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3. Selling Options versus Buying Options
Selling (writing) covered calls, along with selling
put options are strategies that have gained some attention in recent years. Let's
explore some basics behind these concepts.
Options traders often focus their attention on time
decay. Some traders refuse to initiate positions that have negative time decay
because (their reasoning goes) they "don't want to slowly bleed to death."
Other traders shy away from positions that have positive time decay because they
fear market movement will hurt them.
Is one approach correct and the other wrong? I think
both are wrong because both are exclusionary. That is, both approaches preclude
ever using the other technique.
I believe that deciding the type of trade to initiate
should be made only after evaluating other factors. Once those evaluations are
complete, you'll know what type of trade to do. Sometimes the answer will be to
establish a position that sells premium (positive time decay) while other times
the answer will be to buy premium (negative time decay). I'll explain my rationale
below.
First of all, it's a mistake to look at time decay
in isolation. Time decay is only one of three variables affecting position performance,
and I believe two other variables are the key ones to analyze and act upon: those
variables are implied volatility and statistical volatility.
It's desirable to capitalize on extreme levels of implied
volatility by buying options in markets having low implied volatility and by selling
options in markets with high implied volatility. Why? Because studies have shown
that implied volatility will eventually revert to its long term average. So abnormally
low implied volatility will eventually increase and unusually high implied volatility
will eventually decline. This makes sense to me because emotional extremes must
eventually return to a more normal state.
You can choose from various types of options spreads
when buying or selling implied volatility, however, before deciding anything it's
important to take volatility of the futures contract into account. This means
you must review statistical volatility because it measures price movement of the
underlying futures.
It would be foolish to buy options in a market that's
complacent in its behavior, just as it would be reckless to sell options in a
market that's trending or chopping back and forth in a volatile fashion. Instead,
it seems logical to expect a market will continue to behave just as it's been
acting recently.
So using this framework, you want to identify those
markets which currently are:
(A) non-volatile and which possess high implied volatility.
These are markets for initiating short straddles, short strangles, ratio spreads,
or long condors (a credit call spread along with a credit put spread).
(B) non-volatile and which possess low implied volatility.
These are markets for initiating calendar spreads.
(C) volatile and which possess high implied volatility.
These are markets for initiating reverse calendar spreads.
(D) volatile and which possess low implied volatility.
These are markets for initiating long straddles, long strangles, ratio backspreads,
or short condors (a debit call spread along with a debit put spread).
This is where the Data Base Survey (DBS) function
of OptionVue5 enters the picture. In a matter of minutes you can complete and
print surveys which allow you to identify the markets for each of these categories.
"Knowledge is power and all traders can benefit
by continually bolstering their knowledge base. I hope to contribute in that regard."
Paul Forchione
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