Monthly Archives: June 2012

Option Trading Strategy Bias

Strategy Bias

One of the keys to success in trading options or in using options to enhance return on a portfolio is have some flexibility in your strategy selection so you can adapt to rapidly changing market conditions. I have talked with many traders over the years that have a strategy bias and they get good results for awhile only to eventually experience a period where they have heavy losses and have a substantial drawdown of capital.

What strategy bias means is that is that the trader will learn one strategy and use it on a regular basis regardless of market conditions. A strategy like the iron condor is a good example. People learn about the iron condor, understand that it can have a high probability of success, but may not have much experience with dynamic delta hedging and learn the hard way that iron condors also have a poor risk/reward ratio.

The market goes through cycles knows as “regime changes” where the market moves from a period of relative quiet, through a period of high volatility. Iron condor traders can have losses when the market moves from low volatility to high volatility. In 2008 when the volatility spiked to extreme levels iron condor positions would have hit their maximum loss.

If you are forecasting rising volatility, you’d want to consider trade like a long straddle. Long straddles can be effective when there is a know event approaching that could move the market. On Thursday May 31st the SPY closed at $131.47. The monthly jobs report was released pre-market on Friday June 1st and the SPY opened at $129.41 and hit a low of $128.16. A long straddle bought before the close on Thursday could have produced some nice profits and we knew the jobs report was coming. An iron condor held through that would have had an adverse movement.

To be successful over time, master several different strategies and learn how to employ them in changing market conditions.

Put Call Parity

The term put call parity is an important concept for options traders to understand. What it means is that the price of a put option and the price of a call option are such that no risk free arbitrage opportunity exists to create profitable conversions or reversals. A conversion consists of a long put, long stock and a short call, while a reversal, or reverse conversion is the exact opposite, short stock, short put and a long call. The formula for put- call parity is as follows.

C (t)-P (t) = S (t)- K x B (t, T)

C (t) is the value of the call at time t

P (t) is the put value at time t

S (t) is the stock price

K is the strike price

B (t, T) is the value of a bond that matures at time T

The math is very simple and the concept is important for traders to understand. The reality of the market place is such that you won’t be able to find profitable conversions and reversals, because the arbitrage opportunities don’t exist, if they do they quickly disappear.

An alternative way to express it is;

C -P = S – X + i – d

Where;

C = The call premium

S = The Stock Price

i = Cost of Carry = X x R x T (years)

P = The Put Premium

X = The Exercise Price

d = The Present Value of Dividends

For traders looking at live market quotes it is simple to evaluate the three -sided relationship between the price of a call, a put and its underlying contract. Any one contract can be expressed in terms of the value of the other two, so;

Underlying Price = Call Price – Put Price + Exercise Price

Call Price = Underlying Price + Put Price – Exercise Price

Put Price = Call Price – Underlying Price + Exercise Price