Epistemic status: I am not a financial advisor. Please double-check anything I say before taking me seriously. But I do have a little experience trading options. I am also not telling you what to do, just suggesting some (heh) options to consider.
Your “system 1” does not know how to trade (unless you are very experienced, and maybe not even then). Traders who know what they are doing make contingency plans in advance to avoid dangerous irrational/emotional trading. They have a trading system with rules to get them in and out. Whatever you do, don’t decide it on a whim. But doing nothing is also a choice.
Options are derivatives, which makes their pricing more complex than the underlying stock. Options have intrinsic value, which is what they’re worth if exercised immediately, and the rest is extrinsic value, which is their perceived potential to have more intrinsic value before they expire. Options with no intrinsic value are called out of the money. Extrinsic value is affected by time remaining and the implied volatility (IV), or the market-estimated future variance of the underlying. When the market has a big selloff like this, IV increases, which inflates the extrinsic value of options. And indeed, IV is elevated well above normal now. High IV conditions like this do not tend to last long (perhaps a month). When IV reverts to the mean, the option’s extrinsic value will be deflated. You should not be trading options with no awareness of IV conditions.
If you are no longer confident in your forecast, it may be prudent to take some money off the table. You can sell your option at a profit and then put the money in a different position that you like better. Perhaps a different strike or expiration date, or something else entirely.
A “safe haven” investment is one that traders tend to buy when the stock market is falling. For example, TLT (a long-term treasury bond ETF), has shot up due to the current market crisis, but it is also a suitable investment vehicle in its own right, with buy-and-hold seeing positive returns in the long term, so it can hold value even after the market turns around. But being a bond fund with lower volatility, its returns are likewise lower.
On the other hand, if you are more confident in your forecast and want to double down, you could close one of your puts and use some of the profits from your put to buy two puts at a lower strike. (Maybe out of the money for their Gamma*). If your forecast is correct, and the market continues to fall rapidly, you’ll gain profit even faster, but if you’re wrong and the market turns around, they may expire worthless. Keep in mind that these puts are more expensive than normal due to high IV, even considering the current underlying price. If the market regains confidence, they’ll deflate in value, even before the market turns around. Options with less extrinsic value are less affected by IV. (IV sensitivity is known as Vega.)
If you have a margin account, you could take advantage of the high IV conditions by selling call spreads. You would sell the call with a Delta* of ~.3 and simultaneously buy another call one strike higher up to cap your losses if you’re wrong (this also reduces the margin required). This will be for a net credit. If the market continues to fall, you can let the whole spread expire worthless and keep the credit, or buy it back early for less than the credit (maybe for half) and then reposition. If you’re not terribly wrong and the market goes sideways or even slightly up, you can still buy these back for less than you paid for them due to deflating extrinsic as expiration nears and IV falls (due to market stabilization). If you are wrong and the spread goes under, your max loss is limited to your original margin (the difference between strikes, less the initial credit).
[*Delta is a measure of sensitivity to the price of the underlying. It’s also a rough estimate of the probability that the option will have any intrinsic value at expiration. Gamma is the rate of change of Delta. Together with Theta (time sensitivity) and Vega, these are known as The Greeks, and should be available from your broker along with the option quotes.]
Thanks, this is a really helpful intro to options. One thing you didn’t address which makes me hesitant to do any more options trading is the ask-bid spread, which can easily be 10% or more for some of the options I’m looking at. I don’t know how to tell when the ask-bid spread makes strategies such as “sell 1 put and buy 2 puts at lower strike” not worth doing (because potential profit is eaten up by transaction costs).
Also, picking the strike price and expiration date is also a mystery to me. I did it by intuition and it seems have worked out well enough, but was probably far from optimal.
They have a trading system with rules to get them in and out.
I don’t see how a trading system can incorporate new complex and often ambiguous evidence in real time. I definitely take your point about emotional trading being dangerous though.
Maybe out of the money for their Gamma
What does this mean?
Is there a book you can recommend for a more complete education about options? Maybe I can quickly flip through it to help me figure out what to do.
the ask-bid spread, which can easily be 10% or more
Options are much less liquid than the underlying, since the market is divided among so many strikes and dates. If the spread is less than 10% of the ask price, that’s actually considered pretty good for an option. You can also look at open interest (the number of open contracts) and volume (the number traded today) for each contract to help judge liquidity (this information should also be available from the broker.) Typically strike prices closer to the underlying price are more liquid. Also, the monthly (third-Friday) contracts tend to be more liquid than the Weeklys. (Weeklys weren’t available before, so monthly contracts are something of a Schelling point. They also open sooner.)
Do not trade options with market orders. Use limit orders and make an offer at about the midpoint between bid and ask. The market maker will usually need some time to get around to your order. You’ll usually get a fill within 15 minutes. If not, you may have to adjust your price a little before someone is willing to take the other side of the deal. A little patience can save a lot of money.
I don’t know how to tell when the ask-bid spread makes strategies such as “sell 1 put and buy 2 puts at lower strike” not worth doing (because potential profit is eaten up by transaction costs).
I meant close one of the profitable puts you already own, and then use the money to buy two more. (Incidentally, the spread you are describing is called a backspread, which is also worth considering when you expect a big move, as the short option can offset some of the problematic Greeks of the long ones.) Maybe you can vary the ratios. It depends on what’s available. I don’t know how many puts you have, but how aggressive you should be depends on your forecast, account size, and risk tolerance.
I don’t know your transaction costs either, but commissions have gotten pretty reasonable these days. This can vary widely among brokers. TD Ameritrade, for example, charges only $0.65 per contract and lets you close contracts under $0.05 for free. Tastyworks charges $1.00 per contract, but always lets you close for free. They also cap their commissions at $10 per leg (which can add up if you trade at high enough volume). Firstrade charges $0. That is not a typo. (There are still some regulatory fees that add up to less that a cent.) If your commissions are much higher than these, maybe you need a new broker.
I don’t see how a trading system can incorporate new complex and often ambiguous evidence in real time. I definitely take your point about emotional trading being dangerous though.
Systematic trading is not the same thing as algorithmic trading. They’re related, but algorithmic trading is taken to the extreme where a computer can do all the work. Normal systematic trading can have a human element, and you can provide the “forecast” component (instead of technical signals or something), and the rules tell you what to do based on your current forecast.
You need to have an exit already planned when you get in. Not just how to deal with a win, but also how to handle a loss, or you may be tempted to take profits too early, or be in denial and ride a loss too far. The adage is “cut your losses short and let your profits run”. Emotional trading tends to do the opposite and lose money. (BTW, the rule is the opposite for short option spreads.)
Carver’s Systematic Trading is a good introduction to the concept. This one I have read.
Gamma is the rate of change of Delta. It’s how curved your P&L graph is. Gamma opposes Theta. If you want more Deltas (like owning shares) and you expect a big move, Gammas are a way to get them cheaply, because they turn in to Deltas. (Of course, Deltas are negative for long puts.)
Is there a book you can recommend for a more complete education about options? Maybe I can quickly flip through it to help me figure out what to do.
Options are complex, but maybe not that complex. Option pricing models do use differential equations, but everybody uses computers for that. Trading options is not beyond the reach on anyone who passed a calculus class, but I’m still not sure if you can pick it up that quickly.
I did not learn all of this from a textbook. I know there are books that cover this. Hull’s Options, Futures and Other Derivatives is the introductory textbook I hear recommended, but I have not read it myself (you might want to skip the futures chapters.) There may be shorter introductions. I think Tastyworks was supposed to have a good intro somewhere.
Also, picking the strike price and expiration date is also a mystery to me.
Use the Greeks! Watch them and adjust them to your needs. They trade off against each other, but a spread can have the sum or difference of them. Keep in mind that extrinsic value is perceived potential and the Greeks make a lot more sense. The strikes nearest the underlying price have the most extrinsic and liquidity. Those deeper in the money have more Delta. Each Delta is like owning a share (puts have negative Deltas). Those further out of the money have more Gamma for the price. These relationships are nonlinear, because the underlying price variance is assumed to have a normal distribution (which is close enough to true most of the time).
Theta is not constant. It gets stronger the closer you get to expiration. Think about future variance as a bell curve spreading out from the current price like <. There’s much less time to vary left near the tip of the curve. For this reason, when holding a long option position, you probably want 60-90 days so you’re not exposed to too much Theta. But that also means more Vega, due to the higher extrinsic value.
Epistemic status: I am not a financial advisor. Please double-check anything I say before taking me seriously. But I do have a little experience trading options. I am also not telling you what to do, just suggesting some (heh) options to consider.
Your “system 1” does not know how to trade (unless you are very experienced, and maybe not even then). Traders who know what they are doing make contingency plans in advance to avoid dangerous irrational/emotional trading. They have a trading system with rules to get them in and out. Whatever you do, don’t decide it on a whim. But doing nothing is also a choice.
Options are derivatives, which makes their pricing more complex than the underlying stock. Options have intrinsic value, which is what they’re worth if exercised immediately, and the rest is extrinsic value, which is their perceived potential to have more intrinsic value before they expire. Options with no intrinsic value are called out of the money. Extrinsic value is affected by time remaining and the implied volatility (IV), or the market-estimated future variance of the underlying. When the market has a big selloff like this, IV increases, which inflates the extrinsic value of options. And indeed, IV is elevated well above normal now. High IV conditions like this do not tend to last long (perhaps a month). When IV reverts to the mean, the option’s extrinsic value will be deflated. You should not be trading options with no awareness of IV conditions.
If you are no longer confident in your forecast, it may be prudent to take some money off the table. You can sell your option at a profit and then put the money in a different position that you like better. Perhaps a different strike or expiration date, or something else entirely.
A “safe haven” investment is one that traders tend to buy when the stock market is falling. For example, TLT (a long-term treasury bond ETF), has shot up due to the current market crisis, but it is also a suitable investment vehicle in its own right, with buy-and-hold seeing positive returns in the long term, so it can hold value even after the market turns around. But being a bond fund with lower volatility, its returns are likewise lower.
On the other hand, if you are more confident in your forecast and want to double down, you could close one of your puts and use some of the profits from your put to buy two puts at a lower strike. (Maybe out of the money for their Gamma*). If your forecast is correct, and the market continues to fall rapidly, you’ll gain profit even faster, but if you’re wrong and the market turns around, they may expire worthless. Keep in mind that these puts are more expensive than normal due to high IV, even considering the current underlying price. If the market regains confidence, they’ll deflate in value, even before the market turns around. Options with less extrinsic value are less affected by IV. (IV sensitivity is known as Vega.)
If you have a margin account, you could take advantage of the high IV conditions by selling call spreads. You would sell the call with a Delta* of ~.3 and simultaneously buy another call one strike higher up to cap your losses if you’re wrong (this also reduces the margin required). This will be for a net credit. If the market continues to fall, you can let the whole spread expire worthless and keep the credit, or buy it back early for less than the credit (maybe for half) and then reposition. If you’re not terribly wrong and the market goes sideways or even slightly up, you can still buy these back for less than you paid for them due to deflating extrinsic as expiration nears and IV falls (due to market stabilization). If you are wrong and the spread goes under, your max loss is limited to your original margin (the difference between strikes, less the initial credit).
[*Delta is a measure of sensitivity to the price of the underlying. It’s also a rough estimate of the probability that the option will have any intrinsic value at expiration. Gamma is the rate of change of Delta. Together with Theta (time sensitivity) and Vega, these are known as The Greeks, and should be available from your broker along with the option quotes.]
Thanks, this is a really helpful intro to options. One thing you didn’t address which makes me hesitant to do any more options trading is the ask-bid spread, which can easily be 10% or more for some of the options I’m looking at. I don’t know how to tell when the ask-bid spread makes strategies such as “sell 1 put and buy 2 puts at lower strike” not worth doing (because potential profit is eaten up by transaction costs).
Also, picking the strike price and expiration date is also a mystery to me. I did it by intuition and it seems have worked out well enough, but was probably far from optimal.
I don’t see how a trading system can incorporate new complex and often ambiguous evidence in real time. I definitely take your point about emotional trading being dangerous though.
What does this mean?
Is there a book you can recommend for a more complete education about options? Maybe I can quickly flip through it to help me figure out what to do.
Options are much less liquid than the underlying, since the market is divided among so many strikes and dates. If the spread is less than 10% of the ask price, that’s actually considered pretty good for an option. You can also look at open interest (the number of open contracts) and volume (the number traded today) for each contract to help judge liquidity (this information should also be available from the broker.) Typically strike prices closer to the underlying price are more liquid. Also, the monthly (third-Friday) contracts tend to be more liquid than the Weeklys. (Weeklys weren’t available before, so monthly contracts are something of a Schelling point. They also open sooner.)
Do not trade options with market orders. Use limit orders and make an offer at about the midpoint between bid and ask. The market maker will usually need some time to get around to your order. You’ll usually get a fill within 15 minutes. If not, you may have to adjust your price a little before someone is willing to take the other side of the deal. A little patience can save a lot of money.
I meant close one of the profitable puts you already own, and then use the money to buy two more. (Incidentally, the spread you are describing is called a backspread, which is also worth considering when you expect a big move, as the short option can offset some of the problematic Greeks of the long ones.) Maybe you can vary the ratios. It depends on what’s available. I don’t know how many puts you have, but how aggressive you should be depends on your forecast, account size, and risk tolerance.
I don’t know your transaction costs either, but commissions have gotten pretty reasonable these days. This can vary widely among brokers. TD Ameritrade, for example, charges only $0.65 per contract and lets you close contracts under $0.05 for free. Tastyworks charges $1.00 per contract, but always lets you close for free. They also cap their commissions at $10 per leg (which can add up if you trade at high enough volume). Firstrade charges $0. That is not a typo. (There are still some regulatory fees that add up to less that a cent.) If your commissions are much higher than these, maybe you need a new broker.
Systematic trading is not the same thing as algorithmic trading. They’re related, but algorithmic trading is taken to the extreme where a computer can do all the work. Normal systematic trading can have a human element, and you can provide the “forecast” component (instead of technical signals or something), and the rules tell you what to do based on your current forecast.
You need to have an exit already planned when you get in. Not just how to deal with a win, but also how to handle a loss, or you may be tempted to take profits too early, or be in denial and ride a loss too far. The adage is “cut your losses short and let your profits run”. Emotional trading tends to do the opposite and lose money. (BTW, the rule is the opposite for short option spreads.)
Carver’s Systematic Trading is a good introduction to the concept. This one I have read.
Gamma is the rate of change of Delta. It’s how curved your P&L graph is. Gamma opposes Theta. If you want more Deltas (like owning shares) and you expect a big move, Gammas are a way to get them cheaply, because they turn in to Deltas. (Of course, Deltas are negative for long puts.)
Options are complex, but maybe not that complex. Option pricing models do use differential equations, but everybody uses computers for that. Trading options is not beyond the reach on anyone who passed a calculus class, but I’m still not sure if you can pick it up that quickly.
I did not learn all of this from a textbook. I know there are books that cover this. Hull’s Options, Futures and Other Derivatives is the introductory textbook I hear recommended, but I have not read it myself (you might want to skip the futures chapters.) There may be shorter introductions. I think Tastyworks was supposed to have a good intro somewhere.
Use the Greeks! Watch them and adjust them to your needs. They trade off against each other, but a spread can have the sum or difference of them. Keep in mind that extrinsic value is perceived potential and the Greeks make a lot more sense. The strikes nearest the underlying price have the most extrinsic and liquidity. Those deeper in the money have more Delta. Each Delta is like owning a share (puts have negative Deltas). Those further out of the money have more Gamma for the price. These relationships are nonlinear, because the underlying price variance is assumed to have a normal distribution (which is close enough to true most of the time).
Theta is not constant. It gets stronger the closer you get to expiration. Think about future variance as a bell curve spreading out from the current price like <. There’s much less time to vary left near the tip of the curve. For this reason, when holding a long option position, you probably want 60-90 days so you’re not exposed to too much Theta. But that also means more Vega, due to the higher extrinsic value.