Options and momentum

Don't get intimidated...

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It is not necessary to know about the Selling of options strategies or about words used in selling strategies like Butterfly, Strip, Ladder, Box, Condor, Collar, or Strangle.

In order to complete this training process, I have made a refresher course explaining options lingo in the recent previous posts. (Posts 14 to 20)

Any fx spot or futures trader will realize there is no need to get intimidated by the terms and strategy used for buying of options.

The only term you may find confusing is of SELLING.

A seller is a market maker or sort of an insurance company who is offering risk protection to a buyer against payment of premium.

In spot or futures trading, a trader having a bearish view sells in advance or goes short, so to say, to benefit from the price difference after the prices drop.

But in options trading, the trader who has a bearish view must BUY a put option from a seller who thinks the market will stay flat or bullish on the options expiry date.

What are the primary drivers of the option price?

1. Options contracts can be priced using mathematical models such as the Black-Scholes or Binomial pricing models. It is not necessary to go into the mechanics of price determination.
2. It is essential to know that an option's price is made up of two distinct parts: its intrinsic value and its time (extrinsic) value.
3. Intrinsic value is based on an option's in-the-moneyness and is relatively straightforward to compute.
4. Time value is based on the underlying asset's expected volatility (Implied Volatility) and time until the contract's expiration, It is quite complex to understand and predict its size. In times of stress, Implied Volatility acts as an unknown factor that we can't determine in advance.

Let's start with the primary drivers of the price of an option: current underlying asset price, intrinsic value, time to expiration or time value, and volatility. The current asset price is fairly obvious. The movement of the price of the asset up or down has a direct, although not equal, effect on the price of the option. As the price of the underlying asset rises, the more likely it is that the price of a call option will rise and the price of a put option will fall. If the asset price goes down, the reverse will most likely happen to the price of the calls and puts.

Intrinsic value is the value any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money. It is the portion of an option's price not lost due to the passage of time. The following equations can be used to calculate the intrinsic value of a call or put option:

The intrinsic value of an option reflects the effective financial advantage resulting from the immediate exercise of that option. Basically, it is an option's minimum value. Options trading at the money or out of the money, have no intrinsic value.

The time value (or, extrinsic value) of options is the amount by which the price of any option exceeds the intrinsic value. It is directly related to how much time an option has until it expires, as well as the volatility of the underlying asset. The more time an option has until it expires, the greater the chance it will end up in the money.

The time component of an option decays exponentially. The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose one-third of its value during the first half of its life and two-thirds during the second half of its life. The closer you get to expiration, the more of a move in the underlying asset is needed to impact the price of the option. Time value is often referred to as extrinsic value.

Time value is basically the risk premium or the speculation fee the option seller collects from the option buyer to provide the option buyer the right to buy/sell the underlying asset up to the date the option expires. It is like an insurance premium for the option; the higher the risk, the higher the cost to buy the option.

An option's time value is highly dependent on the volatility the market expects the asset to display up to expiration. For assets not expected to move much, the option's time value will be relatively low. The opposite is true for more volatile assets due primarily to the uncertainty of the price of the asset before the option expires.

The effect of volatility is mostly subjective and difficult to quantify. There are several calculators to help estimate volatility. Again several types of volatility exist, with implied and historical being the most noted. When investors look at volatility in the past, it is called either historical volatility or statistical volatility.

Historical volatility (HV) helps you determine the possible magnitude of future moves of the underlying stock. Statistically, two-thirds of all occurrences of asset price will happen within plus or minus one standard deviation of the underlying asset's move over a set time period. Historical volatility looks back in time to show how volatile the market has been. This helps options investors to determine which exercise price is most appropriate to choose for a particular strategy.

Implied volatility is what is implied by the current market prices and is used with theoretical models. It helps set the current price of an existing option and helps option players assess the potential of a trade. Implied volatility measures what options traders expect future volatility will be.

As such, implied volatility is an indicator of the current sentiment of the market. This sentiment will be reflected in the price of the options, helping traders assess the future volatility of the option and the asset-based on current option prices.

A 10-minute complete refresher course on buying of DAX index options requiring no understanding of Greeks, Formulas, or funny terms like butterfly, iron condor, or strangles

Options lingo: (10 terms)

Assets (futures or spot) are called the underlying.
The market or spot price is termed At the Money.
Your forecast price is Strike Price.

Options are termed as being in the money when the CALL price is below the market price while a PUT is considered in the money when its price is above the market price or Out of the money (OTM) when an option has no intrinsic value, only extrinsic value.
A call option is OTM if the underlying price is trading below the strike price of the call. A put option is OTM if the underlying's price is above the put's strike price.

If you wish to find which options are over-valued or under-valued, then an understanding of the following two terms is essential:
Out-of-the-money options have no intrinsic value. Only extrinsic value.
In-the-money options have both intrinsic and extrinsic values

Extrinsic value is the difference between the market price (also known as the premium) of an option and its intrinsic price.

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Skills required: Traders must have a definite view of the direction of the market price and some understanding of how volatile the market can become.
Time to bet: From Monday to Thursday in the week of the Monthly expiration of the option contracts.
Capital required: Euro 500.

This is going to be your maximum loss if your view on direction or volatility does not work out.
Secondary Stop Loss: You can choose to exit any time if you change your mind and sell back the option to the market taking a loss or by a pre-determined stop loss.

Essentially, you know what is going to be your maximum loss beforehand.

This helps to instill a good discipline in your trading, and you would not make changes based on your emotions or market swings.
This is especially good for beginners who may not be used to the volatility of markets, and need that sort of rigour to keep them consistent and on track.

In order to make sure, you trade in the last week of Monthly expiration where options premiums will be lower because of less time decay cost. Also, there will be far better chances of making gains from 20% t0 50% in just one day starting on the first day, Monday, of the week.

DAX is a volatile index and can be traded in Asian and European market hours. ODAX is the options symbol.

Let us say you have chosen the strike price of 15,700 while the current market price is also closer to 15,700.

If you think the price will
(a) go down in
(b) one day
buy Put at the At-the-money strike price of 15,700.

3 scenarios

1. If your view fails, you will lose time decay substantially. You will not lose entire money in a day because the options will expire 5 days later on Friday.

2. If your view wins and the market does drop but not substantially, you may not make any money in spite of your directional view being correct. In that case, you are free to take chance the next day or exit saving the capital for the next try.

3. If your view of a big drop prevails, and if the index drops by 100 pips, your profit will be at least 50 pips. Example If you have paid 100 pips for Index price of15,700 (assuming you bought a Put Option with this strike price), you will sell it back to the market at 150 pips. 50% profit in a day

4. Buying in the money options (as against at the money or out of the money) means you are speculating on two fronts

(a) On the direction of the index
(b) On an option being bought on a discount gaining more value as the futures price keeps dropping

If you buy Put at strike price of 15,750 (spot price is 15,700) that means you are expecting to get in future extra 50 pips by investing 25 pips if the Put price goes down and hits your strike price.

In other words, you are paying 25 pips extrinsic value for gaining 25 intrinsic value based on the market price of the underlying futures.

5. Buying a lottery ticket: If you think the price will crash to 15,300, (your strike or forecast price) you buy the Put option for about 25 pips at a 75% discount to the current market price of 100 pips premium. At the strike price of 15,300, the market has valued the probability of this price being touched at 10% (in options terminology it is called Delta) but the option sellers are not taking chance and expecting 25 pips (or 25%) to be paid for an option whose probability of hitting is 10% only. It is not cheap but if the trader has a strong view that the market will drop, the overvalued option will be bought.

If the index market price drops by 400 pips to 15,300, then the option will gain a big increase in premium value because the probability has jumped from 10% to 50% while there are 4 more days for the option to expire. You can expect to get paid 100 pips for an option bought at 25 pips - a net profit of 75 pips or 300% gain (trading costs are quite small if you use the Interactive Brokers platform and are ignored for calculation purposes).

Well-done Simnz. Surely, i'll follow.

I will conduct a 2-day challenge for 25% gain next Monday to Thursday when monthly DAX options are due for expiration on Friday, the 16th of July, and post results with a few pictures.

Why trade in the last week of Monthly option expiration?

The option-expiration week is a week before options expiration (Friday before each 3rd Saturday in each month).

The buyer does not have to pay high time value and so options are bought at a lower cost.

Exposure will be limited so greater chance of making or losing money quickly. Since the risk is capped, trader is able to observe the market with no fear pressure. It is conducive for developing a bias for direction or even finding overpriced or under-priced options.

As far as institutions are concerned, large-cap stocks with actively traded options (influencing the equity market index) tend to have substantially higher average weekly returns during these weeks.

A simple market timing strategy could be therefore constructed -> hold the largest stocks during the option-expiration weeks and stay in cash during the rest of the year.

Fundamental reason

Academic research suggests that intra-month weekly patterns in call-related activity contribute to patterns in weekly average equity returns.
Hedge rebalancing by option market makers in the largest stocks with the most actively traded options is the main reason for the returns of the stock.

During option-expiration weeks, a sizable reduction occurs in option-open interest (number of contracts) as the near-term options approach expiration and then expire.
A reduction in call-open interest should be associated with a reduction in the net long call position of market makers.
This implies a decrease in the short stock positions being held by market makers to hedge their long call holdings.

WHEN NOT TO BUY OPTIONS

If you are not clear whether it is for

1. Speculation in which case you can buy both Call and Put options
2. Acquisition of new assets at a cheaper price by selling put options (this is not speculation)
3. Hedging existing portfolio for insurance cover by buying options or get protection from the falling price by selling covered call or covered put (this is not speculation)
4. Lowering the cost of assets being held by buying Put options (this is not speculation)

When the intrinsic price of an asset is too high

Buy options, when the option price is well below the intrinsic value. Look for margin of safety, which means the option price must be lower than the intrinsic value and lower by a margin.

Risk of buying deep Out of the Money options

Buying deep out of the money options may deplete your capital if you buy them without any reason, treating it as a public lottery with no idea of any reasoning connected with the market prices. Don’t fall for the deep OTM option trap. They look cheap, but mostly that is what they are worth.

Is it a price play you are after or a volatility play or both?

Buying for a price play? For this, you need to check the intrinsic value of the option and the logic as to why you expect the price to go up sharply. Charts may give you an idea of demand and supply forces.

Volatility play is associated with major economic and surprise events. Options prices are driven by volatility caused, for example, by national budgets, and pandemics. Volatility trades require the knowledge of how VIX (also called Fear gauge) indexes work.

If you neglect the Breakeven consideration

Calculating breakeven is fairly simple. You have to include the amount of premium paid as well as the brokerage fee and taxes if any.

When OTM options are too close to the expiration date

Options are wasting assets. That means if you are holding an OTM option and even if the price does not move, the option premium keeps falling. This works to the benefit of a seller. If there is just one week to go for expiry, then you will find the OTM options lose 40-50% of their value on a daily basis. That is a lot of capital erosion in a short span of time.

When your view on direction or volatility requires overnight risk in the last week of options expiration

If you are not sure if the price will convincingly cross your targetted price, keep a very strict stop loss or better avoid overnight risk altogether.

Get ready to follow me by installing the Interactive Brokers mobile platform which is quite user-friendly.
You can find from Youtube a video on how to use Android or Ios mobile as well as another introduction of IBKR for small accounts.

I will use the free trial version of IBKR mobile.

IB promotes it as
Trade On-the-Go

Access over 135 markets worldwide right from the palm of your hand
Trade stocks, futures, options, futures options, forex, and more.

I conduct all my trades on IBKR. I have been a customer of IB since 2004. After IBKR mobile software matured, I don't use desktop TWD anymore.
I saw a good Youtube video on Interactive Brokers review for beginners with small accounts

Buying of Options demystified by using MT4 platform: a primer for smart investor

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I conduct my trades at IB platform but use the MT4 platform and choose Dax index CFDs for analysis. There is no standardization as to naming convention or labeling digits for CFD symbols.

CFD could as well be used for replicating buying of futures options for demo trading. That is what I do for analysis.

Initially, you can treat your MT4 platform with DAX 30 index as a CFD symbol.

CFDs are also a kind of derivatives (though not permitted by the exchanges for hooking up with them to allow transactions) because they are derived from the underlying instruments. They are like the mirror image of the real assets traded in different financial markets, and there is no delivery of physical goods or securities with CFDs.

CFDs are cash-settled but allowed to use margin trading so that investors need only put up a small number of funds to trade CFDs in a bigger volume of transactions. CFDs essentially allow investors to trade short-term available for both Long and Short positions and are especially popular in forex and commodities products.

CFDs fall into the category of instruments with unlimited loss and unlimited profit and need active risk management.

None of the CFD brokers offers any product as CME or Eurex exchanges offer. Limited risk and Unlimited profit.

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Calculation of leverage offered by Eurex .

Index value calculation : (last close) 15700 @ Eur 5 = Contract value of Eur 78,500.

Option purchase: If you buy a CALL option with a strike price of 15750 you are buying an option which is out of money having ZERO intrinsic value but the market is willing to buy taking it as buying on the discount opportunity for say 25 pips the buyer is paying for the hopeful view 25 pips @5 = premium Eur 125.
So the exchange is giving you the leverage of Eur 125/Eur 78500 = 628%. If I am able to find an OTM option that I can buy for 1 pip or Eur 5, leverage is 3140%, the starting point of leverage. The leverage goes down at the rate of Eur 5 per pip. If the purchase price of an option is 10 pips then the leverage is 314%.

By using the MT4 platform, you will realize there is no difference between trading on the spot market or options market.
The major difference is the options will have no intrinsic value when the price on expiration is below the strike price selected for betting.

Since we are doing demo trading, MT4 CFD as well can be used for learning options buying.
I am giving clues for the highly motivated traders to find indicators that are available at FF.
Hand-holding service is not provided.

Options Buying logic is:

1. Buy call or put if you have a view on the directional move.

I buy only when I feel the market is going to move more than its daily or H4 average. It could be a bullish or bearish view.

I will factor it like it may move by 1.5 times more than the daily ATR or ADR value and use an ADR or ATR indicator that has a factor, coefficient, or multiplier input for forecasting and printing horizontal lines on the chart.

Range runovers and subsequent reversions to normal ranges is what we want to make profit from. Buy Put when the range runover exceeds by 50% than usual and then liquidate when the range settles down to 100% or less. Buy Call when the range overshoots the bottom or Support levels and liquidate when the pullback happens.

XplosinKibo has coded an indicator that uses Moving Average to forecast range overruns rather than the price factor.



2. Before you develop a bias for direction, would you like to take a look at historic volatility. The option is a play on volatility as well.

Jeanlouie has coded this volatility indicator to get a look at historic values.

Preparing for tomorrow options buying

DAX LACKS Momentum as well as volatility, so can't buy options.

The difference between Calls (Blue color) sold/bought as shown by Open Interest, to be treated as Resistance
and Puts (Red Color) to be treated as Support are just not moving.

No sign yet of momentum or volatility.
Can try to buy Put when the options market opens two hour later if you feel the market will go down violently.
If don't have any view, don't attempt.

HK futures index options for a buying spin
dropped DAX 30 for lack of volatility

I have given up the idea of trading DAX 30 for buying of options. Not conducive for buying of options.
Instead, I just spotted the HSI Hong Kong futures index and have bought a PUT option for July 16 expiry (tomorrow) for 150 pips.
Which means I must make more than 150 pips to make a profit.
Anything less than 150 pips is lost even if the price does not move much. Because of 1 day left to expiration, time decay will be maximum. Option buying is like buying fresh vegetables. Limited life span.

Analysis done on MT4 chart to know the volatility mainly. As well as take a bet on the index falling. For volatility assessment I simply use Candle range speed and volume. Volume is low. So I am anticipating the market may fall by the end of the lunch hour (after 2 hours) or by the end of the day.
Global markets seem to be in a moods to take profit after so many All-Time High records have been broken.
How can HK market go against the world trend? I am asking myself.

DAX 30 battlelines redrawn...

If you take a look at the picture, both call and put sellers are expecting fireworks today.
And so they changed their tactical positions.

Waiting for German cash market to open...

Today the challenge fizzled out as DAX volatility has died down

Still made 13.5% instead of 25% by changing to Hong Kong Index options


The probability of HSI going down is evident..
Put Price is gaining value. Actually, the picture I uploaded previously was for another option. That put option was bought as insurance again Bears attacking my position. It was not for speculation as such.

But the position bought today was for pure speculation.
A Put with strike price of 28,000 was bought at 44 pips premium. and sold at 50 . Because the index is not moving and time decay will hurt the position, I have exited.
6 pips profit for 44 pips investment works out to be 13.5% profit in less than 5 hours trading with very low stress, no fear of stop loss etc.

Any time is a good time to liquidate because of the shadow of time-decay hovering over the 1- day position all time. It is not required to have any goal post. Take profit and quit. Don't get greedy.

Dear Sir,

You are the only one telling the truth here and I thank you. And thank you also for your very comprehensive study that all traders should read before embarking on the forex and cfd markets, which I think has been made available to everyone on purpose to ruin the people who would enter it.
Thanks a lot and have a good day. Best wishes.