| Frequently
Asked Questions
The following questions are taken
from previous editions of "Option Wizz". To have your
questions answered email the Wizz at: faq@nickkatiforis.com.
Alternatively, you may find the answers to some of your questions in
amongst our articles.
I still am having some difficulty understanding the whole concept of
option writing. Can you help?
Option writing strategies are different from any other form of trading,
which explains why many people when first exposed to them initially have
some difficulty in comprehending how they work.
Let me explain by using the analogy of an insurance policy that most
people are familiar with. Options have much in common with an insurance
policy. As a buyer of insurance you take out a contract in which the
insurance underwriter will fulfil their obligation under certain
circumstances eg, your house burns down or your car is stolen. For this
you pay a premium to the insurance company which runs for a specific
length of time.
An option buyer also takes out a contract that he pays a premium for
that runs a specific length of time. The premium is collected by the
option writer. The option writer is similar to the insurance underwriter
who has a contingent liability. In this case he will be called upon to
fulfil his obligation at the exercise price of the option if it is
favourable for the option buyer to do so.
The amount of premium that the insurance company will charge will depend
on several variables; eg. age and sex of the policy holder, the
location, type of car, house etc. Generally the greater the risk of
payout to the insurance holder, the more expensive will be the premiums
charged to the policy holder.
Likewise the option premium is also affected by a number of variables
that affect the premium of the option. These include the time to expiry,
volatility of the market, current market price and the option exercise
price chosen. The greater the risk of exercise the more expensive it
will be.
If the insurance contract expires without the policy holder making a
claim (highly likely), the insurance company keeps the premium.
Similarly If the option is not exercised by the option buyer then the
premium is also his to keep.
I have traded options on ASX
stocks for two years. The trading of options on commodity and financial
markets (currencies, bonds etc) is something that is outside of my
experience. What are the benefits of trading options on these markets
over stock options?
Having extensively traded ASX options as well as commodity and financial
market options, for me the later has greater appeal. Firstly the
diversification offered by the commodity and financial markets can’t
be beaten. Secondly the liquidity (volume traded) of these markets is
generally very good. Thirdly there are more option strike prices to
choose from which means that you can more precisely tailor a trade to
your expectations and use a variety of options strategies. There are
also more months to choose from.
I know that there is no margin
requirement when buying options. However I understand that there are for
written (sold) options? How does this work?
A margin is a good faith security deposit which is held by the exchange to
ensure that an option writer has sufficient funds to meet his obligation
should the trade go against him. The market is determined by the exchange.
Generally the larger the potential move a market can make the higher will
be the margin.
Although I have been trading for
a long time, I am relatively new to options. Quite often when I chart I
see markets that I expect to trade sideways. How can I use options benefit
from this analysis?
Traders new to the market, have unrealistic expectations of markets always
being in a trending phase. However the reality is that the majority of time
markets move in a sideways, non trending manner. Research that has been performed
in the past suggests that up to 85% of the time markets can be expected to be in
some sort of consolidation phase which is non-trending in nature.
Options allow
you to profit from these occasions. This is a significant advantage that option
traders have over other forms of trading. Some of the more popular strategies that
can benefit from a flat or range bound market include, the written straddle (write
at the money put and an at the money call with the same strike price), the written
strangle (write out of the money put and out of the money call at different strike
prices) and the protected written straddle/strangle (same strategies outlined above
except with further out of the money bought calls and puts limiting the risk).
These strategies enable you to take advantage of time decay of written options,
which benefit the option writer in flat range bound market conditions.
In what ways can implied volatility
be useful as an indicator of market direction?
Implied volatility as well as being a vital part of the decision process in trading
options, can also be an indicator of a potential significant future price move.
This most often occurs when implied volatility is at extremely low levels
(options are inexpensive) for a significant period of time. These are generally
the markets that traders have ignored because of their inactivity. Often these
markets will break out of their quiet range with an explosive move. Patience is the
key here as you never know when the breakout will occur.
I have heard the term
"rolling’ being used in relation to option strategies, could you
please explain what this refers to?
Rolling refers to the action of closing a current option position and
simultaneously opening a new option position at a different strike price
and or contract month.
Rolling up means that you are closing a current
call option position and opening a higher strike position. Rolling down
means that you are closing an open put option position and opening a
lower strike put option.
Rolling is usually implemented after a large
market move causes an imbalance in the risk profile of your current
market position. For example if you originally wrote an out of the money
call option and the market made a large rally, you could buy back your
written call to close the trade and simultaneously write a higher strike
call at a further distance from the market that would recoup some of the
loss of buying back your written call.
A more aggressive alternative is
to write two options to recoup your losses. This is best implemented
when the market is already over-extended and when the options you are
rolling into are over-priced with a short time to expiry.
The risk in
rolling is if the market keeps moving in the direction of the roll. If
this occurs you may be forced to buy back the option which was just
opened, therefore taking a further loss. Rolling should only take place
if there is an edge to be gained from doing so, not simply to avoid
taking a loss.
Could you please explain what
is meant by a naked option?
The term ‘naked’ when applied to option trading refers to an option
without an accompanying option or underlying asset that protects it
against open ended risk. It usually refers to open written (sold) call
or put options. Therefore a written call option on its own would be
classified as a naked option. Because naked options have potentially
open ended risk, it is important that strict adherence to risk
management principles are followed at all times.
To have your
questions answered please email: faq@nickkatiforis.com.
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