Sunday, February 21, 2010

An Option Trader's Thought Process

I received a question the other day in regards to using options to bet on changes in volatility. Though most seasoned readers are familiar with the many facets of option trading, let's take another look at how options are used by various market participants. Options are typically used to bet on direction, volatility, or a hybrid of the two. I suppose we could create another category for option plays seeking to exploit neither direction nor volatility, but time decay. We'll let that specific subject simmer in the idea vault for a while longer and focus today on the first two.

When contemplating an options trade, most traders first seek to determine whether or not they have a directional bias in the underlying stock. After determining their directional bias (bull, bear, neutral), many novice investors immediately proceed in selecting which strategy they want to use. If bullish they may opt to buy a call option. If bearish, they may simply buy a put option. While placing a trade based on your directional bias is important, due to the huge impact volatility has on an options price, it is also crucial to determine whether or not you have a bias on volatility. Does volatility seem too high or too low? Upon becoming more familiar with volatility, most veteran option traders use a dual approach of considering both their directional and volatility bias. For example, if one was bullish on the underlying stock and bullish on implied volatility, they would probably opt for a different strategy than if they were bearish on implied volatility, such as buying a call option versus selling a put option.

There are yet other scenarios where a trader may hold a bias on volatility, while lacking any significant bias on a stock's direction. Before jumping into a trade, first decide which variable you're trying to exploit: a stock's price direction, volatility, or both. Then select an option strategy that is poised to profit in the anticipated market environment.


Emma said...

Very interesting article. I really liked the information that you have posted above about options trading. I am just a beginner in this area and this article taught me a lot about options trading. Thanks for sharing this wonderful thought process.
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wall street trader said...

I feel it is important to instill in customers a sense of responsibility. People should understand that they have to be careful with the way they invest.