OPTIONS
Making Your Option Decisions
Buying Calls And Puts With PROVEST
by Jay Kaeppel
The second article in this series discusses the details of the PROVEST strategy and how you can apply it to trade calls and/or puts.AS discussed in the first part of this series, several key factors should be considered in determining the best option trading strategy to use at any given point in time for any given security. Likewise, these criteria can also be used to zero in on the best option or options to trade in executing a particular strategy. Selecting the proper strategy involves knowing what to look for in terms of the following variables:
The PROVEST option trading method criteria were developed to identify specific criteria in each of these key areas. The primary factors and key considerations are summarized in Figure 1. In this installment we will look at a specific trading strategy -- buying naked calls or puts -- and how to use the PROVEST criteria to identify trading opportunities.
- Probability
- Volatility
- Time left until option expiration
- The "skew" of implied volatility across strike prices and/or expiration months
- Timing of market price movement.
STRATEGY: BUYING NAKED CALLS OR PUTS
The idea behind buying a naked call or put option is simply to achieve a higher rate of return using leverage -- while also enjoying a lower dollar risk -- than could be achieved by buying or selling short a given stock, stock index, or futures contract. To illustrate, let us consider a simple example.
In Figure 2, IBM is breaking out to a new high. Assume that a trader took the breakout shown in Figure 2 as a bullish signal and believed that a further advance was in the offing. The most direct way to profit would be to buy 100 shares of IBM stock. Of course, in order to do so, the trader would need to invest $10,903 ($109.03 x 100 shares). At the same time, a simple alternative would be to buy the August call option with a strike price of $105 at a price of $5.80. This option would cost the trader only $580 and would give him or her the right to buy 100 shares of IBM stock at a price of $105 a share anytime up until August option expiration.
...Continued in the February issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the February 2008 issue of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.
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