Last week I discussed why and how I sometimes use options for short-term trades. Today I will expand on that with some rules I follow and other thoughts. If you didn’t catch last week’s post, you may want to check that out first.

As a very quick review, when trading in stocks or ETF’s that I anticipate being in for a number of days, rather than weeks or months, I frequently trade deep in the money options rather than the stock or ETF. The reasons and a general methodology were outlined last week. Below are some more specifics for you to consider along with answers to a few questions I received:

How do I decide whether an option is preferable to the stock?
Some general rules as to when I use options:
1) The stock should trade for at least $25 or more. The higher the better. I especially like stocks in the $40-$80 range. – The spread on many deep options is $0.10. Sometimes you’ll find something appropriate with a $0.05 spread, but not always. In many cases you can assume you will lose at least most of the spread on the trade. If I’m looking for a 2-3% move I don’t want to give away $0.10-$0.15 on a $15 stock. Doing that may destroy my edge. With low priced stocks I normally just buy the stock.
2) The option should have almost no premium – Even with higher priced stocks, I don’t want to pay much premium on the option. More than $0.15 or $0.20 and I begin to lose some interest. In low-volatility environments this is easily accomplished. During panic situations when the VIX spikes you’ll be hard pressed to find anything trading without a decent amount of premium.
3) I want enough time for the trade to work, but not too much time left on the option – The contracts are generally monthly. My trades average about 1 week. Two weeks to expiration is the sweet spot. Less than one week and I’m normally looking out to the next month (which means additional premium). Three weeks or longer and your going to have to pay for some time value. If the trade works quickly then you may be able to sell the option with time value left in it. There will be some erosion, though.
4) The delta should be 90 or higher – This is normally the case if you’re not paying much premium for a deep option. Basically, I want the price to move up very close to the same amount as the stock price.

What if the exit trigger doesn’t arrive before the option expires?
In this case some decisions need to be made. If I’m trading a stock then I’m normally not trading a size larger than I would trade if I owned the stock anyway. Therefore, taking delivery of the stock is an option. If it is index shares that I’m leveraged with, then I need to roll them out to the next month.

Rolling out to the next month adds some cost. First, you have basic transaction costs since you are selling your options and buying others. Frequently more significant is the premium cost. You are selling an option with 0 premium and buying one with some premium. To help reduce the amount of premium the roll will cost you, a spread trade normally helps. Rather than entering a sell for X contracts and then a buy for X contracts, put it in as a spread trade. Even though the option may trade with a $0.10 spread, you can enter spread trades to the penny.

When else might it be appropriate to switch option contracts?
If the trade goes sharply against you and you still feel positive about the position you could consider moving to a lower strike price (assuming long call). Two things will happen when your stock price rapidly approaches your strike price. 1) Premium may get built into the option since you are now near or at the money rather than deep into it. 2) The increase in premium will also mean a decrease in delta. So when the stock does bounce your option initially may go up $0.75 for every dollar rather than the $0.95 for every dollar that it would have when you bought it.

Therefore, one strategy to consider would be to sell the now “near the money” option you hold and buy a deep one. This accomplishes two things: 1) You are able to make money on the premium that was just built up and 2) You own an option with a higher delta that will rise faster than your original option.

Of course there is a big disadvantage to doing this, and that is that you are now laying out more capital. Part of the reason for using options is to control risk. Swapping out for deeper ones when the trade goes against you increases your initial risk, so it’s something that needs to be carefully thought through before doing it.

For index trades, why use options instead of futures?
There are advantages and disadvantages to both. Some advantages for options include: 1) They can be traded in the same account as stocks. No need to segregate to a futures account. 2) In low volatility environments, you can actually get more leveraged than with futures.

A big disadvantage rears its head in high volatility environments. When the market sells off hard and volatility spikes, even fairly deep index options carry a decent amount of premium. With futures this is not as much of an issue.

To sum up below are a list of advantages and disadvantages to using deep options for short-term trading vehicles:

Advantages:
Lower capital outlay
Lower risk (option goes to $0 before stock does)
Leverage without paying margin costs
Can be traded in same account as equities rather than separate futures account

Disadvantages:
Lower reward due to delta Higher slippage due to option spreads
Some premium costs
Premiums increase in volatile environments

So the Celtics-Lakers series is back in town. Therefore, no research tonight as I’ll be at the game. (I’m the guy in the upper deck with the green shirt and black and green hat in case you see me on TV.) Instead, I’ve decided to prepare a little write-up on options trading.

As most readers are likely aware, much of my trading is focused on a swing trading timeframe. Most of this focuses on large-cap stocks and highly liquid ETF’s. With these positions, instead of trading the stocks or etf’s, I will many times trade the options. There are two main reasons for this: 1) Risk control and 2) Leverage.

Several of the short-term reversal systems I trade don’t involve stops. An example of one of these systems can be found here. This means two things. 1) If I take a large position and the trade goes against me I may be tying up the capital for longer than I would like and 2) If disaster strikes (think Bear Stearns – and no I didn’t trade it) my position could get wiped out. Who knows where the next 90% drop is lurking?

By using options I an able to solve both of these issues. First, even when buying deep in the money calls, the outlay is significantly less that purchasing the stock. Second, they provide a “natural stop” for the trade (they’ll only drop to zero). I’ll use a recent Subscriber Letter trade as an example. Bank of America (BAC) was scaled into last week and the exit trigger occurred this morning. For my own accounts, I did not purchase any BAC. Instead I bought the June 25 calls. They cost me about 15% of what I would have spent to buy the stock. So if I wanted exposure to $100,000 worth of BAC, I instead would buy about $15,000 worth of BACFE. It’s fairly deep and trades with little premium and a delta of nearly 1. If it goes up, I make nearly the same dollar for dollar. If it goes down, I can’t lose more than $15,000 (unless I roll to another option). To put it another way, if you can get a deep call like this for 15% of the price of the stock, then you can effectively get a 10% position with an account risk of 1.5% (option goes to zero). Also, depending on how the drop occurs, premium may get built into the option, so I may not lose as much as I would have on the stock purchase.

With individual stocks, rarely will I take more exposure than I would if I were simply buying the stock. I don’t normally do it for leverage. I do it to control risk.

Index trades are a different story. Here I will many times look for leverage. The execution is generally the same, though. The S&P 500 is the index I trade the most and I normally do it with SPY options. As I look at my screen while I’m typing this the SPY is trading at $135.73 and the June 129 calls expiring in 3 days (SPYFY) are at $6.80. Only about $0.07 premium. The 129 calls with 12 days (RQQFY) left have about $0.15 premium in them. Either way the premium is quite small. If I want to get leveraged I can lay out about 15% of my capital and have 300% exposure to SPY. ($6.80 * 3 = $20.4 / $135.73 = 15%).

So that’s the general concept of how deep in the money options can be used to control risk and/or gain leverage. If you’re not familiar with trading options then it’s just enough to make you dangerous. I’ll try and follow-up in the next few days with some guidelines I use when considering these kind of deep options plays.

For those who would like to read more and gain another perspective on this type of option trade, check out Steven Gabriel’s write-up from a few years back.