you are wrong and get out!?

With the original currency trade, if you were wrong about price direction, you would get into trouble really quick.  With the option you bought yourself some room if you are wrong... (1) you will take a smaller loss, (2) you have more time to realise that you are wrong.  The fact remains however that you ARE WRONG and should get out.


However that said - how many times have you taken a trade thinking the market will move up.  Then the market moves up just a couple of ticks, not enough to take a profit, then it goes down and down until it hits your stop-loss.  And then, just after hitting your stop and you are out, it turns around and make this really nice big up-move, exactly like you thought it would.  You want to kick yourself - this is the move you've been waiting for - "maybe my stop was not far enough away?" - it is as if the market knows you are there, as if it just waits for you to enter, then enter you into the trade, and then drops, until you get out, and then it does its thing.  It goes up all the way, but you are not part of it - instead you have eaten a loss???   

The option strategy does allow you to stay in the trade longer - your stop-loss, now a mental stop-loss, can be further away, you have time to wait, let the market make its false-move, and then catch the up-move.  However, if you ARE WRONG and the market does continue to drop, you owe it to yourself to GET OUT!!  You will get out with less of a loss than with the straight futures trade, and you did give the market time to show its true colours - but if you are wrong, just get out, it is not your trade any more ..