Trading options has grown in popularity over the years because of the appeal of limited risk associatcd with them. Unlike buying a stock or contract where the losses have no limit and can quickly mount up, buying an option limits the risk to only the cost of the option. This is called the prcm ium. The greatest fear of most traders is that the market will have some disaster and go against them so fast and furious that it puts them into bankruptcy. So rather than bet the farm an option trader can trade the market with a sense of security.
Of course, there is a cost associated with acquiring a sense of security.
The purchase price of the option or premium is non-refundable. Whether you win, lose or draw, you are never refunded this investment. At best, you can recoup your investment if your winnings are great enough to cover it. Despite this fact, if you are right about an option trade then you can actually profit more than if you traded a contract or stock outright. This is because an option investment is generally much lower than the margin required to trade a contract or stock, allowing you to trade much more with the capital you al ready have. The more instruments you are trading on a profitable trade, the more profit you actually make. So the benefit is not only more security, but more money as well . That is of course if you can call the market right. This is the trick that eludes most option traders.
The cost of an option depends on three issues; the time left before expiration, the strike price in comparison to the current price and the implied volatil ity. The way these are determined can be very complex,
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but the price is calculated by set rules and all you normally have to do is to look at readily available quotes to know what an option is currently going for. The rules are not stacked in an option buyer's favor because the option writer or seller doesn't have the same benefit of security as the buyer. It is the sellers of options who are given an edge when it comes to trading options, just as any casino would have over a gambler who walks in through its doors. Writers are in essence "the H ouse". If this leaves you with the impression that the writers (sellers) of options are generally the winners in this market then you are absolutely correct. This makes the selling of options the more profitable venture, as long as a market doesn't explode against you unexpectedly. The problem with writing options is that you have the same risk as when you buy a stock or commodity outright. So if you are an option writer and the market suddenly explodes against you, you have a real problem. So despite having an edge, option writers still have inherent risks associated with their mode of trading. So there are advantages and disadvantages to both sides when it comes to trading options.
Even so, options do offer an excellent trading vehicle and although they are a bit more complicated than buying or selling stocks and commodities outright, sources of information about how they work are plentiful. In fact, some of the best information is available for free from the exchanges and brokers who handle options. Since this is the case, it is not the purpose of this book to explain what a butterfly is or the difference between a call and put. The option trading process is something that can be learned by multiple sources elsewhere. But what this chapter will address is how Channel Surfing can be used to determine option trades that are potentially profitable, whether you are buying or selling them.
Before we discuss either venues of trading options, it is important that you understand something about option value. Profit or loss is not really based on the strike price of an option, but rather on the value it accumulates. If you are a buyer, the true value of an option must exceed the cost of the premium that you paid or no profit is actually realized. So the strike price isn't the real issue here when it comes to determining what is in a safe zone and what is not. You must add the premium cost to the strike price in order to ascertain the actual breakeven point. For the moment, just bear this point in m ind and later on this issue will be discussed in more detail.
For now, we will consider the two distinct modes of option trading, buying and writing.
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Option buying
In the option world time is truly money and the longer the time until the option expires the more expensive the option will be. As time runs low the cost of the option is reduced. Another factor affecting the price of the option is the strike price. This is the price where the option starts to have value. The closer the strike price to the current market price the more expensive it is. In-the-money options, which are those that already have value, are among the most expensive to purchase. Both of these factors are pretty straightforward in how they work. Simply put, the more time and value you have in the option the more expensive it is.
It is the third factor called implied volatility that is the most complicated and variable. This is also the area where we are most concerned with when it comes to options. Basically, implied volatility relates to how much movement is expected out of a market. This is strictly based on what the market has been doing recently so it will vary from market condition to market condition. So if a market has been dead with very little movement for the past few weeks then the implied volatility will be low and so will the price of the option. I f you can buy an option just before it rockets off again you stand a good chance to make money with options. The trick then is to buy an option during passive or dead times all the whi le knowing which direction it will go and when it will get there.
Before you say, "that would be some trick", there are actually a number of ways to do this with Channel Surfing. Channels facilitate the ability to determine the likely progression of a market. Enhance this by using multiple time frames, true support and resistance l ines, and repeating channels and you can develop a pretty good picture of how the market will unfold. This means that you can make a fair estimate of whether or not an option has any chance of becoming profitable based on the market's own geometry.
For example, a market in a downtrend will eventually find support and reverse direction. No market can stay in the same direction forever. The likely spot where this will occur will be at the bottom of a larger channel.
So find the larger channel on a higher time frame and you will know where the odds favor such a bounce. But the benefit goes further because a bounce of such a magnitude will translate into a substantial reversal on the smaller time frame that you are trading. Additionally, a larger channel provides a target for the current move and the succeeding one.
This succeeding move would be the other side of the larger channel. Take
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the previous up trend and calculate the likely angle of progression and you have the factor needed to determine how much time to allow price to reach that point. Time is a key element to trading options because even if you are right about where the market will go it is of l ittle value if you don't make it there in time. If you purchase an option just as it approaches this "bounce point" and allow sufficient time for the move to make it to the opposing channel the odds are you will have a profitable trade on your hands.
In figure 10-1 these elements are combined to calculate a reasonable expectation for an option trade. A lthough a smaller channel in a downtrend is currently the main focus, a larger channel is dictating that a bounce is likely to occur very soon. On top of this, a true support and resistance l ine appears to be stopping price even sooner than this. So this is a good area to consider buying a call option. The recent trend angles have lasted just under 2 Yz months long, from low to high. The average move has been about 12.5 cents. Since this is early September, this move would require more time than the current contract of September will allow. The next available contract month for the British Pound is December, which would be long enough for the needed 2 Yz months. So a call option is purchased with a strike price of $ 1 .58 slightly above the current closing price.
Within the expected 2 Yz months price shoots up to $ 1 .70 for a very nice profit. This is how an option trade is supposed to work, but for most traders this type of result is very elusive. The reason is that there are generally two mindsets when it comes to buying options. In one case you have the approach that both a call and a put option should be bought while option
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cost is low, which is called a straddle. The focus of this strategy is an attempt to exploit an increase in volatility which will eventually follow, but no one knows exactly when. The problem with this is that you spend twice as much in order to set up a straddle and unless volatility picks up dramatically both options expire worthless, or at least fail to generate enough profit to cover the cost of both options. The second approach is to buy options as a hedge or to take advantage of a trend. Both of these will often rcsult in the transaction taking place when the price of an option is high. In addition, most traders fail to balance the cost of an option against the needed time for a reasonable profit. The tendency in each of these is for an option that is either so expensive that you are never able to recoup your investment or one that expires worthless because there wasn't enough time to generate a profit.
Determining what options have any real potential of becoming profitable is a balance between the time required to reach a profitable target and the prem ium or purchase price of an option. Obviously, this means that you first have to be able to determine the amount of time needed to reach a profitable target.
So how do you determine the time needed for price to reach a target or as I term it, "an option profit zone"? The time factor is built into the smaller channel itself. The inside channel is the minimum movement expected out of price. So once a channel gets under way all you have to do is look at the inside line and see where price will be at any given time in the future. If the strike price and expiration fal l outside of this range then you will have a problem pulling in a profit. I f your targeted profit zone is crossed by the inside line before the expiration date then a profit is likely, with all other factors in your favor. Even though you can pul l in a profit with just the outside line crossing your profit zone, a trade based solely on this line is very risky. It would depend on the market maintaining the necessary volatility and this is a variable in the life of a trend. In contrast, unless something changes within the market geometry you can count on the inside line fol lowing through.
Although this technique will dramatical ly add to your assessment of any option trade, there is a fly in the ointment here. It is important to understand something about the characteristics of trends. Markets wil l zigzag as they move. Any trend that develops is more aptly described as higher h ighs and higher lows or lower lows and lower highs. Rarely will you see a straight line anywhere on a chart. It does happen occasionally such as when a market explodes during some earth-shattering event, but usually it will
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just zigzag along until it reaches its destination. Sort of l ike a river flowing through a countryside and weaving across the landscape. This is why we look at the market based on channels that provide an expected range rather than in straight lines. It is a river nourishing the land rather then a rigid road paved in gold.
Trends not only zigzag within a channel, but they also from time to time zigzag out of a channel. While this is not true of every trend most will have a point somewhere in the middle where the market extends beyond the normal range, breaking channel lines along the way. This excessively wide zigzag often turns out to be what was earlier described as a trend shift.
Not all result in an actual trend shift, but many do. But whether you have a trend shift or not, you will generally have some type of zigzag motion that splits a trend in half. Because this zigzag has a habit of occurring right at the center of a trend or at its mid-point it is in turn a gift to you when you are attempting to project how far the trend will go. However, this habit is really a two-edge sword.
The positive aspect is that the mid-point will l ikely be just that, a halfway point of the trend. You simply double the prior distance and you are likely to be close to where a trend will end. The negative aspect is that the shift itself creates a delay of unknown length making it difficult to know when it will actually get there. Figure 10-2 demonstrates the characteristics of zigzags and their impact on a trend.
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A mid-point zigzag occurs quite frequently. Some trends will bypass this step all together, but this is the exception rather than the rule. Look for it in every trend that appears no matter what time frame you are looking at and it will give you one more trick to deciphering a market.
But th is brings us back to the negative aspect of a zigzag. When calculating the time needed for a price target to be met you have to take in consideration any delay that might develop as well. Odds are that a delay such as a trend shift wi ll occur. So how much time should you allow to compensate for such delays? This can vary widely and I do mean widely, but a trend will generally shift no more than three times its width. So this is the maximum that would be expected. Even so, three times its width can still translate into a considerable delay.
Fortunately, markets have a habit of repeating themselves and a past trend shift is a good starting point for determining how much time to allow.
Most will be very simi lar in length and breadth across each trend. So in reviewing one you are I ikely to have a fair estimate of another. But this is not the only way to narrow down your estimate.
A trend will operate within a channel with a set width and this width can be used to measure the likely delay. A trend shift will usually last on average from one to two widths of the channel, with three as its maximum.
In other words, to calculate the time that you need to allow for a trend shift you would simply measure the time between the two channels and use this as your basis for estimating the maximum. Realistically, most trend shi fts will last no longer than a double channel width, but a trio estimate will allow you to cover most worst-case scenarios. I n spite of this, there will still be times when even three widths are exceeded such as when a trading range develops, but this will be the exception rather than the rule.
In figure 1 0-2 the trend ends up shifting two additional channel widths, which is very common. The width of the channel in this example is approximately 1 % months and the actual shift lasts a total of 3 Yz months from the point that the shift begins until it finally resumes the up trend.
Not every trend shift will work out this well, but many do. A llowing for these delays when purchasing an option will reduce those that eventually meet your price, just never in time to make a profit.
While you can never be sure if a market will develop a trend shift or even its smaller counterpart the zigzag, the odds favor some type of delay will occur. If you fai l to take this into consideration then you will delay
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achieving the profit that you had hoped for as well. Old habits are hard to break and a market will tend to repeat them quite often, but so do traders who take shortcuts and think that this time it will be different, fai ling to consider the possibility of a delay in their option trades.
While trend shifts can be unpredictable in general, they do have one tendency that is predictable; they often repeat and maintain the same angle. This enables you to make a reasonable judgment as to when a trend will resume. By using the technique of trend angles discussed in an earlier chapter, the resumption of the trend can often be determined in advance.
When it comes to buying options, time is the enemy. If you cannot conquer it, it will conquer you. Therefore, it is imperative that you understand how to make a time calculation if you want to trade options. While it is not the only factor, time alone will kill hordes of your option trades. Trend shifts are just one of the factors that are commonly overlooked by option buyers.
While you may be right about a particular market and even have the price target reached, if it is not within the required time it is to no avail that you have made the trade. Therefore, you must understand how trend shifts alter the time factor or it will shift you into a losing trend.
Once you understand the concept of trend shifts along with the other idiosyncrasies of the markets, the process of time calculations becomes simple. The amount of time for any movement can be reasonably estimated
Once you understand the concept of trend shifts along with the other idiosyncrasies of the markets, the process of time calculations becomes simple. The amount of time for any movement can be reasonably estimated