In part 1 of the series, I'll discuss the simplest of all option plays, going long a put or a call. I'll outline the advantages and disadvantages of this simple strategy.
As I mentioned in the
Introduction of Options Into Trading Systems article, the use of options in a trading system brings about some new dimensions to consider or at least be aware of. The two biggest, in my opinion are theta and vega. Briefly, theta is the amount an option decays over time with all other variables being equal. To an option buyer, theta is a loss, to an option seller, theta is a gain. Vega is the value of implied volatility. An increase in vega increases the price of the option and conversely, a decrease in vega decreases the price of the option. Stocks or underlying assets with more volatility (think tech stocks vs. blue chips) will have a higher vega and trade at a higher amount to a lower volatility asset. Keep in mind, I've just given the most rudimentary explanation of a fairly complicated topic. I highly encourage you to understand how these and the other greeks work before trading options.
When we're long a put or a call we have theta working against us. Time is not on our side. So the first thing to consider is the average holding time for a position within our system. Obviously this is paramount because if our hold time is a day or two, theta decay is really of little consequence (but vega may be a big deal, more on that later). Once you begin holding for more than a week or so, theta begins to chew away at your profit. It could very easily turn a winning system into a loser. The second item to be aware of with regard to theta decay is profit targets. A system with a relatively low profit target could have that profit eaten away very quickly by both theta decay and/or the bid/ask spread. It is important to take note of your profit target value and your average profit figure to determine if theta would've chewed that away and left you with a loser.
Vega risk is the next topic to consider. When you're buying an option, you're long vega. You profit if vega rises, you lose if vega falls. From day to day, vega can stay within a reasonable range. But like anything else, there are clear exceptions to this rule. Vega can move and move fast for no real reason. However, one known place that vega moves is during earnings. Most often stock holders will hedge their positions into earnings to protect some gains without selling their stock. In addition, those speculating about the earnings reports may put on directional plays. After the earnings reports, the underlying will typically experience what is known as "vol crush" where vega implodes. When purchasing an option, it never hurts to check out a volatility chart (IV chart). One of the better websites for this is
ivolatility.com. It may be foolish to speculate on volatility as a rule, but buying when IV is very high is a loser far more often than it is a winner.
Now that we've discussed some of the potential pitfalls, let's move on to some of the advantages of this option strategy.
One huge advantage that option buyers have is what some might call an "embedded put". Being long a call means you have limited your loss to the amount of premium paid for the option. While this is discussed in Options 101, it bears repeating for trading systems because so many trading system developers stress money management and limiting losses. If you've developed trading systems for any length of time, you're fully aware of how a stop loss will really eat into your profits. However, without a stop loss you open yourself up to being wiped out. Being long a call or a put allows you to have clearly defined risk before entering any trade. This is undoubtedly a huge burden off of your shoulders.
Straight forward calculations and unlimited profit potential. Coming up, I'll be discussing some more complicated strategies to change the risk profile. This adds complication to the whole process. With straight put and call buying, there are much fewer complications. Also, your profit potential is theoretically unlimited. I don't believe in stocks going to the moon or to 0 very often, but with straight long positions, you do not cap your profit as you may with spread strategies.
On the next go, we'll look into ways to mitigate theta and vega risk.
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