Options are nothing else but a choice. Recently, I received an e-mail from a student that took our Options Trader course at our Stamford, CT center. They were faced with a delicate dilemma. They had the choice of either trading options on an underlying that had come up to resistance, or simply shorting the physical underlying itself. I wish to share with the reading audience some insights about his trade.
Below is the actual e-mail that I had received from him:
Josip, I’m having a hard time with risk/reward. To have positions that would generate a worthwhile gain, you have to risk an amount that could wreck an account.
Ex: Feb 3 FLX entered a supply zone(14.67 to 14.90) and should retrace (14.35 at least)- Implied Volatility is in low 10%,
To BTO Apr 12 $16 put would cost $1.52 (1.32 intrinsic value & -.70 Delta)
With a rule to only risk 1% of my account, I would only be allowed 2 contracts. So, risking (1.52 x 2 =) 3.04 to make (.30 move @ .70 delta x 2=) less than .60, minus commissions.
That’s a risk 5 to make 1 ratio; doesn’t really seem worth the risk.
If I just shorted with stock – stop @ 14.90 – entry 14.70 – target 14.36 – that would be risk 1 to make 1.55 ratio.
Any insight would be great.
Jan options class Stamford, CN.
To recap what is in the above e-mail: The underlying is at resistance. The exact supply zone (SZ) extends from 14.67 to 14.90, which is about 20 cents. He is anticipating a short-term pull back due to the fact that this rally into the SZ would be the first retest and most likely also a failure to break out. Such a setup is one of the higher probability trades, technically speaking. He also states that the implied volatility (IV) is low which means that option traders should be considering buying premium. When the IV is low, premiums are underpriced, which is self-evident from his reference to the April 16 put which has intrinsic value of 1.32 and a total premium cost of 1.52. Since the Stamford trader has provided me with the intrinsic value at 1.32 of the April 16 put, we are easily able to decrypt where the underlying was at the time of writing his e-mail (16.00 – 1.32 = 14.68). The put that he has selected was based on the Delta value of 0.70 cents and his contract size (only 2 contracts) was properly done. Nevertheless, the fact that he expected a retracement to approximately 14.35 meant that the target was not attractive enough for the risk he would be taking on with this particular trade using the Apr 16 put. He calculated that his risk was five times the reward and concluded that he would have the better risk to reward (1:1.55) had he traded the underlying by simply shorting it.
My answer to him was a gentle reminder that in our Online Trading Academy Professional Trader class, we teach our students two simple rules: Do not trade stocks that are trading below $15 because the ATR (average true range) on such products is not very great and it would take a long time for the trader to make a significant profit on a 15-dollar underlying. Secondly, we discourage the students from an underlying that does not have ADV (average daily volume) of at least one million shares traded per session. Having said that, I have seen a lot of students trading the BAC (Bank of America) that is currently well below $15, so could it be that they are grocery-selecting from our Online Trading Academy rules? Out of all the USA tradable issues, is the underlying that he is addressing the best he could find? Open-ended question.
If the volume is greater than one million, could he compromise and take a trade with the physical underlying? Yes, very possible. However, as he concluded himself, trading it with options would not make sense from a risk management viewpoint.
In conclusion, when we are presented with a similar situation (the choice between trading put options on an underlying that has come up to resistance, or simply shorting the physical underlying itself), we can always take the choice of trading the physical underlying. Having options listed on an underlying does not mean anything else but that we, as traders, do have a choice to trade the underlying with options. Whether we choose to trade it with options or not, is ultimately up to us. However, be aware of the fact that by trading the underlying we do NOT have the very best and most optimum use of our capital. For either a long or short trade, brokers do permit the use of margin. Using options when possible, especially in spread trading, we have more optimum use of our capital. Nevertheless, in the case of directional option trading, our exits need to be based on the value of the physical underlying rather than on our premium value of options, which we can only guesstimate with our mathematical calculations. Have green trades and be aware which trades should and should not be taken with options.
– Josip Causic