HOW OPTIONS ARE PRICED
Options prices are governed by price of the underlying, time, liquidity and volatility.
We can choose instruments only with good liquidity (without it we are at a severe disadvantage)
Volatility mean reverts. We need to buy cheap volatility and sell when expensive. Pre-earnings, nearly all instruments have a sharp rise in volatility that accelerates from D-7 to D0. IV rank/IV percentile will tell us if an instrument has cheap or expensive volatility.
Time. Options decay with time. Because of this we cannot buy a put and call at the same time expecting certain profits. IF volatility is high enough, it can cancel out the effect of time. Pre-earnings this often happens.
Change of price of underlying. If we know the historical change we can develop an edge.
OPTIONS STRATEGY CHOICE
Relative value is defined as the price of the option divided by the price of the underlying.
We generally choose from a limited set of options strategies:
- Long straddle (when rv is cheap to rv average and in moderate to low volatility conditions).Â Increasing volatility improves the straddle.
- Double calendar (for low implied volatility conditions when long straddles are expensive).Â Increasing volatility improves the double calendar.
- Double butterfly (for high volatility conditions when long straddle is expensive), and these strategies are used when going through earnings.Â Increasing volatility hurts this trade, so caution is needed pre-earnings. Once earnings are announced, there is a “volatility collapse” which benefits the double butterfly.
The bottom line. We need to know the relative value of the option AND how this relates to the mean relative value. For example, if the RV of the long straddle is 50% of the average, it is a good buy.Â If it is 133% of the average it is not a good buy.
If a cheap buy and volatility low – go with long straddle
If an expensive buy and volatility low – go with a double calendar
If an expensive buy and volatility high – go with a double butterfly (some may go with naked short straddle or strangle).
Exit before earnings unless trade designed to go through earnings!
Risk management is critical to success
Do not risk more than 10% of the total amount of capital for trades exited before earnings
If a $10,000 account, risk no more than $1000.
Do not risk more than 5% of the total amount of capital for trades that go through earnings.Â
Exit the trade if the trade makes more than 17%.
Exit the trade if losses exceed 25%.
DO NOT HOLD THROUGH EARNINGS UNLESS SPECIFICALLY DESIGNED TO DO SO.
Keep a diary of expectations and results and how emotions affected the execution of your trade.
Keep an Excel logbook of all trades, and P/L.