Options Indicators

It's trading stock options that I am interested in. A trader from UBS came in and spoke about this today @ my school and commented that the two main indicators he follows when looking to purchase a contract was both the MACD and Stoch charts. He used these indicators to predict directionality of the stock, breakthoughs, etc. He was mainly an event-driven trader, capitalizing on earnings estimates and such. I am wondering if there were other critical indicators that one should take into account before the purchase of an option contract for the purpose of trading.

Ok, so hes using the technicals to predict short term price movements. When I trade options I do the same thing. Another indicator you should check out is the RSI (relative strength index). Also, take a look at the bollinger bands and the price envelope. A lot of traders are into elliot wave theory and fibbonacci indicators.

Besides the advanced technical indicators, you need to study volume. If you see a stock running up on lower and lower volume, odds are the rally will not sustain and will eventualy reverse, and vice versa.

As i mentioned earlier, looking at the open interest configuration of the front month option can give you color on potential short term support and resistence levels that could limit stock movement.

thanks for all the information. Very helpful stuff.

No offense, I think knowing a good strategy is only like 25% of what you need.

Care to enlighten me on what the other 75% entails? I have a good equities market background so valuating the options underlying securities using various methods, forecasting economic/industry trends, etc. are all something I am very familiar with. What am I missing in this equation. I am very willing to learn and am open to hear some value-adding comments...

jotah, riddle me this, how would you see what the probability of an option finishing in the money is?

I can use historical pricing of the stock & the underlying option to run a simple statistical analysis. I would normalize the outcome curve, establish a 3-sigma boundary, identify past outliers, and from there be able to run cumulative distribution functions to determine % of the time an option has been in the money. I can then analyze my outcome with my short-term trend prediction.

My second option is to simply calculate the expected values, or net expected value, of the various price ranges of the option contract and their corresponding profitability.

If you know of a better/more reliable way of going about this please point me in the right direction.

You can actually back it out from the option's price.

Do you know what delta is? what gamma is? vega?

you got me there...

Like I said I really don't know jack shit about options. My background is in equities. I would like to try out options trading but it sounds like I need to do a lot more research before I start. Any good book recommendations?

none of these are that complicated, but there's jargon etc. not sure of good basic books.

simpler question. let's say you own Coke call options. the price of coke goes up by 1 dollar. how much will the price of the option go up by? what more info do you need?

I know I cannot quantify this answer. The three things I would look at to try and evaluate this would be the option's intrinsic value, its time value premium, and its volatility. Coke is not a very volatile stock so I would expect its underlying option to act similarly. To evaluate either intrinsic value or the option's time value, I would want to know both the strike price and excercise date of the option.

These are the factors I would want to know and look at. From here, though, things get a little fuzzy...

ok, let's say coke is at 50. let's say you have a call expiring in october. which will move the most for a 1 point move in the underlying.

the 45 call? the 55 call? the 65 call?

I would assume the 45 call is going to move the most because with coke's current price of 50, the option is the only option @ a premium from that list and has a margin of safety built-in as well if the stock turns around.

correct. what about the 55 vs the 65?

what we are discussing is the option's 'delta' by the way. the sensitivity of the price of the option to a 1 unit move in the underlying.

I would apply my same thinking to the 55 & 65 calls:

The 45 has the highest delta The 55 would have a respectively smaller delta The 65 would have the smallest delta

This will continue to be this way even if the spot price of Coke goes above 65 b/c the 45 would still offer the most profitability, correct? I would also assume that all the different calls' deltas would respectively increase, however.

correct. good work. you've also hit on something else. delta is not stable. it changes as the underlying changes. this second order effect is called 'gamma'.

this gamma is a good thing. like all good things, it costs money. can you guess what that cost is?

on other thing. delta is a 'close enough' approximation for the likelihood of an option expiring in the money, for vanilla options. it is not the actual probability, but it's usually in the ballpark.

assuming your gamma is positive, you would be paying for basically the new found popularity of the option. If gamma is positive, or even increasing, trade volume will be on the rise b/c the option is becoming either more profitable or is trending towards profitability. It is like supply & demand. You are going to have pay a higher price for future earnings b/c this is what everyone seeks.

The easiest way for me to correlate all of these indicators is in a physics/calculus scenario, where:

Option price is like "position" Delta would be the "velocity" Gamma is our "acceleration"

It's kind of a crude relationship but helps me follow...

yes that's a good enough analogy. for a long position in a vanilla option, your gamma will be positive. it has nothing to do with popularity. being long a call gets you long gamma. so what are you short/what are you paying for this?

you get short gamma, which I would assume is negative (opposite of long gamma) b/c you want a downturn in the option's underlying price. This instrument is inherently riskier b/c profits are limited but potential losses are limitless. Not exactly sure how these work beyond this. I am only familiar with long calls...

we're speaking at cross purposes.

the time decay of the option (aka theta) is the price you pay for gamma.

i understand the concept of an options theta. makes more sense now. thanks for all of the good information.

gamma is very similar to convexity in a bond, if you've heard the term.

man just reading that exchange was the most efficient learning that I have ever experienced. Jimbo you are a zen master.

gracias.

motion to instate Jimbo as zen master of IBO seconded

The technical indicators the OP mentioned are very commonly used by chart hogs. Their predictive value is questionable. However, lets not get into that.

To successfully trade options the goal is to have a method to forecast the direction of the underlying or the volatility of the underlying. These two are the components that generate the options price. Thus, when that trader said he uses MACD and stochs he was using his directional bias to take a position using options to take advantage of this insight (whether its successful or not is debatable).

If you would like to get a better understanding of options I strongly suggest reading "Options Pricing and Volatility" by Natenberg. Its not a difficult read and isn't as dry and academic as Hull. It is hands down the best primer IMO. I also suggest using riskglossary.com to get definitions on various terms that you may want to know about. A nice reference tool.

Happy learning!

i strongly prefer Hull for exactly that reason. it reads very much like a math book, presenting you with just the relevant facts, examples, and problems with no fluff. I remember being fairly disappointed by the Natenberg text because it was subtitled "Advanced Techniques For Traders" yet immediately I noticed that the book was pretty much words, words, words. Depending on the OP's preferences though, that might be exactly what he wants.

Could be. I personally hate math books. I personally thought the text to be very to the point. I also liked the fact that it was written from the point of view of a practitioner. It focuses strictly on the subject material and provides more information regarding options trading in an easy to digest manner than Hull.

Thanks for the input on possible reads. Like I mentioned I have a solid background in equities so I am looking for a pratical way to use that knowledge base and apply it to options trading. I will look into both books and go from there...

The action of greeks gets more interesting when you deal with exotic options as well, traditional measures like vega have a flipped profiles with regard to underlying price. e.g. if you are short an option with a knock out barrier level. Initially you are short vega but as you get closer to the barrier you get long vega. That stuff is pretty cool

Definitely. A no touch barrier option with a full spot hedge would have its highest profitability just one tick below the barrier just before it expires but would directly go to break even if that barrier is hit. You get some pretty insane risk profiles with those types of options.

dmoran, can you provide a simple explanation of why the vega (and gamma etc) of say a digital libor cap flips at the barrier? hint: think of how it's hedged/replicated.

and given that vanilla options are usually bid and offered in vol terms, do you think that's true for say digital options, or if not what method do you think is used?

Im not 100% sure, but ill give it a shot

You replicate the digital buy constructing a vanilla call spread such that 1 bp difference in the underlying generates a payout of the digital. So you lever up the notional to that point, so if your libor digital cap w/ a payout of 100 USD, you solve for the notional on the call spread, in this case 1 million USD

Assuming you sold the digital cap, i believe the correct delta hedge is to buy the underlying. As you approach the barrier you have to buy more and more in larger and larger amounts as i believe gamma is much nastier closer to the barrier. You want the barrier to knock out because then you have this huge long position that you need to sell off ASAP, i think at a profit because youve been buying the underlying all the way up. I dunno if gamma scalping using delta is possible around the barrier, since im not an option trader.

Second question, i believe its not quoted by vols, but probability * payout

just a quick ps to my response of Jimbo's first question, im assuming a decent amount of time has passed on the option life such that gamma has a pretty peaked profile

pretty good job dmoran. only problem is when the vanilla call spread is not available, or not available in the right size. that exarcebates the pin risk.

Hey Jimbo,

You're really good with the greeks man. I am just reading John Hull, and have some questions with regards to some options; hopefully you can help. What would be your strategy to hedge:

1. A double no touch, digital option?
2. Accumulator option?

Any reply would be very very much appreciated! Thanks!

don't trade fx. and beside the hedge is not static....but for something like a dnt, i imagine you get pinned near the barrier.

what is an 'accumulator' option? i think it may be something like a daily digital...in which case you replicate as best you can via call or put spreads to get you out of the skew and hope for the best.

hmmm sorry i'm pretty new; what does it mean when you say get pinned?

As for accumulators: you're quite right on that.

thanks a lot