Sheridan Options Mentoring Blog

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The Complexities of Simple Posted: 29 Nov 2011 07:53 AM PST For those who are regular readers, I want to call your attention to a topic that is notable for its absence in my musings of the view from an option trader's desk. A quick perusal of recent topics of discussion reveals a number of beasts such as condors and butterflies, but not a trace of the elusive single legged long option can be found swimming in our blog stream. The seemingly basic maneuver of simply buying a put or call as a single trade position is rarely discussed. Is it that option traders are by nature attracted to complexity or is there a fundamental reason this simple single legged strategy is not the topic of more discussion? The answer to this basic question brings us back to the fundamental reason for trading options. We live in an uncertain world; our task as knowledgeable option traders is to construct and select trades with the highest probability of success within an acceptable risk/reward environment. The purchase of a put or call is rarely the highest probability trade available. The reasons are several and include the inevitability of time decay of premium and the exposure to changes in implied volatility. The current market conditions are particularly difficult for traders using the simple "long premium" strategy. Implied volatility is currently in its highest quartile for most issues. As a result of this elevated implied volatility, option time premium is rich. This has the result of making the usual headwind of theta decay even stronger. In addition, the strong tendency of volatility to revert to its historic mean leaves the trader at significant risk of collapsing time premium for which he has so richly paid. Consider the real world situation of the trader who chooses simply to buy options ahead of what he predicts to be the increase in price of AMZN. During the current month of November, AMZN has traded down from prices above $220 to its current price of $182.57. As a result, the implied volatility of the current front month call, the December 185 strike, is 49.9% and can be bought for $9.90. The trader buying a 10 lot position expecting AMZN to trade higher during the remaining 21 days of life of this contract, has encountered some brisk headwinds. He is exposed not only to the current daily premium decay of $206.48 but is also negatively impacted by the ever-increasing decay rate as expiration approaches. In addition to reliably predictable factor of time decay, the value of the options will almost certainly be reduced by decreases in implied volatility if the trader's price hypothesis proves to be correct. Implied volatility is virtually always negatively correlated with price movement. If volatility were to contract from current levels, and it is important to understand that this would be the expected reaction to an increase in the price of AMZN, and return to the recent mean level of 43%, the option would lose $1.40 as a result of this factor alone. As a general rule, simple is almost always better than complex. In option trading what appears to be the simplest trade, buying a put or a call, rarely results in the best risk/reward ratio.

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