Restricting the trade universe

Options trading books for beginners typically follow a fairly well-worn path. Firstly, a call and a put option is explained. Then volatility is discected and the Black-Scholes model is discussed. Which leads perhaps to put-call parity and the greeks. Theory over, some multi-legged trades are considered. These have exotic names like “Iron Condor” and “Butterfly”. Armed with a few payoff disgrams, you are now ready to take on the world!

All this is fine but, if you are gonig to win in the ASX options market you need to focus on the key factors for success. One of these factors is “restricting the trading universe”. By this I mean ruling out what NOT to trade.

Australian options market

In comparison with the US market, the Australian market is defined by a few key factors:

  1. Trading and liquidity is concentrated in a few stocks e.g. XJO (the S&P/ASX 200 Index), BHP, the banks and Telstra. In comparison in the US there are many liquid symbols spanning different industries.  In addition to stock options there are also options on funds, commodites, FX and futures.
  2. When you trade, your counterpart is likely to be a market-maker. For a bit of explanation, “market-markers” are authorised by the ASX to quote buy and sell prices for options. They are obligated to quote prices for various strikes and expiries for a minium amount of time during the day. There is a higher probability of trading against a real person when trading in the US.
  3. Commissions are higher in Australia than in the US.

My trading guidelines

I suggest the following guidelines (with the proviso that its OK to break them with a good reason).

  1. Focus on liquid underlyings (e.g the name above). Spreads are typically tighter, which gives a fighting chance.
  2. Focus on the closest expiries (e.g. the next 3)
  3. Be careful with trades with three or more legs (e.g. condors and butterflies) esp if not on the XJO.
What I trade
  1. I exclusively trade XJO options with a heavy focus on the next 2 expiries which tend to be the most liquid.
  2. I am equally happy to be a buyer and a writer.
  3. I trade several strategies including straddles, strangles and unbalanced butterflies in addition to buying / writing single options.

Happy trading

Ed

Options Trading: Use an adviser or go it alone?

This is a fundamental point. I’ll present the arguments for both cases.

Use an adviser

There are a few very good reasons for using an ASX-accredited advisor:

  1. Trade Selection. An advisor will typically contact his clients periodically with trade recommendations. The quality of these recommendations can of course vary, but an experienced advisor is likely to come up with much better ideas than an inexperienced beginner. From a learning perspective, this can give the client a few ideas to focus on.
  2. Execution. Advisors can assist with placing orders into the market, which can itself be a little complicated for new traders (particularly if a trade has multiple “legs” i.e. two or more options are being simultaneously traded). Advisors who know their stuff will be aware of the nuances involved in getting the best price. Advisors will require clear instructions from the client but from there they take responsibility for any errors.
  3. Monitoring. Advisers will monitor the trade and recommend the optimimum time to close it to book profits or manage losses. In addition they can advise the client on managing their trades around dividends or corporate actions.
There are of course a few disadvantages of using an advisor. The most obvious is cost. Keep in mind that brokerage on options is typically higher than for shares. Use of an advisor increases the cost further.

Go it alone

An alternative is to use an online broker. The primary advantage of using an online broker is cost savings.  These savings can ultimately lead to a better bottom line, enabling better market timing (cost effectively scaling and out of trades) as well better risk mangement by cost-effectively hedging using additional options trades or stock. Discount brokers can also potentially offer research, information and portfolio analytics (e.g. calculate the option “greeks” for a particular position).
Disadvantage is obvious. You’re on your own.

 

Friday, I’m in love with you

Relentless bad news

Right now, investors have to get used to a relentless torrent of bad news. One minute its weak Chinese data. The next its the possibility of the Greeks exiting the Euro. Or Spanish bond yields climbing over 6%. In the past few years we’ve really witnessed all kinds of trials … from tsunamis and volcanic ash clouds to debates over raising the US debt ceiling and talk over bailouts ….  The mood is definately subdued and financial press is continuously “glass half empty” (in Australia that is … watch US financial TV and you will find hopium is everywhere .. but that’s another story).

The Aussie market gets the wobbles

Most Aussie investors know that we take the lead from overseas – historically the US, but now also Europe and China. And for whatever reason, the worst news of all seems to be delivered over the weekend! So in a risk averse environment (now), Friday is often a dud day on the ASX as “the market” anticipates various weekend crises. Come Monday, the market can see a good “catch up” rally if the anticipated bad news doesn’t occur.

So I’ve turned my mind as how to profit from these situations using options. There are a couple of strategies. I’ll work through an example now.

Case study – BHP on Friday 18 May

On the Thursday 17th of May, the US market was weak, with the S&P 500 closing down 1.5%. Following this poor showing, and anticipating further carnage over the weekend, the ASX was down 2.7%. One of the worst stocks was BHP, which closed at $31.46 (- 4.0%).

The chart below shows BHP with the relevant data highligted. Click on the chart to open it in a new window.

The effect of this drop was that volatility increased significantly. The composite implied volatility for BHP rose from 30.3% to 36.5%. As can be seen from the chart below, volatility over 30% is relatively high (but certainly not unprecedented).

Suggested trade

In order to exploit this increase in implied volatility, one strategy is to sell a strangle. I chose to sell $35 call options and $26 put options for a combined credit of 54c per contract, excluding brokerage. Based on 50 contracts, this resulted in a credit of $2700 to my account, before brokerage and fees of $30. I required $17,000 available margin to do this strangle. The diagram below shows the payoff at expiry on 28 June 2012. More technically minded readers will note that the implied volatility for the put is 54% and for the call is 33%.

Summary of this trade

A credit of $2670 is received when initiating this trade. At expiry, the full credit is kept provided BHP remains within the range $26 to $35. So in essence when we initiate this trade we want two thing to happen:

  • Realised volatility to decline. Simplistically this means we want the stock to go “sideways”. Of course “sideways” is a relative thing … but as a rule of thumb if the stock ranged between $30.50 and $32.50 in the two weeks following the trade, that would be fine
  • Implied volatility to decline. If the market become less anxious, and the stock moves sideways or increases, implied volatility will usually decline. As an option seller this is good for us. Lower implied volatility means that the options will depreciate.

Trade mangement

This is not a “set and forget” trade. When we set out to do the trade, we had in mind a desire that the stock move sideways and implied volatility decline. If either of these things don’t happen we will have to take action. One thing we can do is buy back both the options and close the trade. One guide as to when to buy back the options is when either option doubles in value. So in this case we received 27c per option. A good guide is to consider corrective action when either option is over 54c.

Outcome

Its impossible to know what will happen to this trade, since it expires on 28 June 2012. However, one week later the results have been very good. Composite implied volatility has dropped from 36% to around 30%. BHP was relatively stable over the week, closing at $31.61 (+0.5%). As a result the spread has depreciated by about 60% to around 22c. We can book a profit of $1540 if we buy back the options. Or alternatively hold the position and hopefully accrue further gains.

Happy investing!

Ed

PS Option trades can involves losses. Please read the site disclaimer.