IPI and the comparative test

I have a number of option and stock positions in play right now. Overall I am in the green...considering that these are mostly positions taken this week that is not too bad for a three day run in a questionable market.

One test I ran was to enter limit orders this morning for a stock and an option at the same time. I calculated what the option entry price should be based on my trigger price from the stock chart using the various variables for the option and my spreadsheet formulae.

The test subject is Intrepid Potash Inc. (IPI).

The limit orders placed were for $25.50 in the stock and $6.40 for the Jan 20 call option (IFJAT).

Both orders filled quickly off the bell and I might have been able to get slightly better prices for the stock by another 15 cents and 10 cents for the option...but I would probably have sacrificed getting one or the other altogether as the price bottom was hit 3 minutes in. I am satisfied with both entries and happy to see that my estimate of the option price that I calculated from yesterday's EOD numbers was still accurate... and that is the only point for the trade in the first place, profit a close second.


Here is a little chart reflecting some of the numbers for each position.

It is well worth noting that the Extrinsic Value (EV) decreased between 9 and 39 cents (depending on if you use the bid or ask numbers...I would tend toward the bid as that would be the price to sell given a market order...a whole other topic). This drop counterbalances the Intrinsic Value (IV) gain of 69 cents (the increase in stock price) and results in the EOD Delta being lower.

Delta is the expected ratio of stock price movement vs option price movement... initially the 0.823 would mean that if the stock moves $1 then the option price would move 82.3 cents. The IV will always change by the price of the stock, the variable becomes the EX as it is not only a time premium (as it is often referred to) but a volatility expectation premium as well. Higher volatility expectations can yield higher EV values. This is why a flat trading stock that is not expected to move quickly has a very low option EV premium and why some options are very cheap and other can be very expensive even given zero or negative IV.

That's about it for tonight.

Jeff.

Options

Well, I think I may be coverting my stock positions to option positions. For now I will run both as I see how the options trades work out. Using options forces me to take a closer look at the pricing and nature of the option, decide on a strike price, expiry date and determine if the option is viable to trade based on the charting that I have been doing. It seems to get me more in tune with the underlying stock as I have to do a LITTLE bit more homework before placing the trade.

All of this slows down my trading, which is a good thing. I am forced to take more time in setting up and reviewing all of the factors that go into deciding to trade or not. This extra time has me looking closer at sector rotation again. While I think that the nature of my stock selection sort of handles this automatically for me I would like to use the rotation strategy more aggressively to make it work as one more factor in pushing the odds into my favour.

The pricing of the options is a factor, obviously. I would trade 100 share lots all the time but find that my capital dissappears quickly, trades entered and not filled still count as buying power used up. Options will run between $5 and $15 for stocks between $15 and $50. Rather than filling up my account with orders this lets me sit in a bit more cash while already having my orders in place. The only possible downside is the inability to buy 1/2 contract sizes, minor problem.

I currently have three option positions, 6 stock positions and a few of each order in place. I think I will let this settle for a bit and see where it all goes now.

Jeff.

Absorbing a loss, visiting the pit of the stomach

No, I am not currently considering a loss on any of my positions. I have stops in place for all but two of them... those two are in the absorption consideration. One is a penny stock and the other is my option trade.

I started trading with a small account, and I still consider that I am using a small account even though it is larger than when I started. I read emails, blogs or accounts of people who are getting jittery over a position that they have that is not moving for them as expected or when expected. If the emotion is strong, then sizing down is in order...or re-thinking whether trading is a good idea in the first place. I have resigned myself to the fact that I could lose every penny of my trading accounts and, while I might miss the money, it will not affect any part of my personal and financial well being.

One of the first things that I threw out the window was expectation. No matter what I expect, the market is going to do what it is going to do and, with very very few exceptions, I will have a negligible affect.

This is where the pit of the stomach comes in.

If I find that I have that nasty feeling in the pit of my stomach then I probably shouldn't be trading that particular trade for a few reasons. Perhaps the size is too big, the possible loss is too big or the trade was placed with a hope or expectation. I have had a few of those trades where I felt terrible watching what was happening and realizing that my money was flowing in the wrong direction.

I am at a point where, while I still care that I may lose money, I know how much the maximum loss will be and I have already accepted that as a fact... "prepare for the worst and hope for the best". I would rather prepare for the worst and plan for the best...otherwise the best may come and go and may be missed altogether.

Jeff.

Holiday is over, new scaling and options.

Back from my two weeks off. As much as holidays are a nice get away it is nice to be home again. I had lots of time to ponder a great variety of topics and aspects of life....but I will only write about the trading related stuff here.

I gave some more though to my entry strategy, the 25, 25, 25 share scaling and decided it was not the best approach. I ended up sticking on a two trade entry which can be left as a single trade depending on capital and price moves. As a typical trigger may fall on $30 (using 25's I would enter at $30, $29 and $28 with the stop at $27 with an ACB of $29 at 75 shares) I changed my entry sizing to 50 shares and lowered my entry after the trigger.

New entry is 50 shares at $29.50...which is the same as 25 at $30 and 25 at $29 with slightly lower trade costs (minor) while arriving at the same ACB.

The next trade would be another 50 shares at $28.50 which ends up with the same ACB as a full load of 25's, except now it is 100 shares instead of 75. The slight increase in risk is still within my tolerance.

The 25's entry worked well enough while I was away as I placed VTSOs on all of my positions and netted a small profit as they all closed out in the first week. The disappointment was TCO as I only ended up with 25 shares with a $4 and some per share profit... but a profit is not a loss.

Seeing as I am happy with a 50 share trade by itself this makes me feel better about getting only the first trade in. This still let's me trade the slightly higher priced stocks and maybe fill up more often on the lower priced stocks...which leads me back to the topic of options.

There is much not being said about options and exactly how the "greeks" are calculated and what they mean. While there is lots of free information available on stocks there is less on options so I am working on my own knowledge base for these. I have sent off the necessary paperwork to my broker to allow me to trade options in all of my accounts rather than just the one.

Any stock on my hit list over $25 in price has now become an option trade. I have setup a spreadsheet to automatically calculate the option price that corresponds to my P&F trigger price on the stock...this takes into account the various factors relating to how the price can change given the delta, Intrinsic and Extrinsic values. I realize that my estimate will only be close until the stock price actually approaches the initial trigger but close seems to count for more in options than in stocks due to the method used to set quotes (5 and 10 cent graduations).

The reason I decided to go with $25 as the break point for options rather than stocks is not only due to capitalization. Stocks under $25 I have room for quite a few trades and stocks are easier to trade for me right now, quicker trigger calculations, quicker order entry and a comfort level. Previously I had decided to qualify my trade priority based on lower priced stocks first, this allows me to continue trading while studying the option/stock relationship with the larger prices.

I currently have an order in for IPI at $24.50 as well as the Jan 2010 call at strike $20 for $6.40. I am curious to see how the option execution compares to the stock execution.

Upon rethinking the justification for using options for only the higher price stocks I may consider just going to options for all trades. This means I may have to select a few other stocks to base these on as the options chain should have enough liquidity to get in and out smoothly. The advantage to using options for even the lower priced stocks is in the leverage. If a $15 stock have an option that I would trade at, say, $5 then the leverage is an advantage. In addition to leverage this would allow me to enter more trades to keep my diversity up and not have to commit 100% of my cash to active trades...always leaving a bit in reserve for another nice trade setup.

Currently I have one option and four stock positions, one additional option order and three stock orders. I also have a penny stock position and a penny stock order in place. Pennies are something I decided to stay away from in the past but, upon a suggestion I have two trade "dabblings". One thing about pennies, the profit and loss is fun to watch as a 500 share position creates a quick P/L move. 1 cent = a $5 move. I won't mention anything other than my trades here so anyone else's suggestions will remain un-named.

Jeff.

Holidays

As I prepare for leaving on a bit of a vacation I thought I would drop into my trading account and set up some VTSOs and close any active buy orders. I am reasonably pleased with my portfolio thus far as there is lots of green even in the stop ranges, profit is stopped out is a good thing.

I have long positions in MS, ABX, IPI, TCO, CVA and AEO. My shorts are MWW and GNK...although GNK is likely stopped out already at a loss. I'll start tracking my performance on the home page of my blog once I get more positions that are based on my final plan and stock selections closed.

I started looking at the "greeks" of options last night while working on something else. The new one is the THETA which indicates how many cents per day the extrinsic value decays based on the current numbers. I also noted that the extrinsic value, which is commonly called the time value, is in now way tied only to the time decay. It has as much to do with volatility as some of the options that I have been looking at have had the extrinsic value change in the opposite direction than I would expect after a few days passed. higher volatility has a higher expectation of price moves which can make the option more valuable to traders which basically raises the premium they are willing to pay for them. Interesting stuff and one more reason to watch for options with a small extrinsic value.

I tried placing an option order after setting my accounts up for options trading and the order was rejected...I guess I need to fill out some more paperwork to activate options in the registered accounts. I'll mail this today so that I can activate my options level first of next week and be able to trade options upon my return in mid August.

This summer is disappearing rather quickly considering that we, here in the Ottawa area, have not really had many days that we could call "summer".

Jeff.

Options, Options, Options....

I have started looking deeper into options to see what kind of strategy might suit me the best. In the process I have found out more about them than I already knew and this has changed the way I think about trading options.

I am looking at trading call options and put options instead of, or in conjunction with stocks, nothing fancy.

The basic tenets of options are that a call gives the owner the option to buy the stock at the strike price within the time frame of the option. The presumption is that the price will be higher at some point before the expiry date so the option is worth more to trade OR the stock option can be exercised to buy the stock at the lower price than current market. A put gives the owner the option of selling the stock at the strike price in the hope that the price will be lower.

The interesting part is that the trading price of the option is made up of two parts with a correlation factor to the stock price itself.

Intrinsic value, Extrinsic value and Delta

Before that, a single option contract controls 100 shares of the underlying stock so the following example, and any options quote, represents one share value...multiple by 100 to get the actual value of the trade. A $4 options contract will be $400 even if the underlying stock is at $23. This makes it easier to trade options with less capital.

Intrinsic value is the difference between the strike price of the option and the trading price of the stock. If the strike price is $20 and the stock is trading at $23 then the intrinsic value is $3 and it is considered to be In The Money (ITM).

Extrinsic value is the premium that factors in the potential value of the option going forward as well as the time value until expiry. The value that traders are willing to pay in the hopes that the stock price will move in favour of the intrinsic value increasing at a greater rate than the extrinsic value decreases. As time progresses the extrinsic value decreases, although time is not the only factor, and the closer to expiry the faster this extrinsic value erodes. The rule of thumb is that the extrinsic value decreases the fastest in the final three months before expiry.

The $20 strike priced option with the stock at $23 might have an extrinsic value of $1 so the option trades at $4. Even if the price does not move on the stock, holding the intrinsic value at $3 the extrinsic value will drop to zero near expiry thereby losing the owner $1.

Delta is the relationship between the option's intrinsic value an the stock price activity. The number is from 0 to 1. A Delta of 0.5 would indicate that, at the current price, if the stock moves $1 the intrinsic value would move 50 cents. A higher Delta is better for my purposes. I cannot see the moving relationship easily but given the different delta numbers at different strike prices the farther in the money the option is the higher the delta is, up to 1. A higher delta gives a higher stock price to option price correlation which comes closer to being able to use options in place of stocks directly.

It is interesting to note that, as I pointed out, the farther in the money the option is the higher the Delta is. This means that the reverse applies, as the stock price gets closer to the strike price the Delta gets lower. This should mean that losing money on an option trade is progressively slower than being in the same stock directly. An option that may be $15 ITM might have a Delta of 0.9. As the option strike prices are closer to the actual price of the stock they reduce, in one case 0.1 for every $5 down to about 0.5, once the option is out of the money the Delta keeps getting lower. So the option still has some intrinsic value left.

An example, Morgan Stanley (MS) call option expiring in January 2010.

Buying an option with a strike price of $17.50 yields a Delta of 0.93, single contract is $11.40.
Compare buying the stock at $28.56, $2856.00 or the option at $1140.00.
The intrinsic value is 11.06 (stock traded last at $28.56), the extrinsic value is 34 cents. If the stock price moves up $1 the option will move up 93 cents and will be $1 farther into the money. The farther into the money the option goes the higher the Delta, which makes the rate of option value increase non-linearly...on the flipside the rate of decrease, should the price drop, will also decrease in a similar non-linear fashion. This will make the downside easier to take and mean that the potential loss on the option is actually lower than the potential loss on the stock itself as a full $10 stock price drop is a full $10 loss on a stock position but the option will not lose the same $10. There will be value left even if the option is at the money.

I do not have the math to show this definitively but the theory is sound and, worst case, the option has the possibility of losing the same as trading the stock...no real downside.
The current $28 strike option is at $3.72 and is only 56 cents ITM.
Intrinsic value is 56 cents, extrinsic is $3.16 Delta is 0.62.

I presume that such a low extrinsic value may be attributed to the sentiment that the stock is likely to drop before January, if the prospects look good for the stock going forward I would expect that the extrinsic value might be higher...but this is just a guess.
That is just some of the basics glossed over. The real point is that there are, in my thinking, two types of options that can be traded, other than calls and puts. I consider a high leveraged option and a low leveraged option.

The high leverage includes any options that have a very high extrinsic value compared to the extrinsic value even though they are priced extremely low. a $1 option looks like a great deal but the extrinsic value may be 90 cents. This means that, if the price does not move in favour 90% of the trade will be lost at expiration. An option, with a higher intrinsic value like the example, leaves only 25% to be lost at expiration. The key is going to be to buy options that are far away enough from their respective expiry dates that eroding extrinsic value is not really a problem AND that the stock price is likely to move in favour of the trade in the short term...relatively speaking.

An expiry at least 6 months in the future with a trade timeline of two months or less would probably be ideal. A higher intrinsic value than extrinsic would also be good and an underlying stock that is in a good high probability setup for a favorable move just adds to the mix.

So here I mix P&F charting with options trading and I have setup a quick spreadsheet that breaks down the option price into it's two values, compares these to the stock price and gives the option price that should correspond to the trigger price on the stock chart. This saves paying for data link for charting option pricing.

All this to avoid having to be restricted to short selling in my small margin account. I will replace short selling with put options and can trade these in my registered accounts.

Oh, there is an advantage to buying puts instead of short selling as well. A short sell has an unlimited loss potential, in theory, and a stop loss is not a 100% guarantee that the price will not gap up way over the stop...I see lots of cases where this has happened on stocks that I have been trading, most were in my favour. At least with a put the loss is restricted to the cost of the options only, and there still may be some value left in the option at that, if it is saleable afterwards.

Options, here I come. More reading to do and some trial to see how the trading is executed though, spreads are larger than I like so I may have to do some searching but I like doing the research.

Jeff.