Analyzing Your Option Trading Opportunities

The following is an excerpt from David Caplan’s The Options Secret

In The Option Secret, we compare trading to playing poker in many areas.  This analogy is not meant to be cute, but rather because they are quite similar in many ways.  Also, it may be the easiest way to visualize when and why we should be trading.  (In comparing statistics to trading, gambling analysts have stated that 80%-90% of poker players lose and professional players, although they may lose occasionally, year after year come out ahead).

One of the biggest mistakes and money losers for beginning poker players is playing too many hands.  These players tend to like the "action" and are not discerning enough about when a hand should be played or dropped. 

The expert player, on the other hand, plays only when he finds the odds significantly in his favor.  He may adjust his style according to the other players in the game (loose versus tight; expert versus amateur, etc).  However, in general, he will not put his money in the "pot" unless he feels that there is a good reason to do so.  He knows that eventually the cards will turn in his favor and better hands will come up to provide him with his best playing opportunities.

This is exactly the same for the trader.  Beginning traders are normally excited, wanting to get involved in the "action."  Positions are taken without adequate planning.  The professional option trader does not get involved without being able to obtain a significant opportunity.  He analyzes option volatility levels, the technical pattern of the market, the trend of the market, and the market's current reaction to fundamental news to determine whether volatility is high, low or there are disparities in option premium.  He then decides the best trading strategy to take advantage of both the volatility levels and the technical pattern and plans his trades accordingly.

IF THERE IS NO SIGNIFICANT ADVANTAGE OR TRADING OPPORTUNITY, HE WILL STAND ASIDE.

He knows there will be other days and other markets that will provide "better playing hands" for him.

We analyze the underlying futures market to find a directional "bias" for our options positions.  As we said earlier, you can not trade options in a vacuum.  That means you must know what is going on in the underlying market as well as the options market.

Again, this is similar to playing poker. Three aces is generally considered a very good hand.  However, in a situation where there are many other players in the "pot" betting strongly, it could be the right move to throw that hand away.  Not playing borderline hands, and not trading in inappropriate situations are probably the two most important things new poker players and traders must learn.

After analyzing the technical pattern of the market, we now look at option volatility levels.  The following outlines virtually all the trades that we consider for the different volatility levels.  (This information is directed at the off-floor trader.  Floor traders have the ability to use these positions plus other, more "arbitrage" type positions because of their speed of execution and low trading costs.  Floor traders tend to use many "delta neutral" positions to squeeze out premium from options on a short term basis.  This includes not only the neutral option position and ratio spreads, which are our favorite (delta neutral) positions, but positions matching futures and options in almost any configuration to provide them with an advantage including "boxes," "conversions" etc).

The following are the only positions we use in our trading portfolio 99% of the time:

1. NEUTRAL OPTION POSITIONS – High-medium option volatilities/trading range market (sell out-of-the-money put and out-of-the-money call in the same expiration month). The "Neutral Option Position" is best used in markets that have extremely high premium (by selling far out-of-the-money options), and trading range markets at any volatility level that have little likelihood of significant movement. 
2. FREE TRADE – Low option volatility trade/trending market (buy close-to-the-money call or put, and if the market moves in the direction intended, later sell much further out-of-the-money call or put at the same price).  The "free trade" is used in trending markets to purchase options of low to medium volatility that are close to the money (particularly on pullbacks or reactions against the trend), and further out-of-the-money options which can have much higher volatility levels are sold on rallies to complete the "free trade."
3. RATIO OPTION SPREAD – Premium disparity between option strike prices, high volatility in out-of-the-money options/mildly trending market (buying close-to-the-money option and selling two or more further out-of-the-money options).  The "Ratio Spread" is used when disparity in option premium exists.  This generally occurs in extremely high volatility markets such as those that occur in silver and soybeans during rallies.  In this case the close-to-the-money option is purchased and two or more further out-of-the-money options which can have up to twice as high option volatility levels are sold.
4. CALENDAR OPTION SPREAD – Premium disparity between option months, high volatility in close-to-expiration options (sell close-to-expiration month, buy deferred month in the same market).  The "Calendar Option Spread" is used to take advantage of disparities in volatility between different contract months of the same option.  The trend is not as significant for this position as long as we feel the option we sell will probably not be "in-the-money" at expiration.
5. IN-THE-MONEY DEBIT SPREAD – Premium disparity between strike prices/trending market (buy in-the-money, or at-the-money option and sell further out-of-the-money option).  The "In-The-Money-Debit Spread" is initiated in volatile markets that are trending.  Again, similar to the "ratio spread," the at-the-money option which is more fairly valued is purchased and the further out-of-the-money "overvalued" option is sold.
6. NO-COST OPTION – Higher option volatility in out-of-the-money options/take advantage of strong technical support and resistance levels (by near money option, sell out of money put & call).  The "No Cost Option" allows us to purchase an option with the premium we receive from selling other option premium to pay for it.

That is it and that is all there is.  You may want to use other positions yourself, you may want to invent complicated multi-legged positions, but we have found these to be the only consistently effective ones that can be practically used and provide a significant advantage.