I've recently started to dabble in stock options after having quite a bit of success with trading stocks successfully. Essentially I am attracted by the idea of unlimited profit potential with limited risk. I would prefer just to buy calls and puts if possible. So far I have had mixed success. I've done the research and I've found IV to be the culprit of my losses despite the underlying increasing (in the case of calls). My understanding is that the price of the underlying and change in IV have the biggest effect on stock option prices. Therefore to succeed I would need the underlying to go up and the IV to go up as well. This would imply that I would need to buy options that have a low relative IV. However the confusion that comes about is that fact that each strike price has it's own IV resulting in what seems to be called the Volatility Skew. So if I have understood things correctly I should check the IV of that particular strike to the IV of the strike 20 to 30 days ago to see whether the current IV is relatively high or low. Have I understood this correctly? Also somewhere I ready that if I buy an option of a stock that is at a market bottom and that starts to go up then the IV will most likely go down. How strong is this correlation? Am I doomed to using options to leverage my mean reversion strategy?
You are asking to understand a lot from this. If you goal is stock replacement, use ITM or ATM options. Don't worry about skew, but check Ivol vs other months of the same strike. If there is a big difference, there is likely some event like earnings that have elevated prices. You need to expect premiums will come in after the event, but the underlying might move a lot, which is what you want anyway. Don't try to understand everything, just what you need for your strategy.
Thanks. I am just trying to figure out why the price of the option doesn't go up in tandem with the underlying. I realized that in some cases IV was working against me. So now I am trying to figure out how to avoid having IV work against me....
You should read some books... You may find some food for thought and get some sense of how to go about obtaining answers to your questions.
For basic topics, probably Hull, Natenberg, etc etc. For more sexy stuff, Euan Sinclair's books are the bee's knees and the dog's bollocks both.
Look up the greeks Delta and Vega to understand them. Delta will estimate how much an option will go up to down with the movement of the underlying. Vega is volatility risk. How much the option will change as supply/demand effects the volatility and premiums.
I've read about the greeks and I understand how they effect the price of the options. My issue is identifying options that have a low IV i.e. comparing current IV with past IV and finding options with low relative IV thus keeping the probability of IV going down as opposed to staying put or going up, as low as possible. I use interactive brokers and the number of different IVs quoted is quite a lot. There is an IV for each strike and several other IVs. See attached file. I've circled the IVs in red. Which one do I use? And what do I compare it to, to get an idea of whether current IV is high or low?
Nevertheless, your risk per trade is still 100% of your invested capital. Pop off a few of those in a row, and you'll understand why long options generally aren't a good substitute for the underlying in most equities systems. Yes, they have their place in special situations. But not in a run-of-the-mill, day-in and day-out equities system.
Hi thanks for this insite. I currently trade stocks using a hard volatility based stop. I either get stopped our or exit when my indicator says so. So my risk is the same regardless of whether I use stocks or options. With stocks there is always the risk of slippage and gapping. So the risk is slightly higher. Of course with stocks I don't have to worry about time or volatility. Still trying to figure things out so any insite is much appreciated.