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Let's Look at the Mail
I've been writing these options articles since November of last year and there have been lots of comments and questions. I've been responding individually to most of the questions, but recently a reader asked if I could share some of the questions I get. It seems to make sense, so every once in a while, I'll devote an article to responding to some of the mailbag. I will however, assert writer's privilege and will audit the questions for brevity and clarity.
Q) I really like the concept of options trading, but I have very little money and would rather pool it and let a pro manage it. What do you think?
A) Several points come to mind. Let's take it as a given that nobody cares about your money as much as you do (okay, maybe spouses do.) If you think the pros can do a better job than you can, ask an Online Trading Academy instructor how many professional money managers beat the indexes. The answer should cause a change of heart. So I would not be so inclined to turn my money over to someone else.
I would suggest that you learn as much as you can about options trading from books, CDs and from classes here at Online Trading Academy. Once you feel a little more comfortable about options trading, you may want to paper trade and then start trading small positions. Of course, only risk capital that you can afford to lose should be traded when you first start out.
Q) Would you please tell me the difference between buying a Call and selling a Put? If the stock goes up in value then the Call goes up and the Put you sold should go up as also. Am I missing something?
A) Both the purchase of a Call and sale of a Put are bullish positions, i.e. we want the stock
to go up. However, their characteristics are very different. A Call is a VERY bullish
position, whereas the sale of a Put (short Put) is a neutral to mildly bullish position. The Call
has unlimited potential gain and a maximum known loss; what you paid for it. The short
Put has a limited gain and a very large loss potential. For example, if XYZ stock is trading at $50, let's compare what happens at expiration if we buy a Call versus selling a Put:
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XYZ Stock at expiration is: |
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$30 |
$40 |
$50 |
$60 |
$70 |
if we buy the $50 Call for $4, then we |
lose $4 |
lose $4 |
lose $4 |
gain $6 |
gain $16 |
if we sell the $50 Put for $3, then we |
lose $17 |
lose $7 |
gain $3 |
gain $3 |
gain $3 |
Notice with the Call we can't lose more than what we paid ($4) but our gain is unlimited,
imagine if stock goes to $500, (we can dream.) On the other hand, with the short Put the most we can make is what we sold it for ($3), no matter how high the stock goes. We can lose a
significant amount, up to $47, if the stock declines in value.
Q) Do you believe that options can successfully be day-traded, e.g., if one uses the most volatile stocks like RIMM, SPWR, AAPL as their universe? If one expected a quick move in a stock what option would you purchase? Would the DELTA be the major ingredient to watch?
A) The quick answer to your question is that, in my opinion, it is very difficult to day
trade options successfully on a consistent basis. That being said, I'm sure there are
traders who do it, and in fact, there is a book by DeMark and DeMark entitled "DeMark on
Day Trading Options." (I am not recommending it, merely making you aware that it's available.)
If you do decide to day trade, you probably want to use ITM options. The general rule being that the shorter the time frame, the higher delta options you should use. Trying to use OTM options is a recipe for disaster, in my opinion, although you will hit some occasional home runs.
My bottom line is that if you are going to day trade, learn how to do it correctly at the Online Trading Academy, and do it with stocks and ETF's, etc., not options.
Q) With regards to Put/Call parity, if there is a material difference between the Call and Put quotes, how do you know which one is correct?
A) The short answer is that you don't, you just know that one option is priced lower in relation to the other option. When you find a situation like this you may be able to lock in some profit. If the Call is underpriced relative to the Put, buy the Call, sell the Put and short the stock (this position is called a reversal.) Conversely, if the Call is overpriced relative to the Put, sell the Call, buy the Put and buy the stock (this position is called a conversion.) These positions have been described previously in my articles. An alternative way of extracting profit from this type of mis-pricing uses a technique I haven't described yet; delta neutral trading. Don't worry, it's coming!
Q) I have a question, suppose I want to buy a Call that is quoted $5.80 bid, offered at $6.00 but I see that the theoretical price is $5.50. At what price will I get filled?
A) If you want to get filled immediately, you would enter a market order and probably get filled at $6.00. If you didn't need an immediate fill, you could bid less than $6.00, but you may not get filled at all. If you bid $5.50, your estimate of theoretical value, you probably wouldn't get filled (assuming the stock price doesn't change.) In fact, your bid would probably not even be seen by the market since there are bidders at a higher price; $5.80. In this situation, if you were convinced of the validity of the theoretical value, you may want to consider selling the Call since you know you can sell it for at least $5.80, .30 more than theoretical value.
Q) Concerning your second probability question, I don't care whether it is your first or second child that is a boy (It is given that at least one is), the probability of the remaining child being a girl is 50/50! Your presented answer of 66 2/3% is simply wrong.
A) Here is the exact question restated:
“A man states that he has 2 children at least one of which is a boy. What is the probability that he has a girl?”
Sorry you disagree, but the math is on my side! There are 4 possible ways that a man can have 2 kids; Boy-Boy, Boy-Girl, Girl-Boy, and Girl-Girl. Each is equally likely with a probability of 25%. I'm told that at least one is a boy, so that eliminates Girl-Girl as a possibility. Of the 3 remaining possible outcomes, 2 of them have a girl, so the correct probability is 2/3, or 66 2/3%. Alternatively, the mathematicians out there can use Bayes Theorem to get the identical result. If you're still not convinced, I'd like to start trading options with you. :-)
Okay, so now that you see what your friends, neighbors and other options traders are asking, feel free to do the same. I'll continue to try and answer your questions individually, but don't be surprised if your question shows up in a future article!
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!