Trading options is appealing for several reasons: leverage, spreads, and pricing is based on a ‘model’. Each of these reasons appeal more or less to traders who use options as part of their trading strategy.
Lets take leverage, the most obvious, for only $150 I can ‘trade’ an 80 Dec call option on SBUX (Starbucks). The nominal value of that option contract is ~$8000. (I’m assuming you understand the basics of option pricing.) Multiply that by 10 and for $1500, you can trade 80k of SBUX stock. Who wouldn’t like options? (That’s the trap, on too spreads…)
Good spread trading allows you to stay in business a bit longer – bad spread trading puts you out of business quicker. I can create spreads or ‘construct’ combinations of put, calls (and futures) which fit a particular strategy. For example, if I think SBUX is going stay flat for a while, I’d like to create a spread, selling options outside my projected range.
There are a few models, the most common is Black Scholes. These models appeal because they give traders a structure and theoretical pricing. They help you determine if a particular option is over-priced or under-priced. From this perspective they act as an indicator. Experienced traders will pay significant attention to models and pricing. For good reason. Statistically the ‘premium’ you pay for an option is based on the likelihood that it will expire worthless. Many traders will tell you that the only way to make money with options is on the sell-side. In other words, the pricing model, is better at predicting future prices than they are. That’s hard to argue with.
Lets take our Starbucks example and look at it’s option chain – I’m going to avoid the weekly options, they were designed to tempt the retail trader into losing their shirt. We’re also going to see if we should use options as part of a strategy with SBUX.
The first thing to look at is OI (open interest). SBUX OI is saying the 80 strike is the most active, but 6 or 7 times more active than the put side – that’s bullish. Does that correspond to our strategy? No, we’re assuming SBUX is going to stay flat. Though if we look at the IV (Implied Vol), calls are relatively cheap. If you want to continue to dig into ‘relatively cheap’, work on the model, and have a look at HV (Historic Vol).
The second thing is volume/price spread. There are NO institutional bets ‘out of the money’ on SBUX. Volume is low. Often you’ll see big trades being made around earnings, and those are good indicators. SBUX is NOT showing any big out of the money bets. Price spread is bid-ask difference – low volume leads to large spreads which implies bad pricing (remember our model?). I’m oversimplifying, but if you don’t know what you’re doing, STAY AWAY from low volume, high price-spread, low open interest options!
Back to the problem, should we use options to fit our strategy of ‘flat’? I’ve highlighted a proposed range ~80-82.
Technically this is a very bullish chart with two bull flags, hence the high call open interest. If we’re flat we’re predicting that we’ve jumped to the next range. Is ‘flat’ still a good strategy? December expiration is the only contract period we might sell calls or puts outside our range and even in December our Condor strategy is very limited with almost no open interest at 79 and 84. If you’re flat SBUX, the option chains are screaming, stay away from me.
Should we adjust our strategy? Is the bullish open interest enough for us to change strategies or start looking for another? That’s a personal call, but lets say it’s time to go full bull. 6-7 times Open Interest on the Call side is a strong indicator. Not as strong as an institutional trade, but strong none-the-less. What’s the trade? Buy the 80 expiration sell the 82.50 expiration. That trade will make money if the SBUX December contract closes over 81. We’re still theoretically in our range so I’d take that spread one step farther and look at a calendar (diagonal) spread, selling the Jan 82.50 and buying the Dec 80.
What’s the P&L look like on this trade? Break even is ~ 81.25, you’ll have to get out or adjust around Dec. expiration… The probability curve based is in blue and the P&L is based on 10 contracts.
How can I learn more about option chain indicators? My favorite tool is livevol pro. If you can’t afford that, watch option chains with high activity. Most trading platforms will give you scanners that find: high open interest, high call/put activity and high/low vol filters. Option chains can be great indicators for stocks you trade, Starbucks in this example. They can also be used as a tool for finding new stocks to trade.