Q&A

Explore Your Options

with Price Headley

Got a question about options? Ask Price Headley, who was inducted into the Traders’ Hall of Game in 2007 and is the founder of BigTrends.com, which provides investors with real-time stock and option strategies and investment education. To submit a question, post it to our website Message-Boardsor price.headley@bigtrends.com Answers will be posted at the message-boards, and selected questions will appear in future issues of S&C.

VOLATILITY VS. TREND
Should I trade options on the higher-volatility names for greater profit potential, or am I better off focusing on lower volatility for greater stability?

Certainly, the tradeoff between potential profitability and risk assumed is a personal choice. However, there’s an assumption among most option traders that trading higher-volatility names will offer more potential if they can stomach the wider swings. I recommend an alternate path.

There’s a big difference between the volatility of an underlying asset and its trend or price direction, from the beginning to the end of the time period being examined. For example, over a 20-day period, I could show you an example of a volatile stock, ABC, moving up 10% one day, down 10% the next, and in this same zigzag pattern it would make no net movement from its starting point to its ending value over the combined 20 days. Or you could choose another stock, XYZ, going up a consistent 1% per day over 20 days, with no variation. And you’d be up more than 20% net (including compounding) on the stock.

Certainly, the tradeoff between potential profitability and risk assumed is a personal choice.Trend traders know the answer regarding which stock to buy options: it’s no contest, XYZ will be better for those who want a trend with that type of consistency. In the real world, no stock is that perfect, but the concept still applies. Focus on significant trends for option buying, while considering volatile trading ranges like stock ABC for your option selling strategies, like iron condors.

Here’s a question. What do you think the volatility is for a stock that moves up 1% per day, with no variation? In the standard option pricing model, it’s a reading of zero in theory. I’d love to buy an infinite number of contracts for nothing at zero volatility if I could. In reality, commissions would be the only cost you’d incur (so much for infinite contracts). The closest strategy to model this concept is to buy stock options with reasonably low volatility in steady trends. The more efficient and consistent the trend, the cheaper your option premiums, which is especially powerful when you spot a meaningful trend moving in one direction.

WONDERS ABOUT WEEKLIES
What’s your favorite strategy for weekly options?

Weekly options continue to gain in popularity. A good source for more information on weeklies is the Chicago Board Options Exchange site at www.cboe.com/weekly. The premise of weekly options is that if you don’t intend to hold a position for more than seven trading days, why buy more time than you need? In addition, other traders and investors with longer-term options or stock positions can use the weeklies to create time spreads or covered positions as well.

I trade weekly options in a variety of ways. My favorite consistent strategy that still gives meaningful profit potential is the debit spread strategy. Debit spreads have the advantage of reducing your net outlay and when done properly, they can take all of the time risk out of your position. Given that weekly options have little time until expiration, this becomes an important consideration. My basic rules of thumb are:

Buy deeper in the money options. Your goal here is to create a stock substitute core position on your long premium side. I typically want to see the delta of this option at least at 70 and within the final few days before the Friday expiration, I’d move that minimum up to at least 80 delta (delta measures the percentage the option will move for a one-point move in the underlying, so an 80 delta should see your call option move up 0.80 points when the stock rises 1.00).
Sell out-of-the-money options, or at-the-money options in the final day or two. Here, the guideline is simple. I want to sell enough time premium to more than cover the time I had to pay on my long premium position.

So if you bought a 100-strike call with five trading days remaining for $4.00, with the stock at 103.00, then I’d target to sell the 105 call at 1.00 or more to gain back that point of time I had to pay for the 100 call. If the 105 call is under this target, then I’ll consider another option nearer the money, or do the straight purchase only, or pass on the trade.

The downside of the debit spread strategy to me is that if I’m right on a trend move, I do not want to cap my upside potential on my best ideas. So a good rule of thumb for me is to consider buying back the short leg if it reaches a stock price equal to the written strike price plus the initial premium collected for that options sale. So if I sold the 105 call for 1.00 when the stock was at 103.00, then when the stock hits 106.00, I’m looking to buy back the short call. If that happens quickly, I’m going to take a loss on the short leg. If it happens close to the expiration the pain in the short leg is minimal, and the combined debit spread position is still profitable due to the gains in the option purchased.

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