Tag: Traders Toolbox

Traders Toolbox: Money Management - Part 1 of 4

Posted on by lindsay

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.
Plenty of books, manuals, and software packages will help you form and opinion of a market, but not many will tell you how to trade once you have decided to get long or short. The goal of money management is to increase the odds of high quality trades. And as we'll see, leaving the money management variable out of your trading equation can lead to ruin, even if you're correct about the market direction.


In a broad sense, money management can encompass those elements of trading outside the initial decision to get long or short in a given market or markets – that is, how many positions to put on, when to get out, where to place protective stops. More specifically, it refers to the strategic allocation of capital to limit risk and optimize trading performance in the long run. Allocation of capital can refer to how much money to put into any one market or how much money to risk on any one trade. These decision directly affect how many positions to put on and where to place stop orders.
Given the negative odds inherent in trading (a successful trader can expect to lose money on 60% of his trades), how do you go about maximizing the profit potential of the few winning trades you can expect to have? The answers vary with the disposition and trading style of the individual trader. There exist, however, basic concepts that can be successfully adapted and modified to individual needs, and when the followed in spirit, can boost the promise of long-term trading profits and take some of the stress and uncertainty out of trading.
-Establish A Goal- Having a clear idea of what you want to accomplish by trading, whether it is a short-term profit on a single trade or the desire for a long-term trading career, can go a long way toward building successful trading habits. Regardless of whether or not the goals are set on a per trade, daily or long-term basis, establishing from the outset basic levels of acceptable risk and financial reward will help curtail avoidable risk and extreme losses. Also, determine a specific time frame in which to trade: Will a position have to be liquidated by a certain time for tax purposes or for same other reason?

-Diversification- Just as in the stock market, a portfolio of different instruments can be one of the best hedges against several and unsustainable losses; a loss in one market will hopefully be offset by gains in others. Traders must take caution, though, to truly diversify their portfolios with contracts that are price independent. Spreading your trading among three or four different interest rate contracts that move in a similar fashion is not a good example of diversification, because a loss in one contract is likely to be mirrored by losses in the others. But over-diversification is dangerous, too. A trader can spread his money over too many markets, and not have enough capital in any one of them to weather even small adverse price swings.
A good rule of thumb is to stick with what you are comfortable; do not venture blindly into unknown markets just for the sake of diversification. A balance must be stuck between available resources and a manageable trading scenario. Capital constraints will, of course limit the choices traders can make, forcing those with smaller trading accounts to bypass or minimize diversification.

Traders Toolbox: Learning Options Part 4 of 4

Posted on by lindsay

In real estate, they say that the three most important things are location, location, and location. In options, the three most important things are volatility, volatility, and volatility. Often neglected by option rookies, volatility is the cornerstone of an option professional's trading strategy.
In its simplest form, expressed as the annualized percentage of the standard deviation, volatility measures how far a contract can be expected to swing from a mean price. A contract trading at 50 would have a volatility of 10% if it traded between 45 and 55 over a given period of time.

Historical volatility is just that: the volatility calculated (using closing prices) over a given period – 20 days, 20 weeks, one year, etc. Implied volatility is the volatility using current market prices. For example, using four primary option pricing inputs – futures price, settlement price, time until expiration and volatility – would result in a theoretical price.
By plugging in the current option price in place of the theoretical price and working backward, it would be possible to determine the volatility the current market is implying. (It is not mathematically possible to work backward and solve for implied volatility using an equation like the Black-Scholes model, but an approximation can be derived.)

Options on quick-moving, highly volatility contracts will demand a higher premium because of the increased possibility of such options being in-the-money. For example, an out-of-the-money option on a slow, non-volatile contract will have a lower premium than a comparable option on a volatile contact because there is a greater chance the volatile contract will shirt in price enough to put the currently out-of-the-money option in-the-money.

Astute options traders look at volatility figures to evaluate the potential of a trade, buying or selling options when volatility is exceptionally high or low. If a market is trading at historically low volatility levels, options premiums could be expected to rise as market volatility increases, presenting a buy opportunity. The revers is true for high volatility situations.

Traders Toolbox: Learning Options Part 3 of 4

Posted on by lindsay

Two of the more common option strategies are horizontal spreads (identical strike prices, different expiration days) and vertical spreads (different strike prices, same expiration day). Other spread types are combinations or variations of these categories: Diagonal spreads are a mixture of horizontal and vertical spreads; butterfly spreads combine two different vertical spreads.

Selling a March 450 S&P call and buying a June 450 S&P call is an example of a horizontal spread, also known as a time, or calendar spread. The object is to profit from the quicker decay of time value of the nearby short option compared to the more distant long option. The trader is, in effect, selling time value. Most time decay occurs in the last three months, and especially the last month, of the contract. This strategy is generally most profitable with equity options than with future options.

If you sell the March option at 7.75 and buy the June option at 11.75, you establish the calendar spread at a 4.00 debit. (Debit spreads are spreads that the trader pays to establish, while in credit spreads the trader collects premium). The March contract then drops to 1.25, while the June option drops to only 10.50. You could then “lift” (offset) the spread, buying the March back at a 6.50 profit and selling the June for a 1.25 loss, for a total profit of 1.25 (5.25 minus the 4.00 paid to establish the spread).

In a vertical spread, the options share the same expiration date but have different strike prices. An example would be buying a March 445 S&P call at 6.50 and selling a March 455 S&P call at 3.00 with the futures at 450.00, for a 3.50 debit on the spread.
In the market rallies, the deeper in-the-money long option would gain more than the short option would lose. If the futures are unchanged at expiration, the 445 call will be worth 5.00 (its intrinsic value) and the 455 call will expire worthless, for a 1.50 profit on the trade. Once the futures price rises above the higher strike, against on the lower strike are offset by losses on the higher strike, so profit is limited. If the market falls, loss is limited to the amount paid for the spread.
Option spreads are characterized as bear or bull strategies depending on whether they will profit in up or down markets. The previous example is a bull call spread, because it would make more money in a rising market. A bear call spread would consist of selling the lower strike option and buying the higher strike option.
Bull and bear spreads also can be established using put options. For example, a bull put spread would consist of buying a December 445 S&P put and selling a December 445 put. Selling the 445 put and buying the 445 put would be a bear put spread. Generally, you should use calls for bull spreads and puts for bear spreads.
You can alter spreads by modifying the number of options, for instance establishing a vertical bull call spread with two short calls for every long call, also known as a ratio spread. Whether all or some of the options in a spread are in-, at- or out-of-the-money also will affect the risk/reward profile of a spread.
Other strategies focus on the magnitude of price movement rather than direction. Straddles and strangles are two strategies traders use to take advantage of volatility swings. A straddle consists of buying at-the-money puts and calls with the same strike price and expiration day, for example, buying a June 100 bond call and a June 100 bond put. The straddle buyer expects a futures price move large enough (in either direction) that they profit on the in-the-money option will be more than the cost of putting on the spread. If you thought the market would remain virtually unchanged, you could sell the straddle (at a credit) and reap the profits as time eroded its value.

A strangle consists of combining out-of-the-money call and puts. With June bonds at 102, a strangle buyer might purchase a June 104 call and a June 100 put, again expecting a sizable move in either direction. (An advantage to this strategy is it is cheaper than a straddle, but the market also has to move more to make it profitable.) For a trader who expects bond prices to stay between 100 and 104, however, selling this straddle offers an excellent opportunity to “sell volatility.” If the market does stay between these prices, the seller will keep his premium.
Traders should be away that because of higher commissions and increase slippage, a marginally profitable options trade can actually be a loser when all is said and done. Understanding volatility and time decay concepts will help identify strategies with the highest probability of success.

Part 4 Will Be Posted On November 17th, 2008. So come back soon!

Traders Toolbox: Learning Options Part 2 of 4

Posted on by lindsay

Many people like options because they believe them to be less risky than futures. Options sometimes offer reduced risk, but usually at the cost of reduced profit potential.

One drawback of options is that a trader must consider market speed (volatility) as well as direction. Traders who buy or sell options outright to profit from up or down moves in the underlying market can find themselves fighting an uphill battle against volatility and time decay. With futures, if you're right about market direction, you'll win. With options, you can be right about the market and still lose.

If a market is trading at 200 and you buy a 210 call expecting a rally, you'll still lose on the trade if the market only rallies to 205 by expiration; your 210 call will be worthless. The same thing would happen even if the market rises as high as 220, but does so one week after expiration. In each case you would be right about market direction but would not profit.

The advantage of options is their flexibility. Because of the variety of strike prices and expiration dates a trader can choose, options naturally lend themselves to spreading strategies (simultaneously buying an selling different options), accommodating varying views of market direction and risk levels. Traders can design option strategies that will profit if the underlying market goes up or down, moves in either direction by a certain degree or remains unchanged.

Options also allow you to profit without predicting market direction because of time decay and fluctuation in volatility that increase and decrease premium. For example, a trader might sell as out-of-the-money call on a relatively volatile futures contract he thinks will fall. Over then next two months, however, the market does not fall, but gradually moves higher, trading in a narrow range (but still below his strike price). The trader was wrong about market direction, but finds the combination of decreased volatility and time decay has eroded the value of his option to the point that he can buy it back at a profit (or perhaps hold it until expiration).

Part 3 Will Be Posted On November 14th, 2008. So come back soon!

Traders Toolbox: Learning Options Part 1 of 4

Posted on by lindsay

There are four components to an options price: underlying contract price, intrinsic value ( determined by strike price), time value (time remaining until expiration) and volatility. (A fifth element, interest rates, also can affect option prices, but for our purposes is unimportant.)

Intrinsic value refers to the amount an option is in-the-money. With Eurodollar futures at 95.55, a 95.00 call has an intrinsic value of .55. The more an option is in the money, the greater its intrinsic value. At-the-money and out-of-the-money options have no intrinsic value.

Options are referred to as "wasting" assets because their value decreases over time until it reaches zero at expiration, a process called time decay. Time value refers to the part of an option's price that reflects the time left until expiration. The more distance an option's expiration date, the greater the premium because of the uncertainty of projecting prices further into the future.

Considering two equivalent call options. With May corn futures at 232 1/4, July corn futures at 236 1/4 and 10 days left until May corn options expire, a May 230 call might cost 2 3/8 while a July 234 call costs 6 1/2, even though they are equally in-the-money.

Volatility, perhaps the most important and most widely ignored aspect of options, refers tot he range and rate of price movement of the underlying contract. The "choppier" the market, the higher the price that will be paid for this unstability in the form of higher option premiums.

Volatility usually is expressed as a percentage, and is comparable to the standard deviation of a contract. Higher volatility means higher premiums. Lower volatility means lower premiums. A trader familiar with the volatility history of a contract can gauge whether volatility at a given time is relatively high or low, and can profit from fluctuations in volatility that will in turn increase or decrease option premium.

The Black-Scholes price model, first introduced by Fischer Black and Myron Scholes in 1973, is the most popular theoretical options pricing model largely because it was the first relatively straightforward arithmetic method for determining a fair value for options.

Part 2 Will Be Posted On November 10th, 2008. So come back soon!