Selecting an Option... With a Hint of Gamma
Tuesday, February 12, 2008 at 10:43AM Everyone has a different methodology of selecting an option; most of which are wrong. Most option buyers will tell you it all comes down to their forecast, while most option sellers will tell you it all comes down to the probability of success. I have plenty of experience in both camps, and as most of you know: I am an option buyer. As such, it is tougher to pick the right option since they are wasting assets, and naturally they favor the seller. Over changing market climates my strategy has always been the same...I pick them short & sweet. Short meaning short dated... specifically, front month or second month expirys preferred. Anything longer dated messes with my ADD.
I say "sweet" meaning that in order to get the right outcome, strike selection is critical. When trading breakouts or stocks I have predicted to make big price moves over a short period of time...I trade OTM options. Normally only one strike out on cheap stocks, maybe as much as two strikes out on expensive stocks. Aside from being an "Option Addict" you'll know I am also a technician, and I rely on these breakouts and big moves for the majority of the stocks I buy options on.
The other situations are when I buy dips or sell rallies at support or resistance levels. In these situations where I am not expecting monster moves, I normally buy my options one strike ITM. In situations where I do expect a big move, I trade one strike OTM. As you can see, my selection process is a function on my analysis...which is how it always should be.
I don't do much in the way of "Greek Analysis" when selecting an option. This is because my mind is the next best option pricing model that has yet to hit the market. Know this...Greeks are not static, so getting a specific value of greek is like asking for the final score in the 3rd quarter. It does you no good since the numbers are going to change. However, I will give you some insight to the Greek called Gamma, and how it works in an option trade.
Gamma is a measurement of how sensitive your option delta is. A low gamma means your delta will not experience much change, hence not changing the sensitivity of an option to a change in price. An ITM option or OTM option will have a low gamma, while ATM options have a higher gamma (relative to month of expiry). If you are long gamma (own options- calls or puts) this means your delta has the chance to increase closer to 1.00. If you are short gamma (short calls or puts) this means your delta has the chance to decrease closer to -1.00.
Your total gamma position is considered a risk, especially if it is negative. A positive gamma position generates better deltas, which generate better returns. This is similar to the effect I get from trading OTM options.
Imagine an OTM option. Naturally it will have a low delta and low gamma value. These options are cheap, but that is only because they have a low probability of expiring ITM. If you are a decent in your ability to pick stocks, and your timing is spot on- this increases the chances of success.
Note: Buying OTM options carries the lowest mathematical probability of success. Ask McMillan.
Next, let's say you were right on the direction of the stock and the OTM strike now gets closer to ATM- what is the outcome? Now your delta and gamma both increase (ATM options have highest gamma). Now, this cheap option is more sensitive to price changes, and has a very sensitive delta. At this point, the cheap option has now increased quite a bit in value (expressed in percentage terms) and if the stock price keeps moving in your favor, your delta will continue to increase, while the gamma will start to decrease. Gamma decreases as the delta gets closer to 1.00 (that is as high as it goes).
I have always preferred this type of approach for a few reasons....most importantly because I am comfortable with being wrong, and being wrong a lot at times. I manage risk well, and I am disciplined in cutting losers quickly. However, the times that I am right, I make a killing as you can see. For example...on the CLF trade I have mentioned in my last three videos, Friday I took down Feb 110 calls for $2.30. As of today, these are bid at $9.00. These options have an explosive reaction to a changing delta/gamma as they go through the process of moving from OTM to ITM.
To wrap things up here, this is not an endorsement for you to trade OTM options. Especially in a volatile market. I just wanted to revisit the option selection process as I see it, and talk a little about gamma.
Class dismissed.
Reader Comments (49)
Thanks Jeff.
It is good to see that your option selection process is similar to mine. Hopefully mine will keep up with your results.
Berkshire
Peter C
Re: POT my resistance line is at 150 a close above this I will consider a break-out with good volume supporting.
Ken,
Cool that is what I thought.
Jeff- That was the PERFECT post at the perfect time. Thanks!
Any thoughts on LEAP? I know, i am repeating myself.
Jeff,
The other advantage, as I see it, is that when you are wrong on a price pattern, the low delta and gamma of an OTM option limits your loss and helps to control risk.
Jeff
Thanks for that post, very enlightening, and congrats on the CLF trade, I wouldn't say there are too many option traders out there making 400% in 3 days !!
Sheepdog,
I see LEAP as a symmetrical triangle currently at support.
Jeff..
LOL..great timing..if you know what I mean...
Copied and saved for later date so I can keep re-reading it!
liz
Thank you Jeff. I follow your blog, not JUST for the watch list, but for great lessons like this.
I'm not sure I want to trade OTM options like you do, but I admire your approach and overall success.
Thanks. I am pretty new to using charts and graphs and i was looking for somebody else's opinion. From what i have read, i need to see which way this goes in order to trade it. Correct? One more point. Can i expect a pretty big move in price since the triangle is pretty wide.
Jeff,
Thanks for the post. You've been blogging like a mad man lately! Really appreciate it. Don't know how you find the time.
Raimo,
Thanks for the thought!
Scooter,
Fabulous Post. You're a genius!
Sheepdog,
Yes, you need to wait for the pattern to confirm. Symmetrical triangles can go either way. I see a possible 17 pt move but in this market, you may want to take profits sooner.
Jeff,
You picked up OTM Feb options with only 6 trading days left?!! Makes my 60 day options look freekishly long term. What do your exits look like?
PB
Jeff..
U r welcome!
I have been taking advantage of your knowledge buddy. Can I buy you a Yuengling? Or would you prefer the Maserati?
Jeff:
Thanks for the post. I definitely need to work on my Gamma.
Jeff, I needed that! I need to work on my gamma as well.
Coal stocks falling on a disappointing earnings report by ANR.
Thanks for this post Jeff. I reread some McMillan the other day about greeks, but I like your take best.
So did you buy longer term options on CLF too, or was that rec just for those of us lacking a calculator brain like yours?
Thanks for putting it in simple terms for us simple people!
Anyone taking a stab at BIDU today going into earnings? I know I'm not, I need to start working on trading on higher probability trades rather than hope and luck. Hope and luck haven't been doing too much for me thus far.
FWIW, I think they'll miss.
PB,
Like I have said over and over, I have reduced my timeframe.
Even though CLF might double in the next three months, that doesn't mean I want to own one set of options over that period of time. I plan on hoping in and out along the way. Once I am done taking profits in these, I will re-up in March paper.
Cool?
Nate,
The longer dated option has a higher probability of a win, but I took the lower probability for better returns. Like I said above...when it gives out another entry signal, I will move into March options.
Thank you for the post.Have a question on one of your prior suggestions Sunday.SLB broke out of it's triangle yesterday(up more today) but on low volume.Would you have considered buying yesterday afternoon despite the low volume.Educational question only as it looks to be a little late. Thank you. Jim D
JimD,
This is something you need to decide. As long as you are managing risk, it shouldn't matter.
I would metion that breakouts supported by volume are usually more potent and have a higher probability of success.
All you have to do when you see these...is make a decision and support it.
This tape is dizzying, emotions are running high, day traders are laughing all the way to the bank !!
Jeff,
Cool indeed. I normally pick options 2-3 months out, but rarely (never) hold them longer than 30 days. Think about this I must.
PB
CME - goodbye, at least I made enough for a cup of coffee. The only thing lost - my time!
VIX/VXN - I suspect a short term bottom - Time to switch hats again
Shadow Trader claims, "I'm tired of this, up/down, my gosh, I don't care which direction but a direction would be nice."
I agree, go down - that's ok, go up, that's ok but this market on meth (drugs)! Going back to market neutral - cash!
JK,
Your take on DBA is this a place you would ADD?
But more than that when Wheat is locked limit up and the market maker raises the level of the limit is that bad for this little commodities backed gem?
Alpha on the Gamma
Cheers,
Arty
Thanks Jeff, One more question if I can. Are you still bullish on gold and the gold miners in this market environment.Thanks for all your help.
PB,
Stop paying for time you don't use, dammit!
This will enhance your returns ten fold.
Jeff, youve already outdone yourself with everything you have done for us, but I could not imagine a better time for that "coming up with a day-trading plan" post you had an idea for the other day. What do you think?
Stephen
X - hit the $100 with pain. Went bearish with Mar Puts!
Hello Jeff,
I know you are expecting XHB to hold over the 20 dollar mark for this expiration week, However, are you bullish on XHB past this point?
Appreciate your thoughts
Kiera B
That's a bold move Free2trade considering the breakouts yesterday in CLF and MTL
Jeff,
Your posts are so timely. I have always over analyzed the greeks in the chain but you make it simple. You are an awesome teacher. I get it now.
well done Professor
Stephen,
That might be a dangerous request for you dude.
I've already recorded it. I just need to post it sometime.
Whoops, I know! I was watching steeltoday & with the touch line today at $100 & the 60 minute going down, the $VIX looking perky for a move up I took a position.
Jeff,
And though I normally agree with you Scooter, and even though it doesn't matter which way the market is headed, I am not convinced we have bottomed out yet. Just because some "fly by night" stock operator bails out the bond insurers...you think that is it?...for shit sakes we have got to pay sometime.
Cheers,
Arty
Arty,
I'd wait 1-2 more days....ask me how I feel in the morning.
Where in the hell have you been by the way?
Jeff,
I have been detoxing at Whispering Hills, no more trembling it has allowed me to do more BEFORE pictures for the Body For Life book series.
But I appreciate the offer to spend a morning with you so I will ask.
If i tell you the truth you will be dissapointed.......I have been working......AHHHH
OUT!
Arty
Free2trade
Hey it could turn out to be a great trade, as in this market, up is down and vice versa, as far as I can see, but with X I would go short at 95 and long at 105
Raimo,
I need a Yuengling!
Cheers,
Arty
Raimo,
I don't need a Yeungling, but I want one! Do you need a mailing address or should I just stop by?
Sean,
I'll second that one. My shuttle looks like a return visit, but looking up was not good.
Berkshire
Jeff, Great advice, from now on when i feel i have found one ready to explode i won't buy 1 - 2 strikes ITM 40-60 days out! Sick!!!
TBM
GREAT POST