Tuesday, July 26, 2005

The Mechanics of Making a Trade (software screenshots postponed)

I wrote an application in C# that interfaces with my brokerage's software to compute option probabilities and greeks in real-time. At the simplest level, this application is a substitute for excel, and various free web based probability calculators I use. The application goes further though. It computes quantities that I previously couldn't, using excel and web based calculators. The progam should also prove to be a huge time-saver, by eliminating the need to manually enter values into excel and by removing the need to visit various web-sites. As the program evolves, I see it developing into a general-purpose option strategy evaluator.

Before I get into the screenshots, let me explain a little about the actual mechanics of how I enter a trade, so that it will be clear what the purpose of this program is. Say, I'm interested in entering a bullish position in a stock. The first thing I'll do is check out the options and see if there is a way for me to modify my risk/reward profile by selling puts or going long calls. For example, if implied volatility is high, and the market is fearful, high-yielding puts with a high probability of profit may have a high expectation (based off of the statistics, not necessarily the reality) of profits. So, since I hate taking losses, I might choose to sell those puts with a high probability of profit, if I think the market is too fearful of a large move to the downside.

Often if I'm interested in a entering a bullish position in a stock and I don't find "good" puts to sell, I'll forget about it. This is because even if I do have a "bullish" opinion, it usually isn't a very strong one, and so I feel that I should also have the extra "edge" of selling expensive volatility. Furthermore, I like to be able to have a high-frequency of profitable trades, which selling out of the money options gives me.

Now, if I really have a strong opinion and I don't see puts with a good probability, I will often buy deeply in the money calls as a substitute for stock if the trade is a short-term one. This gives me a degree of downside protection if the stock should make an unexpected extreme move, although in practice the option is far enough in-the-money that if the stock were to move enough so that that downside protection actually kicks in we'd be talking about a catastrophic move and I would be taking huge losses nevertheless. The main reason for using the deep in-the-money calls is not for loss-protection. It is so that I don't tie up a lot of capital for the trade. This used to be my "bread-and butter" trade...but this year I have not been very successful speculating with in-the-money options. I think this is partially due to the fact that I have generally been puting on larger trades than I used to when making these types of trades, and this has clouded my judgement. Come to think of it, I'm not even making these types of bets in the same types of scenarios that I used to. (I just had a major epiphany here. I'll try to remember to make a blog post later.)

Sometimes when I check out the options for a stock (I'll use a bullish example again), I find that out-of-the money or perhaps at-the-money calls have a high expectation of profit relative to the amount of money that needs to be put down to buy the calls. If it is a stock that makes explosive moves, I might be inclined to place a low-cost bet. This is a low-probability trade, meaning more than likely I'll lose money. The potential reward though is high. This is usually a longer-term strategy for me. (6 months or more.) This is a newer strategy for me, and I have not taken any profits yet using it so I don't know how well this is going to work for me. So far I am showing an unrealized profit on my long-term call purchases.

The final type of trade I make are the very long term stock purchases that I make. I don't even look at options for those trades.

Well, I meant to show you screenshots of my software...but I seem to have filled up this post talking about the mechanics of how I place an option trade. Since this post is allready long, I will make another post about the software specifically.

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