Novice needs help

[Kerberos]

***keep in mind all of this pertains to the US options markets (I can't find a useful US discussion board so if I'm out of place just slap me around)***

Ok, I'm new to this game and need a little help. I have already read the sticky thread "guide to trading options" but I'm a little slow. I started out reading quite a bit of information and then decided to do a bit of paper trading. The paper trading worked out for me so I decided to open an account. I have opened an account with TDWaterhouse, but have not traded anything yet. Here is my dilema.

I am attempting to start day-trading options. Currently, I am researching companies that are coming out with their earnings in the next couple of days and basing my judgements on this.

The process I have been taking is this:

Let's say the company releases earnings today. Last night, I would have researched all earnings coming out today and picked the one I want (I am practicing with only 4K US so I'm only using one company). So today I picked BBOX (Blackbox). After hours trading last night showed the stock down $6 US. This morning pre-market price was down $7 US. So, when the market opened, I bought 100 contracts for the May 45 put @ .35. About 30 mins later, this option was up to $4.00. So, I sold my 100 contracts to close out my position. Ok, quick math puts that at a 1000% profit. There is no such thing as money that easy. Please tell me what I am doing wrong before I blow all of my money finding out the hard way. Any help would be GREATLY appreciated. Thanks a bunch.

-Kerb

 

[TheBramble]

Kerberos - this is only on paper trade, right?

How do you know you would have got filled at these levels in reality?

I'd be delighted if this was winner for you, but to beat the pros on the news, especially the options traders, would be a very rare thing.

 

[binsley]

Haven't checked all the details but it appears bbox opened at 41.75. Therefore you couldn't have got the 45 put for 0.35 today. (It may have been trading around that level yesterday.) Theres already 3.25 of intrinsic. You sold at $4 - that seems closer to the mark.

 

[Kerberos]

See, I don't know that I would have gotten these filled in reality. That's why I need help. My reality doesn't exist yet because I have never traded options. I am looking for flaws in the way I am doing things.

Binsley, I show that the May 45 put is up $3.15 on the day, which means it had to open at .35, correct? If I am not, please inform me. As I stated, I THINK I have a grasp on this, but I have never done it so I can definitely THINK incorrectly. So what you're saying is in this case, the option didn't open at .35, it opened much higher so when my order was placed at 8:00 this morning, when the market opened at 9:30, my order could have been fulfilled at anytime during the day at the current price?

 

[binsley]

Couldn't have opened at 0.35. Simply too much free money. An option can on occasion trade below parity (ie at less than its intrinsic). But this will typically involve deeply in the money options that have no premium. And it will only trade at slightly below parity because market makers will compete over this free money to the extent you would only ever see 5 - 15 cents of profit.
Options are very dependent on their underlying. So when the stock opens so much lower, there is a recalculation of the worth of option. In this case, an opening price of 41.75 means the 45 put is worth 3.25 + the price of the 45 call (interest calculations aside).
0.35 i guess was the closing price of the put. (against a stock ref. of 48.21 i.e all premium).
Given that you have $4000 to stake buying an out of the money put for 0.35 100 times is investing $3500 in an unlikely outcome ie gambling most of your money on an event that will occur less times than not. So you should look at you money management also.

 

[Kerberos]

(Justification for poor money management) if you look at my logic before, thinking the option would open at the same price it closed at the previous day, add to that the after hours and pre-market prices, one could justify dumping 3500 into it. But, since it doesn't look like that is the case, then my money management would have been drastically different.

So, I could have bought yesterday before market close and straddled my position on the $45 strike price and made half that, theoretically, minus whatever I lost for the calls. More realistic?

Another question. Does anybody trade on the US options market? If so, what is the average time in which a market order is filled. I know it varies, but a ball-park figure. Thanks again for all of your help, especially you binsley. You just saved me a BUNCH of money!!

-Kerb

 

[TheBramble]

So, I could have bought yesterday before market close and straddled my position on the $45 strike price and made half that, theoretically, minus whatever I lost for the calls. More realistic?

Not really. You're saying "Last night, I would have researched all earnings coming out today and picked the one I want" AND you're choosing and buying BEFORE the market closes on the night you're doing your analysis. Don't think so.

Kerb, you're trying to buy ahead of the news and beat the pros. Trust me, the pros get the news before you (we) do.

The pros are the people who SELL options. If you want to make money in options, you too may want to consider selling options. Others will disagree, but you only have a 1:9 chance of making money by buying options.

The other thing is your fundamental analysis may not be 100% accurate. No reflection on you personally, but what you think is going to result in 'good' news may already have been factored into the price days/weeks before or may turn out to be 'bad' news (i.e. wasn't as 'good' as expected). Trying to guess the impact of earnings/news is at best a 50/50 endeavour.

 

[Robertral]

Where did you get this magical figure of 1:9 from?????

 

[TheBramble]

I'm sure you and I have had this dicussion before, but anyway...

It's not magical - just incorrect. Should have been 1:7

From John Piper's "The Way to Trade".

Say you buy CALLS (could be PUTS, same issue either way).

The market (or your options) can do one of seven things:-

1. Move up fast - you win
2. Move up at a medium pace - you break even
3. Move up slowly - you lose
4. Move sideways - you lose
5. Move down slowly - you lose
6. Move down at a medium pace - you lose
7.Move down fast - you lose

Option pricing strategies (and I know you're an expert in this field RR) are geared to benefit the seller, not the buyer.

Implied Volatility and Time Decay do not work in the buyer's favour.

 

[vladimir]

It's not magical - just incorrect. Should have been 1:7

You could break medium movement rate in 2 grades to proof 1:9 theory. :cheesy:

 

[TheBramble]

Vladimir - I could have done, but I would have been found out and thrown out of the club!

Always best IMO to own up to your mistakes as quickly and publicly as possible.

(...unless you think you can get away with it completely of course )

 

[vladimir]

Always best IMO to own up to your mistakes as quickly and publicly as possible.

I agree, but I do not see a big difference between 5, 7 or 9 gradations of market movement. If those 7 things (possible outcomes) are evenly distributed on the price scale, they have different probabilities with highest for the thing at the middle where buyer looses. Hence, 1:7 is already a wrong result. The tree based pricing models end up with 30 and higher number of possible outcomes at expiry date to calculate worthiness of the option with slightly higher precision.

Generally speaking, the option pricing models make it equally probable to gain or loose money on both sides for buyer and seller in a long term. It is definitely more likely that trader who stays exposed to a greater risk earns on premium until rare sequence of events happens.

 

[TheBramble]

Generally speaking, the option pricing models make it equally probable to gain or loose money on both sides for buyer and seller in a long term.

Not sure I follow. If a buyer of options has a 1:7 chance of making money, the seller has a 6:7 chance.

This isn't an equally probable event.

 

[vladimir]

Not sure I follow. If a buyer of options has a 1:7 chance of making money, the seller has a 6:7 chance.

Well, it would be wrong to say about options that 1:7 bet may bring 7 pounds against 1 invested, because it is a bit more complicated. A buyer's chance to get 7 is lower than 1:7 but he has a chance to get 8 or 9. Equally a seller has a good chance to retain his 1 as a premium but his risk exposure is higher than 1. The size matters.

 

[TheBramble]

Vlad - I think I know what you're saying. To point this more directly at what Kerb was initially asking...

Piper was trying to make clear that with 'normal' instruments (stocks, indices, FX etc) they either go UP, DOWN or SIDEWAYS. Their value is always and only their intrinsic value.

Options bring an additional factor into the equation - time value.

The speed or rate at which the underlying goes UP or DOWn also determines your exposure, risk and reward for options.

To simplify Piper's position even further - let's say a price will move up either only quickly or slowly (forget the medium rate of change).

This means in this case that the buyer of an option has a 1:5 probability of making money.

Your position (I think) is to say that the inherent gearing an option buyer might enjoy outweighs the standard and fixed premium the option seller gets.

However, if you take a position that a certain stock is going to go up, and you have a 1:5 chance of making money as an option buyer.

Unless you can specifically and quantifiably determine the target at which you expect your option to settle based on your expectation of the magnitude of the underlying's move - you would be better off taking the fixed premium with a 4:5 chance of keeping it by selling the PUTS rather than buying the CALLS.

I think that's all I way trying to say.

 

[vladimir]

If we could predict future volatility of the underlying price changes, the theoretical prices would give buyer and seller equal opportunities over a large number of trades to average otherwise random results.

The fact that option has negative theta (its price decays with time) may seem a bit confusing, but it does not mean that selling options is more rewarding. You may loose money in a first hour after selling a put. The longer maturity time, the greater risk - higher price.

The magnitude of the underlying's move is normally taken as interest rate minus dividends or storage cost during the option's life. No prediction is involved here to price options. However, if you know something for sure about the future that gives you advantage no matter selling or buying. Otherwise, implied volatility might be a better indicator.

 

[RedE]

RE: "Options pricing models are geared to favour sellers over buyers."

I do not agree. Options pricing models assume an equal probability for an upmove or a down move - the degree of movement over a given period is determined by the "assumption" about volality (thus "implied" volatility). Therefore I would say that options pricing is geared to protect the seller rather than to allow him/her a licence to print money.

If the maket (-maker) is pricing his options way too high (in your opinion) then you are free to join him in selling, thus taking advantage of the overpriced insurance policy!