We get it. After you have tried forex. After you have tried futures. After you have tried ETFs and simply find them too boring. After your account has dwindled down to a minimum level and when the percentage return you need to see just to get back to break even seems too large, options are where you land.
This is a two part blog. This week we’re going to define options and the parameters traders need to consider before trading them. Next week, we’ll dive into the math behind options. You may need whiskey at some point.
First, what is an option? Let’s keep this very simple.
An option is a contract to buy or sell a market at a pre-determined price by a certain date (direction and duration). There are call options which the buyer purchases anticipating a bullish trend… and there are put options which ideally profit during bearish trends. These options come with risk limited to the “premium” (price paid for the option) and unlimited profit potential (to the moon).
Aanndd… that’s where the simplicity comes to an end.
For every buyer of an option (whether it be a call or a put), there must be a seller of the option. When you go long by purchasing a call, someone on the other side thinks you’re wrong (you likely are). They have to sell that call option to you which is referred to as “writing a call.” Unlike purchasing options mentioned above, writing an option comes with unlimited risk and limited, pre defined, profit potential. This is called being “naked.” Accounts that write options often come with significantly higher minimum requirements and restrictions imposed by a broker. More than 99% of all option writing is done by institutions… the big boys.
To complicate things even more, one can be bullish not by just buying a call or writing a put… but options strategies can also be created with a covered strategy, a straddle, a strangle, a spread, a butterfly, a collar, or a married option. These strategies can be used to mitigate risk, elongate the curve and pre define the specific scenario in which you win or lose. They can also overcomplicate a situation where you already have virtually no chance of profiting.
It’s enough to make your head spin. And don’t even get us started on binary options. You might as well just hand your money to someone else when trading those.
To make matters even worse… there are the Greeks. Beta, Delta, Gamma, Theta and Vega. Time decay, interest rate sensitivity, volatility, hedge ratio, rate of change (and the rate of change of the rate of change… something we use a lot), and a frightening amount of math.
Options are complicated. They require a long history of education and understanding. They demand an enormous amount of math (and physics in some cases). And they are not for you if you see them your salvation or return to glory.
But… (and that’s a big But), with all of that said… options trading can be for you if you have the time and patience to understand the peeks and pitfalls. Options trading can be for you if you have a strategy… a systematic and unemotional one that predefines when and if you go long and for how long (direction and duration). Options trading is realistic as long as you don’t see it as a lottery ticket or a way to dig yourself out of a hole.
Next week, we’ll get into the math and physics behind options pricing. More of the Greeks, some Black-Scholes and even some of the links to Gauge theory.
Want to learn more about how math and physics can improve your trading (even with options)? Take a more analytical look at the markets and remove the emotion… and misperceptions that run infectiously through the minds of most traders. Fill in the form on our home page and a member of our team would be happy to give you a call or engage via email.