Real Options Trading – The Adventure Begins

In this article the author gives an example of how to put together all the information learnt in the past articles Covered Calls – Part 1 and Covered Calls – Part 2.

It’s time to put it all together ? all the stuff you’ve learned to this point. We’re going to go through the process of selecting a position ? without adult supervision. We’re going to make believe we have an opinion about the direction the market is going. What is this opinion based on? It came via a fortune cookie from last night’s Chinese carryout. First it gave you next Saturday night’s lottery numbers. Then, it told you that EBAY was going up eight points in the next month.

Wow! What a tip! However, you look at a chart of EBAY and see that it’s trading near its 52-week low ? about $26. But who are you to argue with a fortune cookie? Plus, some bald guy in a 3-piece suit on CNBC said something about EBAY possibly making a bottom at this level. Gee, how much proof do you need? Let’s take some of your hard earned money and put it to work. It’s time to roll the dice.

Look at the above chart of EBAY. There are a few resistance levels to recognize. The 20-day moving average (red line) is at about $27.80. Then, the 50-day moving average (green line) and a consolidation are right above the $30 level. Finally, there is another consolidation at the $34 level. Those are the obstacles EBAY faces on the way up.
Three (or more) resistance levels aren’t enough to dissuade us from the trade ? seeing as how our sources are so credible. Hey, it’s almost a sure thing. Let’s look at an option chain and see how we’re going to play this move.

With EBAY at $25.93, let’s look at the August $25 call. It would cost $2.40. As you learned before, the option price consists of two components ? intrinsic value and time value. Since EBAY is trading at $25.93, and is in-the-money, that means that the intrinsic value is $.93 and the remaining $1.47 is time value.

Now, let’s check the delta, knowing the delta is an important factor in the decision making process. We know that the delta of an option that is at-the-money is usually about 50%. But EBAY, at $25.93, is in-the-money. Therefore, the delta should be higher. Check the EBAY chain above for the delta of the $25 call. The red arrow tells us that the delta is 64.3%. For the next dollar that EBAY goes up, the price of the option will likely go up about 64-cents.

What is the breakeven point at expiration for the $25 call? Do the math. It’s the cost of the option ($2.40) plus the strike price ($25) = $27.40. That’s where EBAY needs to be, at expiration, for you to be even. Remember, though, you don’t have to hold an option to expiration. You are free to sell it at anytime.

For the $25 call our entire risk would be the cost of the option — $2.40 ($240 per contract). That’s where leverage comes in. We’re actually controlling a $26 asset with only $2.40. That’s the lure for the speculative trader.

What if you chose the $27.50 call instead? Look at the numbers. Is it in-the-money, at-the-money, or out-of-the-money? With EBAY at $25.93, the $27.50 call is out-of-the-money, but it costs only $1.15 ? the risk is less than half of the $25 call.

The delta is (see the blue arrow) only 38.9%. We won’t be participating as rapidly as EBAY rises. The breakeven point for the $27.50 option is less — $28.65 ($1.15 + $27.50).

Which option will you choose? It depends on how strong of a move you think EBAY will make and how much money you want to risk on the trade. If you trade 10 contracts, you’re not locked into trading all at one strike price. You can always buy five of the $25 calls and another five of the $27.50 calls. Too many traders believe that trading options is an all-or-nothing proposition. Your money management skills will have a huge bearing on your bottom line.

Exit Strategies
Well, now that you’ve made your option choice, what is your exit strategy? You shouldn’t enter a trade unless you know when you’re going to get out. Look at the chart again. See the resistance at the $30 level. There’s a good chance that EBAY will not make it through that resistance. So, consider exiting your trade when EBAY gets to about $30. You’ll have a nice profit since, to get to $30, EBAY will have to move up over $4.

If you want to throw caution to the wind, you can consider taking some money off the table and letting the rest ride. It’s a rare occasion indeed that you will buy at the exact bottom of a formation and sell at the top. Don’t be greedy. Be content to take a nice chunk out of the middle and be happy you didn’t lose money. Remember the saying about how, in the market, pigs get slaughtered. You don’t want to be a financial ham sandwich, do you?

If you traded 10 contracts, perhaps lock in the profit on five contracts and hold the other five to see if EBAY makes it through the $30 resistance level. There are no hard-and-fast rules about exits. Just use common sense.

Now, you’ve come up with an exit plan if EBAY somehow moves up. But, you’re not done yet. What if EBAY goes down? Yes, as implausible as it may seem, the fortune cookie and bald guy could be wrong. You have to know where you are going to exit the position.

Look at the chart. You will see that there seems to be a little support at the $25.50 level. You want to preserve your trading capital, so it might be wise to establish an exit point at $25. If you don’t have the self discipline to get out, you can accomplish the same thing by putting in a "stop loss" order ? and the broker will do the dirty work for you. In an upcoming column we’ll discuss the different kinds of "stop loss" orders and their positives and negatives.

So, we’ve gone through the thought process of selecting, and placing, a trade. There’s more to it than we’ve discussed above ? more technical indicators, etc. Keep in mind that when you’re trading options, especially using speculative strategies, that you’re trading against market makers ? arguably the best traders in the world. The more thought you give the trade, the better your chances for success.

If you’re not ready for trading the real green stuff, this is an excellent exercise for you to use on your broker’s virtual trading platform on simple paper trading on your own.

Mike Parnos has "been there and done that" – plenty! Known as "OTA's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."

Mike Parnos has "been there and done that" – plenty! Known as "OTA's Options Therapist," Mike has been trading, consulting and te...