Copyright (c) 2009, Commodity Trading School, All Rights Reserved! Intro To Identifying Favorable Option Trades By: Paul Brittain Options provide a flexible and effective way to trade in the futures markets. They offer investors the ability to capitalize on leverage while still giving them the ability to manage risk. By combining put and call options, and investor can design a strategy that fits their expectations of market movements. Strategies will ultimately be determined by a trader’s objectives, time horizon, market sentiment, and risk tolerance. When looking for a suitable market to trade, it is often helpful to look for extreme prices. Markets coming off of long-term highs or lows present traders with an extraordinary opportunity. For example, orange juice prices are hovering near all time lows. Soon the market will be poised to rebound, giving traders one of the most advantageous times in history to be long the OJ market. This methodology is based on the idea that extreme prices are the result of extreme market conditions that cannot be sustained. However, identifying such scenarios is easy, it is more difficult to predict the timing involved. A strong trending market is also desirable. With a long-term bias in place, a trader can “ride” the market by executing several short-term trades along the way. Trending markets are excellent candidates for ratio strategies. For example, the Eurocurrency experienced a powerful uptrend beginning in 2002 and continuing into 2004. Throughout this cycle a trader could buy a call option and sell two put options below the strike of the call. The result is an inexpensive trade, with a relatively high probability of success. However, it is imperative that a trader closely monitors a trade with “naked” options. Theoretically, selling an option leaves investors with unlimited risk; but options are flexible and adjustments can be made should the market go against your position. In search of a promising option trade, it is important to look at whether or not the options are priced fairly. Option prices fluctuate according to supply and demand in the market. At times, prices become inflated or undervalued relative to theoretical models such as Black and Scholes. Buying options in times of low volatility will prove to be advantageous. A lack of deviation in the price of the underlying asset will produce cheaper options. Inversely, an option on a contract that is undergoing massive price swings will have a volatility premium built into the price. The amount of time remaining until expiration will also have an impact on option prices. Obviously, longer time horizons will be more expensive because they give the market more room to move. Similarly, in-the-money or close-to-the-money options will be highly priced because they are more likely to be profitable at expiration. Because eight out of ten options expire worthless, it is advantageous to construct option strategies that are affordable without sacrificing the probability of profit. In other words, you want an option that is close-to-the-money but don’t want to pay a lot for it. This is easier than it sounds. Just like you would borrow money to pay for a house or a car, you can “borrow” money from the exchange to pay for trades. There are many combinations of “self-financed” trades. A ratio spread is one of them. You could by an at-the-money option and sell 2 options farther out. The money brought in through the sale of the options pays for the purchase of the third. We will go into further detail on the different types of strategies in subsequent lessons. A strong trending market is also desirable. With a long-term bias in place, a trader can “ride” the market by executing several short-term trades along the way. Futures Traders Helping Future Traders