Two ways to look at option premium

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• 0:01Speaker 00

  Did someone call for a doctor? Remember that scene from Ocean's Twelve? It was very funny, Brad Pitt. I'm actually gonna change my last name to Martin Pitt in solidarity with Brad. Anyway, so I got a question about, you know, can you add to your winners using options and this and that? And I'm gonna cover the adding to the winners part probably tomorrow. Options are kinda trickier that way, really. And this'll be a short, a shorter episode. The, the idea being

• 0:36Speaker 00

  that with options, I really look at them as, as like the option premium, right? To say we're having one option. So say, you know, the option has a price of five. I kinda look at the option premium in two, in, in, as, as the sum of two things. It could be how much of in the money value is there? So intrinsic or inherent value? And then the volatility piece with time value. So you're real, I kinda, when I think about trading options, I'm thinking about, okay, which, which am I trading today? Because if the option's in the money, right? Now I have intrinsic value. You know, the delta should be increasing as the price goes up. But I also have that volatility component in concert with theta.

• 1:21Speaker 00

  Now, if you look at the knee of that theta chart, it really starts to fall off a cliff at like the 30-day mark. So, so for my own tastes and preferences, and this comes from my days as, as, as a hedger. That's how I was physically trained in commodities. Oftentimes, we would buy like six, six-month call options to cover a runaway market. And then in the near term, what we would do is we would sell. Monthly expirations to kind of help offset the cost of that longer term insurance. Right? So that that's, you know, certainly one way to kind of get your calls or your puts a little cheaper is to kind of sell calendar spreads.

• 2:06Speaker 00

  You have to obviously marry that with the chart. So that's kind of how I started to think about the vol with the intrinsic value. Now, at the beginning, you might, you might be buying 25 deltas, they're out of the money and give yourself enough time.

• 2:23Speaker 00

  I don't want to talk about zero DTEs is a whole different ball of wax. But ultimately, you know, you need to be trading off of the chart of the, of the underlying security or the futures contract. You know, as well.

• 2:38Speaker 00

  So, so when I look at that option, I have to say, okay, like, look, the market has spiked. The instrument itself might be four ATRs above the 20 day exponential moving average. So is it going to mean revert? Now, mean reversion doesn't necessarily mean I want to sell and go the other way. Cause it could channel sideways and just kind of let the moving average catch up to the damn thing. And so, you know, it depends on how much of, of, of your gains do you want to give back? But usually at that moment in time, I would look at the volatility as much as the intrinsic value and then use that as the trigger. Right? How much is the IV changing with respect?

• 3:21Speaker 00

  Like when you look at the premium and you take out the intrinsic value? What's happening with the, with the intrinsic value day after day? Knowing that there's theta. If you go out far enough, to me, the theta.

• 3:35Speaker 00

  The volatility should offset the theta. Doesn't always do it, as you can imagine. If you're trading shorter term, the theta is a much bigger issue. And so you need to, you know, use time stops, right? In the short term, right? Because you just don't have the time at that point. And although you can certainly say like, okay, I'm risking one half of 1% of my account on this particular trade, I can let the thing go to zero. I'm typically not built that way to let things expire worthless. So, you know, with options, I'm very rarely buying things that have less than 30 days to expiration. It's mostly, you know, 90 plus. Because I want to kind of buy myself the time, if you will. Because I know that, again, the theta is going to really accelerate, kind of like

• 4:19Speaker 00

  at the knee of the chart, if you will. And, and really start to hurt me. So there's no point for me like, look, if the thing didn't start working out in like the first week, then it's like, okay, my timing's off. I got to come back to this, but I'm not going to sit and wait. So maybe, you know, go look at a 120 day option, let it trade down to 90 days. And if something's not happening by then, then I offset it. I don't care about the spread. I don't care about whatever, because that's pennies on the dollar compared. Look, if, if you have an option that's trading three bid, offered at 330, right? And then it's down to 270 after 30 days. I don't care about a 30 cent spread. I care about not losing the 270, right?

• 5:02Speaker 00

  Because if the market's 250, 270, 240, 270, I'll take my 240, right? Don't, they talk about the forest and the trees. Like, who cares about the spread at that point? Like, I'm not going to sit there and go, let me hit the mark. Let me try to get the midpoint. That's too anal. It's like, your job is to manage risk. And if the thing didn't work out and it stalled, or if it looks like it's rolling over, you got, I don't necessarily think you have to go the other way, but you have to do what you have to do to protect your capital, even with the options. It is very popular out there in the interwebs for people to say, you know, just buy your 25 basis point, 100 basis point risk unit and let the thing go. Because when you buy the premium, you kind of have your built in stop. You know, I get all that. I figured that out when I was just starting.

• 5:47Speaker 00

  But at the end of the day, you know, your job is to still protect your capital, no matter what asset class you are, you know, trying to trade.

• 5:58Speaker 00

  I'll talk about it more tomorrow, but I think it's difficult to add to winners with options. You know, I made, I had a couple of really big trades this year. I caught Exxon in January and I had at first in January, it was January 6th, that day the market was down and coming into the close, I bought a big position, knowing that it was a, at least thinking it was a retest, you know, and sometimes you get lucky. And I bought the, the May, like the May 140s and then the thing ripped.

• 6:34Speaker 00

  Took a bunch of money off along the way.

• 6:38Speaker 00

  And then the market peaked and it kind of consolidated, then it looked like it was going to make another run. So I came back and instead of adding, I was really just buying, because I had liquidated my first piece. I went out and bought like the, the 180s, because that was only 20% above the market at that point. So I find it's better to just, to adjust and to kind of roll the position. Because as if the market's going up, you know, since there is an expiration, right? You need to kind of systematize a way to kind of, how can you have the exposure? But to roll some of your capital out, like the same way people do that with property, right? They buy a house, they fix it up, right?

• 7:20Speaker 00

  They get it reassessed, they borrow money out and this and that. You can't really borrow anything with options, but you have to think like, okay, I don't know where the top is, so I have to finance out some of my gains. Or, you know, if it looks like it's going to stall, sell a good chunk, if not everything, wait for the, the retracement to say a moving average and then look, look back at a, at a higher strike. That would be cheaper, so that this way, even on that piece, if you lose, you'll still be a net, net winner across all of your positions. So that takes a little timing. It took me a long time to understand that, because there's just so many moving parts. And I, I didn't have the time, so maybe that will help you.

• 8:04Speaker 00

  I get a lot of questions about how do I look at options and when's a good time to sell and this and that. You know, I tend to sell. My winners, right, which are less frequent than my losers. Again, I'm looking for three to one, because if I sell at two to one, and I know I have really, really good friends, and you know who they are, that say, you know, sell at the double, finance out your cash, and then free roll the rest. I'm a working class dog, right? I grew up waiting tables, cutting grass. I had a landscaping company. I'd go to work, you know, at Wingfoot and Quaker Ridge, and then at night I'd go to Glen Island Casino and work there. So when I go to work, I need to get paid. I don't like the idea of selling at, excuse me.

• 8:49Speaker 00

  Yes, if I have a stock or a future, and I can adjust my protective stop to break even as soon as possible, within reason, that's, that to me is different. With, with the futures, because it requires a lot more cash, right, to, to put down. With, with options, it's more like, I know the thing's going to expire, so I have to, I have to take action, maybe before I want to. But I have to read the tea leaves, right? So then it's like, okay, boom. I will, I will offset, usually at three to one. So if I buy a one dollar call, like those Exons, I paid one and an eighth for, and I sold the first batch at like seven. But that's just because the thing ripped. Normally, so now I knew it's seven to one.

• 9:33Speaker 00

  There's no way I could lose money on the trade, never mind what happens to the rest. So the point I'm making, if you do the math, is if I sell at three to one, and the other half goes to zero, I'm still going to make money on the trade. Again, that's my working class upbringing, in that I need to make something. I need to make some kind of return on my capital to make it worth my time. Again, I'm going to harp on asymmetry, because I think if you're a chart reader, you should be able to kind of see on the chart if there's an asymmetric proposition there for you, meaning if you know you're going to risk five bucks a share, has it been 25 bucks higher than where you proposed to buy it? Right? And if you can't see that, who cares about two to one?

• 10:18Speaker 00

  There's always two payoffs to every trade, and I'll leave you with this. There's the emotional payoff, there's the financial payoff. So I'm not trading to be right. I'm trading to make money. And if you do the math, right? When you focus on five to one payoff, your accuracy rate can drop to 20% and you'll still make money. You clearly can't make a living with that. But the main thing is you're not losing. And what you don't lose, you don't have to earn back. Anyway, thanks for being here. Go get your copy of The Inner Voice of Trading from tradermindset.com. I'll see you tomorrow.