Translating ATR To Option Premiums
Monday, January 8, 2007 at 12:12PM I wasn't sure if I wanted to open this can of worms, but I figured "hell with it" let's do it! Weeks ago I talked about indicators used to set stop orders. Average True Range was one of the indicators discussed, and in my opinion one of the best ways to set a trailing stop order on a stock. How does a stocks average true range help you exit an option trade though? Here are a couple ways...
With all the wonderful technology now days, there are many capabilities as far as setting orders are concerned. Contingent orders, bracket orders, OTO (One Triggers Other), etc. Using these orders makes it fairly easy to sell an option based on a trigger defined by the stock price. For example, if I am using ATR on a current trade, and let's say that ATR is a value of 1.5, and the stock price is currently $50. I can set an order to sell my option contingent on the price of the stock reaching $48.49 (a penny below my current ATR). This would be something that would need to be adjusted daily, especially if you are away from the computer often.
What if you wanted to translate an ATR into an options premium? We can use black scholes to give us a theoretical interpretation of this difference. Let's use an example.
With all the wonderful technology now days, there are many capabilities as far as setting orders are concerned. Contingent orders, bracket orders, OTO (One Triggers Other), etc. Using these orders makes it fairly easy to sell an option based on a trigger defined by the stock price. For example, if I am using ATR on a current trade, and let's say that ATR is a value of 1.5, and the stock price is currently $50. I can set an order to sell my option contingent on the price of the stock reaching $48.49 (a penny below my current ATR). This would be something that would need to be adjusted daily, especially if you are away from the computer often.
What if you wanted to translate an ATR into an options premium? We can use black scholes to give us a theoretical interpretation of this difference. Let's use an example.
LMT just broke out today, and the price is currently about $94. The current ATR of LMT is about $1.25. Let's say we wanted a Feb 90 call, which is currently priced at $5.30. We are going to purchase this call, but want to set a stop specifically on the value of the call if the stock dropped one value of it's current ATR, which is $1.25. Below is the current option parameters input into the black scholes calculator, along with a version that includes a stock price at $1.25 cheaper. Take a look...
Based on current parameters, theoretical value is $5.10 (current ask is $5.30). Based on a $1.25 drop in the stocks value would mean the option would trade roughly at $4.15, which is roughly a $1 difference in premium. You could set the option as a $1 trailing stop, but this equation we just did does not take time decay into consideration, nor changes in implied volatility. However, it is a way to at least get a trailing stop on your option based on the stocks ATR.
What a complicated business we work in, huh? There are various other ways that this can be done that I did not mention. Otherwise I would be here typing this for days. If you have a few alternate suggestions (or criticisms), please feel free to leave them.
Reader Comments (10)
Henry
Could you run that by me again? Are you asking why not trade a synthetic instead?
You could, but that was not the intention of the post. It was how to translate an ATR to an option premium.
Great post for us "busy" people that are away from the PCs most of the day. This is how I have been doing it for the last couple of months. It works pretty well for me as long as I re-compute it each night to update the Black-Scholes inputs to obtain a current number for the next day of trading. I use a similar method for my Sell limits as well. I do not use the ATR for Sell Limits (does not apply). I use the anticipated target area/level based on my technical analysis. This has definitely helped me keep much of my gains! As I get closer to the target area/level I will actually adjust my trailing stops tighter in order to not allow a major pullback from the gains. This adjustment must be based on the price action, volume(to some degree) and the proximity to the target area. I normally use Bracket Orders for my trades to set my Initial Buy Entry, Sell Limit and Trailing Stops.
This is a great SIMPLE method for those of us that can not be near the screens allday!!!
Regards,
Randy B.
-Steve
I use the delta to estimate the target, and stop loss of the option. But I will compare the ATR to the way I was setting my mental stop loss, I might be buying more contracts that I should. I use emergency stop loss at 50% of the option premium because I can be in front of the computer. When it is close to my target then I set a order with trailing stop and set the stop based on the risk to reward ratio. That is if I think the stock can still move $2 more I set the trailing stop $1 from the bid, so I can have 2 to 1.
This is helpful. Now if you are really away and set this up as a trigger to sell the option you would have to enter a market order, correct? I am not a great fan of market orders. Is there a better way to place the trade to sell? Best Regards, Laura
Were you asking whether to use a stop order or a stop limit order? Were you deciding between the two? If you really meant market order here, it wouldn't really apply. For me personally, between the two orders (stop vs. stop limit) I have never used a stop limit, nor would I ever.
Happy Trading!
Jeff
Since your delta is constantly changing would it be tough to keep up with it? Would it apply for OTM options?
JK
The point here is to set the stop-loss order. Since the normal call or put pricing have less than 1 delta and IV to consider, it is hard to set the exit point. While using the synthetic option strategy, it allows to buy more time with less money (e.g. long Call premium less short put premium) and delta of 1. So it is straight forward for setting the exit point.
Does this make sense?
Henry
The point here is to set the stop-loss order. Since the normal call or put pricing have less than 1 delta and IV to consider, it is hard to set the exit point. While using the synthetic option strategy, it allows to buy more time with less money (e.g. long Call premium less short put premium) and delta of 1. So it is straight forward for setting the exit point.
Does this make sense?
Henry