Back on the 19th of August I placed a trade for IPI stock and the Jan 20 call option. Here was the table as the trade stood at the end of that day. Note the EV of $2. Even on this short timeframe the EV lost far more than I might have expected.
Now, keep in mind this is a little experiment to compare the two trading vehicles and I am not expecting any real profits other than gaining some more knowledge in the realm of option trading. My expectations going in were curious in nature.Here is the table for today:
The major thing to note on this one so far is that the stock is up 20 cps and the option is down 50 cps. Basically the intrinsic value is up by the 20cps of the stock but the extrinsic value dropped by 70 cps.. even though the Delta would suggest that a 20cps gain SHOULD result in a 16cps gain in the option value. The greeks are definitely not infallible.
Here is the daily six month chart for IPI :
The indicators that I have on the bottom are the Relative Strength Index and the Average True Range. The price is obviously in a bit of a limbo right now as it waffles around the long Volume by Price bar between $25 and $26. This bar looks to be more related to indecision than any support or resistance levels.
The ATR is just the average daily range over the last 5 day period and reflects a lower volatility. I could use other volatility indicators but this one also gives me a guideline for setting stop orders or VTSOs should I decide to employ them.
Seeing as the ATR is getting lower it would imply that the EV of the option should also drop in sync with this indicator. I was not tracking it but I expect that even the put EV is dropping as either option gets some of it's EV from this volatility. I knew this already but seeing it act on my money is a very interesting experiment.
This will affect how I place my stops for options trades. I should be wary of placing stops based on the option price as compared with the stock price at the time of the trade. This is why it is important to look for options that have a smaller percentage of EV as this value is not strictly a time value as option "guru's" would have us believe. Sadly, in this case, the option purchased was not the best deal as the EV was over 30% of the option price...that's a lot of slush.
Basically, the stop is more dependent upon the price of the stock than the price of the option. This is more important as the EV% gets higher. Perhaps a good way to set an option stop, rather than trying to accommodate the Delta and EV would be to completely ignore the EV and base the ultimate option stop upon the IV only. So if the stop on the stock, had a regular stock been purchased, was $3 lower than the price, the option stop should be the option purchase price minus the EV minus the $3. This writes of the EV as a variable that may cause the option price to be higher initially, a sudden drop in volatility with the associated EV drop could hit a well placed option stop inadvertently.
Write off the EV, use the stock stop difference and set this as the absolute worst case stop loss order for the option. Once it is in the money and there are profits to protect, the stop can be moved up or the option sold to crystallize these paper profits.
Options trades I look for now generally have an EV of less than 20% with the exception of trades that I may take that are out of the money...in which case I consider the entire premium as a potential loss, even though I know that there will usually be SOME value left in the option if I get rid of it before the last three months to expiration. I have one down around 7%.
Options are somewhat more complicated as this brings up another consideration.
Is it fair to use the same loss allowance for options as for stock trades?
Jeff.
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