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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