Low Risk Options Trading Strategy - Option Spreads

[simple_trader]

I think, that is individual's perception. There are traders, who would go for far lower RRR ratio eg. stock trader buying a stock of 500 rs to make 50 rs on this giving RRR of 50/500 = 0.1 to 1.
Atleast in this case you have the RRR of 56/44 = 1.27 to 1.
Similarly, brokerage cost vary from trader to trader, Some people just pay 1 point in brokerage, whereas others pay 5 points.
Just sharing my views.

Hey, am I looking for some more posts for correcting my prev posts ? If that comes, then I will be very happy to recieve them and update the content wherever required so that it doesn't not pass wrong msg to any reader in future. So keep writing.

Happy Trading

Like your nice way of giving reply. I do not have much knowledge in option trading. However, with my little understanding, risk reward ratio has no mean unless we catch the market mood (market trend).

For example, if one buys naked option perhaps it will have highest risk reward than any other form of trading. Does it mean, if any one buys naked option will make tons of money?

What I mean, for example, if I buy 5000 PUT at 50 rs now and theoretically if market falls to 4500 it will be 500. It means my trade's risk reward ratio is 50/450=1:9.

Does it mean buying 5000 PUT at 50 is the best trade in terms of RRR? are we not missing something?


I am yet to read all your writings. Though I will read for my learning, but if I get any doubt, will let you know.

regards

 

[gautamparmar]

Hi Sibuji,

Hope you guys are doing great.

I know you did not forget to email me your strategies but I can't resist myself to ask again. As soon as you get time do send it to me.

Offcourse I have to tweak it to my personality. I will do it.

Thanks Again.


Gautam

 

[AW10]

However, with my little understanding, risk reward ratio has no mean unless we catch the market mood (market trend).

For example, if one buys naked option perhaps it will have highest risk reward than any other form of trading. Does it mean, if any one buys naked option will make tons of money?

What I mean, for example, if I buy 5000 PUT at 50 rs now and theoretically if market falls to 4500 it will be 500. It means my trade's risk reward ratio is 50/450=1:9.

Does it mean buying 5000 PUT at 50 is the best trade in terms of RRR? are we not missing something?

Simple Trade. Reward to risk ratio (RRR) is one of the important factor in decision making process for selecting whether to take a trade or pass it on.
We also need to look at the probability part of it. What is the probability of
mkt hitting 4500 in remaining life of market ? Generally, I don't like buying naked options cause odds are against them. They make money only in 1 situation, when market moves in their direction. But they loose money in many situations like
- when market stays sideway
- whem mkt goes against them
- when mkt moves in their direction but not fast enough to cross the break even point
- when mkt moves in their direction but not early enough to recover the value that they have lost due to timedecay.

That means, chances are much higher the the put buyer will loose money. Fact that more then 90% options expire worthless.. i.e. there are so many 90% people who bought the option but did not get anything from it and decide to let it go in the bin..


They are just my views and the way to look at trading.

Looking forward for more of your posts..

Happy Trading

If you read first few posts of this thread, then u

 

[AW10]

Hi Sibuji,

Hope you guys are doing great.

I know you did not forget to email me your strategies but I can't resist myself to ask again. As soon as you get time do send it to me.

Offcourse I have to tweak it to my personality. I will do it.

Thanks Again.


Gautam

Gautam, you can also use Private Message feature of the forum to get in touch with SLM Uncle directly.

Hope you remember the TJ rules about sharing personal contacts etc which is not allowed on TJ.

If you won't mind, then Plz edit your post and remove personal email before TJ or moderators find it out. (my personal request).

Thanks
Happy Trading.

 

[findvikas]

AW, With due respect... your post will have his email id as well you missed to edit his post.

 

[fabrics]

Simple Trade. Reward to risk ratio (RRR) is one of the important factor in decision making process for selecting whether to take a trade or pass it on.
We also need to look at the probability part of it. What is the probability of
mkt hitting 4500 in remaining life of market ? Generally, I don't like buying naked options cause odds are against them. They make money only in 1 situation, when market moves in their direction. But they loose money in many situations like
- when market stays sideway
- whem mkt goes against them
- when mkt moves in their direction but not fast enough to cross the break even point
- when mkt moves in their direction but not early enough to recover the value that they have lost due to timedecay.

That means, chances are much higher the the put buyer will loose money. Fact that more then 90% options expire worthless.. i.e. there are so many 90% people who bought the option but did not get anything from it and decide to let it go in the bin..


They are just my views and the way to look at trading.

Looking forward for more of your posts..

Happy Trading

If you read first few posts of this thread, then u

thanks .I have lost presently buying naked puts 4900 at 85/-.expecting the marlets to go down,

 

[simple_trader]

Simple Trade. Reward to risk ratio (RRR) is one of the important factor in decision making process for selecting whether to take a trade or pass it on.
We also need to look at the probability part of it. What is the probability of
mkt hitting 4500 in remaining life of market ? Generally, I don't like buying naked options cause odds are against them. They make money only in 1 situation, when market moves in their direction. But they loose money in many situations like
- when market stays sideway
- whem mkt goes against them
- when mkt moves in their direction but not fast enough to cross the break even point
- when mkt moves in their direction but not early enough to recover the value that they have lost due to timedecay.

That means, chances are much higher the the put buyer will loose money. Fact that more then 90% options expire worthless.. i.e. there are so many 90% people who bought the option but did not get anything from it and decide to let it go in the bin..


They are just my views and the way to look at trading.

Looking forward for more of your posts..

Happy Trading

If you read first few posts of this thread, then u

Yes, that's what I was trying to mean as well. If anything has good RRR, it means probability for risk is more in built in that trade.

That's why even though theoretically risk reward is 1:9, people lose money in buying naked option.

Though this is not the prime reason why people lose money in naked option. May be more to do with position sizing and time value.

The main point I was trying to make is every trade has always 1:1 = risk+probability of success in trade : reward+probability of success in trade when we initiate the trade.

Hence risk reward would not be main attraction of executing a trade. Other wise buying naked option would have made lot of money for people as we can show 1:9 risk reward in that.

To me risk reward primarily plays big role when we are into a position and how we manage a position.

Like adding position to a wining trade, or moving SL to higher level. That way we can bring down actual risk:reward.

Other wise, risk:reward before taking a trade a illusive thing.

For example,

say if we say BUY RELIANCE at 1020 with 1000 SL for 1100 target. It means my risk:reward in my trade is 1:4. Is it really a 1:4 risk reward? may not be really. because, more probability that 20 SL will hit than 80 points target.

These are my own thinking. Please feel free correct me if I am wrong in anything.

In my example I took naked option be case, 4800-4900 and buying 4900 naked PUT both are directional strategy. We will lose money unless my trade direction is right.

However there is more chance of making money in 4900 PUT with the same risk as the beard spread (4800-4900). But bear spread has more chance of winning in more number of probabilities than buying naked PUT.

However if we get direction wrong, risk is almost the same. Basically, there is no easy thing in market to make money.

rgards

 

[simple_trader]

Dear AW10,

I have posted my thoughts. but it says admin needs to approve it. Hope admin approves it. Not sure, why it needs to approval. may be it exceeded word limits.

regards

 

[munde_77]

Simple Trade. Reward to risk ratio (RRR) is one of the important factor in decision making process for selecting whether to take a trade or pass it on.
We also need to look at the probability part of it. What is the probability of
mkt hitting 4500 in remaining life of market ? Generally, I don't like buying naked options cause odds are against them. They make money only in 1 situation, when market moves in their direction. But they loose money in many situations like
- when market stays sideway
- whem mkt goes against them
- when mkt moves in their direction but not fast enough to cross the break even point
- when mkt moves in their direction but not early enough to recover the value that they have lost due to timedecay.

That means, chances are much higher the the put buyer will loose money. Fact that more then 90% options expire worthless.. i.e. there are so many 90% people who bought the option but did not get anything from it and decide to let it go in the bin..


They are just my views and the way to look at trading.

Looking forward for more of your posts..

Happy Trading

If you read first few posts of this thread, then u

http://www.investopedia.com/articles/optioninvestor/03/100103.asp

 

[munde_77]

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Home > ArticlesArticle Comments (0)Do Option Sellers Have a Trading Edge? by John Summa,CTA, PhD, Founder of OptionsNerd.com and HedgeMyOptions.com (Contact Author | Biography)Email Article Print FeedbackReprintsFiled Under: Derivatives, Futures, Options
While there are certainly many viable options-buying strategies available to traders, options expiration data obtained from the CME covering a three-year period suggests that buyers are fighting against the odds. Based on data obtained from the CME, I analyzed five major CME option markets - the S&P 500, eurodollars, Japanese yen, live cattle and Nasdaq 100 - and discovered that three out of every four options expired worthless. In fact, of put options alone, 82.6% expired worthless for these five markets.

Three key patterns emerge from this study: (1) on average, three out of every four options held to expiration end up worthless; (2) the share of puts and calls that expired worthless is influenced by the primary trend of the underlying; and (3) option sellers still come out ahead even when the seller is going against the trend.

CME Data
Based on a CME study of expiring and exercised options covering a period of three years (1997, 1998 and 1999), an average of 76.5% of all options held to expiration at the Chicago Mercantile Exchange expired worthless (out of the money). This average remained consistent for the three-year period: 76.3%, 75.8% and 77.5% respectively, as shown in Figure 1. From this general level, therefore, we can conclude that for every option exercised in the money at expiration, there were three options contracts that expired out of the money and thus worthless, meaning option sellers had better odds than option buyers for positions held until expiration.


Figure 1 - Percentage CME Exercised & Expired Worthless Options
Source: CME Exercised/Expired Recap For Expired Contract Report


We present the data as options exercised versus those expiring worthless. Figure 2 contains the actual numbers, showing that there were 20,003,138 expired (worthless) options and 6,131,438 exercised (in the money) options. Futures options that are in the money at expiration are automatically exercised. Therefore, we can derive the total of expired worthless options by subtracting those exercised from total options held to expiration. When we take a closer look at the data, we will be able to spot certain patterns, such as how a trend bias in the underlying affects the share of call options versus put options expiring worthless. Clearly, however, the overall pattern is that most options expired worthless.



Figure 2 - Total CME Exercise & Expired Worthless Call and Put Options
Source: CME Exercised/Expired Recap For Expired Contract Report


The three-year averages of exercised options (in the money) versus options expiring worthless (out of the money) for the markets examined below confirm what the overall findings indicate: a bias in favor of option sellers. In Figure 3, the totals for exercised (in the money) and worthless-expired options for the S&P 500, NASDAQ 100, eurodollar, Japanese yen and live cattle are presented. For both puts and calls traded in each of these markets, options expiring worthless outnumbered those expiring in the money.

For example, if we take S&P 500 stock index futures options, a total of 2,739,573 put options expired worthless compared with just 177,741 that expired in the money.



Figure 3 - Total Exercised/Expired Options Contracts
Source: CME Exercised/Expired Recap For Expired Contract Report


As for call options, a primary bull market trend helped buyers, who saw 843,414 call options expire worthless compared with 587,729 expiring in the money - clearly a much better performance by option buyers than put buyers. Eurodollars, meanwhile, had 4,178,247 put options expiring worthless, while 1,041,841 expired in the money. Eurodollar call buyers, however, did not do much better. A total of 4,301,125 call options expired worthless while just 1,378,928 ended up in the money, despite a favorable (i.e. bullish) trend. As the rest of the data in this study shows, even when trading with the primary trend, most buyers still ended up losing on positions held until expiration.



Figure 4 - Percentage Exercised/Expired Options Contracts
Source: CME Exercised/Expired Recap For Expired Contract Report


Figure 4 presents the data in terms of percentages, which makes it a little easier to make comparisons. For the group as a whole, put options expiring worthless for the entire group had the highest percentage, with 82.6% expiring out of the money. The percentage of call options expiring worthless, meanwhile, came to 74.9%. The put options percentage expiring worthless came in above the average of the entire study cited earlier (of all the CME futures options, 76.5% expired worthless) because the stock index options on futures (Nasdaq 100 and S&P 500) had very large numbers of put options expiring worthless, 95.2 % and 93.9% respectively.

This bias in favor of put sellers can be attributed to the strong bullish bias of the stock indexes during this period, despite some sharp but short-lived market declines. Data for 2001-2003, however, may show a shift toward more calls expiring worthless, reflecting the change to a primary bear market trend since early 2000.

Conclusion
Data presented in this study comes from a three-year report conducted by the CME of all options on futures traded on the exchange. While not the entire story, the data suggests overall that option sellers have an advantage in the form of a bias towards options expiring out of the money (worthless). We show that if the option seller is trading with the trend of the underlying, this advantage increases substantially. Yet if the seller is wrong about the trend, this does not dramatically change the probability of success. On the whole, the buyer, therefore, appears to face a decided disadvantage relative to the seller.

Even though we suggest that the data understates the case for selling because it does not tell us how many of the options that expired in the money were winning rather than losing trades, the data should say enough to encourage you to think of developing selling strategies as your primary approach to trading options. Having said that, however, we should emphasize that selling strategies can involve substantial risk (buyers, by definition, face limited losses), so it is important to practice strict money management and to trade only with risk capital when deploying selling strategies.
by John Summa (Contact Author | Biography)

John Summa, Ph.D., is the founder and president of OptionsNerd.com LLC, and TradingAgainstTheCrowd.com. He co-authored "Options on Futures: New Trading Strategies and Options on Futures Workbook" (2001). He is also the author of "Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets" (2004), which presents contrarian sentiment trading indicators and trading systems for stocks, futures and options. Summa is also co-authoring a book on hedging employee stock options, which will be published in late 2009.

Founded in 1998, OptionsNerd.com provides professional training and educational support to stock, options and futures traders. Summa is an economist, author, options trader and former professional skier, and he presents small-group, online and in-person training seminars. Visit OptionsNerd.com or TradingAgainstTheCrowd.com for more information.


Filed Under: Derivatives, Futures, Options
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