A few newbie option questions....

Discussion in 'Options' started by user83248324, Dec 7, 2008.

  1. Hey guys, thanks for taking the time to check out my question. As I have been studying options for the past few weeks, these have been the questions lingering in my mind that I have not been able to find an answer to.

    1. Why would anyone buy extremely far OTM calls? It would seem almost impossible to make money on these calls due to the huge IV drop one would see at those price targets, which would in turn drop the price of the call. Is there something I am not seeing as to why anyone would make OTM calls part of their trading strategy?

    2. Following up with the above thought about calls, am I wrong to be more inclined to base my option trading strategy around puts then calls. It seems that the most a calls value can do(even on high beta/ extremely volatile stocks) is possibly double, triple, or maybe quadruple. But with puts, if you pick the right stock you can make as much as 10,20,30, or even more times your money. Now I realize calls do better when the market is going down then puts do when the market is going up, but since I am mainly interested in tight OTM options, this added protection would not seem worth it to me since an OTM call would still eventually expire worthless not matter how high the IV was. Now I understand the market generally has an upward bias so would this be why I would not want to trade puts in favor or calls, or what would be the reasoning behind making calls a large part of your strategy? With my current understanding of calls, the only calls that seem to be worth it are the deep in the money calls that have a delta of 1 where your premium would be safe and you would essentially be buying the underlining security but adding a bit of volatility.

    3. Are options price action based of off a formula using the IV, time decay, and stock price, or is it just based off the bid and ask? I would think it would just be the bid/ask, but when using thinkorswims option theoretical price calculator, I am amazed at how I can go back in time to different dates and enter in current dates price action, IV, and time left and it will tell me the price spot on of what the market it has it at? This makes me question whether options are based on the markets bid or whether it is just based of a formula?

    4. When selling straddles, wouldn’t the seller have to always be concerned about one of the in the money options being exercised? Or am I misunderstanding how selling options and them being exercised works? I have also heard that very few options ever get exercised, if this is the case why not just take the chance selling expensive ITM covered calls and risk whether you get exercised on or not? Or is it that all ITM options are always exercised, but relative to how often they change hands very few options are actually exercised?

    5. Are ETFs and Options on ETFs (such as SPY, DIA, etc) taxed as futures are (the 60/40 rule) or are they just taxed at the normal short term capital gains rate? I this topic had been brought up before when I searched the forum, but no one was able to provide a definitive answer, so I was hoping someone could help.

    6. Does anyone know of a good back-testing software package specifically made for options and futures, or is there any other software I should look into to help me with options trading.

    Thanks for any help you can provide with any of these questions, and if anything is to confusing at this point please tell me and I will try to elaborate more on what I was trying to say.
     
  2. user83248324,

    I'll try to answer the questions the best that I can. There are a few others here who might have better answers for some of the questions.


    JJacksET4
     
  3. I'm going to assume that we're talking about the outriight buying puts and calls - no complex strategies.

    It's not much of an idea to buy extremely far OTM options. However, you'd buy OTM calls for the same reason that you'd buy OTM puts ---> LEVERAGE. Going up? Buy calls. Going down? Buy puts.

    If the stock is at the strike and you're comparing a 5 pt OTM put with a 5 pt OTM call, if the stock drops 5 pts, the put will gain approx same pct gain as the call will make on a 5 pt rise (pre expiration). So again, going up? Buy calls. Going down? Buy puts.

    Option pricing is based on formula utilizing stock price, strike price, time remaining, volatility, interest rate and dividends, if any.

    a)Options that have time premium remaining are unlikely to be exercised.

    b) If the option is ITM at expiration, it WILL be exercised.

    c) Never "take a chance" on an option and just let market movement dictate your result.

    d) Never sell (or buy) an option w/o a follow plan in place as to what you will do as events occur (time passes, volatility changes, underlying price changes, etc.)

    Dunno...maybe an expert who knows will show up (g)


    Various brokers have trading simulators. I wouldn't be too concerned about back testing options as much as figuring out where the underlying is going and what option strategy will do best under those circumstances.. as well as learning how to adjust positions as well as some good money managemment.

    I'd suggest that you concentrate on learning as much as you can about options.

    It's not this simple or this easy but you're a self proclaimed newbie (g) so let's not get way ahead of basics. And if you've grasped this much after studying options for only a few weeks, you should own Manhattan within a few years:D
     
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  5. Hey Jjacks. It's a minor point but John Q Public has been spooked by brokers, authors, etc. into believing that shorting is bad because of potential unlimited losses. Ergo, shorting has more risk than errrrr, longing. Kinda like thier advice that covered calls is a safe strategy for newbies. LOL.

    Technically, that's true and might have some merit if one was dealing with a $5 stock. But AFAIK, markets and regular stocks (not distressed $5 ones) don't melt up. Most of the time they go down a lot faster than they go up (let's ignore infrequent takeovers). And earnings announcements as well since that's a known event that one would play or get out of the way of.
     
  6. Spin,

    I'm not quite sure what you are referring to in my comments, as I didn't say anything about shorting options. I was writing about long puts versus long calls. No matter what, the most a 5 strike put can ever go to is $500. On the other hand, a 5 strike call theoretically has unlimited value. Of course, I realize as much as anyone that a $5 stock has little hope of going to $50 in a short time, but it is possible.

    I think the original poster is confused about time value, intrinsic value and the real meaning and use of IV, because he states that calls can only go up 2, 3 or at most 4 fold, where as puts can go up 10, 20 or 40 fold. That is of course completely false. I think he is thinking that as a stock rises, the IV will drop, thus offsetting any gains, but as you well know, as a stock moves higher and higher, the instrinsic value of the calls will continue to rise and what the actual IV is becomes less and less important.

    I understand of course that brokers have taught that shorting is risky, whereas for example selling a put is basically the same as doing a buy/write, yet most brokers frown at the first one, yet endorse the second one.

    To start to have a good understanding of options, the OP is going to have to sit down and study Time Value, Instrinsic value, Time Decay and what IV and HV really mean IMO.

    JJacksET4
     
  7. Jjacks,

    It wasn't about short options. What I was referring to was your comment that calls can go up many fold compared to puts. IMHO, stocks go down much faster than they go up so I'd rather be playing the downside with long puts (or short stock) than trying to catch an increase to the upside with long calls (or long stock).

    IOW, while theoretically you can get a larger multiple gain to the upside with long calls versus long puts whose stock can only go down to zero, in reality, it's easier to catch a bigger move with falling stocks. Just my opinion about velocity.

    No biggie... No correction or criticism intended.

    Spin
     
  8. Buying OTM Calls could be part of a spread position to cap the maximum potential loss of a short call position. Sort of like buying insurance.







    forex-forex :)
    ---------------
    Trading Guru
     
  9. E R

    E R

  10. =======================
    User832-777
    1]-3 [Three ]answers, but not limited to 3], on OTM calls.
    Asked a lottery buyer in the BP station one time-''ever won anything-''No he said but i got close'' Dave Ramsey [on FOX business]called lottery, ''stupid tax on those who cant do math.''LOL.

    2]Same wise reason i shop well, buy earthquake insurance;
    and really dont hope to collect.................... Live in west TN,beautiful, big Reelfoot lake was created by a killer quake.

    3]Ever seen/recorded a good/strong uptrend in a bull market-QQQQ,POT??
    You may change your mind .

    6]Yes but had to custom design it;
    including end of day prices recorded.Wisdom is limited to a few words on this one.
     
    #10     Dec 11, 2008