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Directional Strategies For Option Trading

06/22/11 12:37:17 PM
by Billy Williams

Option trading has a big edge over stocks when it comes to leverage and risk control, but a trader must understand how to apply the principles of timing, using delta, and profit taking to succeed.

Security:   AGU
Position:   Hold

In boxing, if you pit two evenly physically matched fighters with equal skill with the exception that one of the fighters has a slight edge with defensive skills, then that is the fighter who will almost always win. So it is with trading, where option traders have a slight edge at protecting themselves over an evenly matched stock trader in that the option trader can control his risk better using options since they have tremendous leverage, but their risk is limited to the cost of the premium versus an entire lot of shares that could fall as much as 50% on bad corporate earnings, as an example.

Add to that, options are much more flexible in their approach in that they can be implemented with several trading approaches -- volatility based, income strategies, hedging, nondirectional -- while stocks are limited in large part to whether or not a trend is present. Since the market is dynamic and always changing, this gives the option trader a huge edge in trading the market.

This can be a mixed blessing since it takes a certain kind of sophistication when dealing with options, which is why it is said that if trading stocks can be like playing checkers, then trading options is like playing chess.

It takes a higher level of skill, but for those traders who strive to maximize their returns while reducing their risks by becoming an expert at option trading or, at least, familiar with using them when the time is called upon, you can make large leaps of progress in both your trading and your overall performance.

In order to get off on a good footing in using options, it is easiest to begin with what many stock traders would consider familiar territory, which, in this case, would be catching moves in stocks that are trending and then using options for superior gains due to their high leverage and limited risk to the cost of the premium of the option itself.

There are certain key characteristics to directional option trading that must be well understood and applied with discipline if you hope to trade successfully with this approach.

First is timing.

FIGURE 1: AGU. AGU broke out of a narrow channel and rocketed higher. Buying high-delta at-the-money (ATM) call options with at least 30 days till expiration could net you a big return in a short time plus let you rollover the options to the next month to ride the trend higher if need be, plus take profits along the way.
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While options have superior leverage and lower overall risk in relation to stocks, the key factor for using options to capture moves or trends is timing the move itself because options have one weakness in comparison to trading stocks: They have limited shelf life. Options expire at key dates - the third Friday of the month they are written on. For example, October 2011 call options will expire on the third Friday of October.

If you expect an upward move to materialize in June 2010, for example, and buy the calls, the move has to happen before the third Friday of October, or they expire worthless.

The second thing to keep in mind is to buy options that have a high delta, that is, they are as close to one as possible. Delta is a mathematical algorithm that calculates how closely an option moves in tandem with its underlying instrument.

For example, if a stock moves one point and the delta on the option you are trading has a delta of 0.80, then your option will move up 80 cents for every point in the stock. Since each option controls 100 shares of stock, then that translates into $80 for you. See Figure 1.

Finally, have a plan to take profits.

Aspiring option traders who make a sudden windfall of profits often hang on too long in the hopes of gaining even more profits in the likelihood that the stock continues in a direction that favors their position. At times, it warrants hanging on, but keep in mind that you don't make money until you sell off a profitable position, so taking some profit helps your trading capital grow along with your confidence.

You can take profits by rolling over your position by buying a higher strike price on the option you're trading with some of your profits, while banking the difference.

If you're trading ABC call options at the $75 strike, which is what the stock is trading at when you enter your position and it moves up to $90, then you can sell off your $75 strike calls at the same time you buy the $90 strike and bank your profits while riding your position higher.

This rollover maneuver keeps you in the trade while avoiding the effects of time decay on your $75 strike, which is when the value of the option begins to decline as the expiration date gets closer.

Directional trading using options can be much more useful to a skilled stock trader than just trading stocks alone, but you must use these three key factors in your decision-making process as you size a potential option trade up in order to put the odds of success on your side.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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