Lazy Man's Guide To Trading
By: Chris Verhaegh
The following is an excerpt from Chris Verhaegh's Money From Nothing
The laws of option pricing state the following: An At-the-Money option always has the highest time value. It’s time value will drop whether the stock’s price change causes it to go either “In-the-money” or “Out-of-the-Money”. Not some of the time, not most of the time, but all of the time! This undeniable fact is the basis for our Straddle Trade.
We look to buy both a Call and a Put right when they have the highest time value. Understanding that no matter which way the stock moves, they will both lose some of this value. It seems counterintuitive to want to lose on both. But, this is only part of the equation.
While both options may be losing time value, one of them is gaining intrinsic value. Understand if an option is truly “At-the-Money” it is only a cent away from being “In-the-Money”. We profit when the option, either the Call or the Put, gains more intrinsic value than the pair loses in time value. Sound risky? But it is far less risky than you realize if you place the trade at the right time.
Speaking of time, we try and time our trades less on any technical or fundamental analysis, but on the liquidity provided by institutions and large volume traders - usually near the open or near the close.
As much as our system is based on laws and rules, the reality of your life might be such that you can’t place your trades at either time, or if you could, the stock’s price wouldn’t cooperate to the extent it would be at a price where the risk would be the lowest. So we have created a methodology to place your orders when it’s convenient, allowing you to go about your business as usual.
We call this the “Lazy Man’s System”. Please understand, even though we use the term “lazy” in the name, we are not implying this is as easy as turning off your alarm clock and sleeping your way to wealth. There is some work involved, but you won’t be shackled to a monitor all day waiting for a stock to move in your direction.
We have a lot of experience trading Goldman Sachs (GS), so we will use GS as our example. Our premise revolves around the fact that GS is not a stagnant stock. Its price moves. We look to capture some of this movement without needing to forecast direction.
Follow my logic… If on a Friday, a week before expiration (in theory, we could do this any day) we are able to buy a Straddle on GS right when its price crossed a strike price, we would have a mathematical advantage. A Statistical Edge!
Assume it happened the moment we looked, we would not be lazy, we would be lucky. This is not the “Lucky Man’s Guide”, so we will need to put some work in. Without our order placing system which I am about to share, we either need to wait or walk away.
Understanding the Law of Option Pricing and the ramifications which go along with it, we are able to calculate what the option’s price would be if and when the stock’s price was to cross a strike price.
First Rule: If a stock price goes up, the Call will go up in price and the Put will go down.
Second Rule: If a stock price goes down, the Call will go down and the Put will go up.
Myron Scholes won the 1997 Nobel Price for Economics for a mathematical formula he wrote with Fischer Black, (Mr. Black died in 1995, so he was ineligible to win). I don’t have the keys on my keyboard to write the Black-Scholes formula out for you. However, it’s not the formula that matters; it’s how we can take advantage of this formula that counts!
Here’s where it get complicated. The amount these options move is predicted by this Nobel Prize winning formula. The math will tell us exactly what the changes will be. The formula is made up of a bunch of squiggly lines that look like hieroglyphics. So to save everyone the trouble of doing the math, I created a shortcut.
Before I share my shortcut, I want to share the fact that a student of mine made a different shortcut for different reasons. As much as I want this to be a truly lazy way to do it, I think you should look at both. Let me start by sharing mine.
A reality of the Straddle Trade is as the stock’s price moves further away from the strike price, the trade increases dramatically in price. Since I have taken many liberties in my shortcut, I will say it only works when the stock price is within a few dollars of the strike price.
My system has three parts. First, calculate how far the stock is from the strike price. Next, multiply the result by 20%. Finally, remove this amount from the then current midway price of the Straddle. For example, if the stock is $95.70 and we have a $95 strike price, the first result is 70 cents. Twenty percent of .70 equals .14. Subtract this from the current Straddle price and we have a Good-Til-Canceled (GTC) Limit Order amount we would place to buy the option. Understand, we are never guaranteed of a fill.
I make my calculations on midway between the bid and the ask. I might add a little more if I really want to be filled. I might hold to my principles and the lower price if I am feeling economical (cheap).
My student’s shortcut may be simpler. As with mine he is not assured of a fill, but I like his line of thinking. He basically places his GTC buy order at the same price as the Professionals. He places his at the bid price. He feels he has a safe exit if he can sell it for what he paid. If it never crosses the strike, he shouldn’t be filled. If it does cross, it shouldn’t stay there.
Which ever system you use to buy your Straddle still requires you to sell it. You may be surprised how fast you can take a profit if your goal is a quick return. If you are not able to watch, you might be well served with an alert to your phone. Once you get filled you will want to place your sell order.
Here’s to trading Lazy!