Equity trade settlement t+337 comments
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In all kinds of trading, we have to assess risk and potential reward on every trade. Being able to select trades that pay enough to be worth the risk is what separates the traders from the former traders and trader wannabes. In trading most instruments, the risk and reward calculations are straightforward. How many dollars do I make if the stock or futures contract or forex contract hits my target? How many do I lose if it hits my stop?
In options trading though, there are some unique challenges. Fortunately, technology gives us the tools to meet them. When we enter an option position, we are hoping to take advantage of one or more of the three forces that move option prices. All three of these forces are at work at all times on every option. They push and pull, sometimes together, sometimes against each other.
Figuring out our risk and reward requires that we take into account all of them. Here is an example. On April 24, the equity indexes were trying to decide whether to break to the downside or not.
It seemed, for a variety of reasons, that that had a pretty good chance of happening. If it did, bearish trades would work out. That day Allegheny Technology ATI showed up on a scan for stocks at the lower end of their recent range of implied volatility. Below is the chart:. Its implied volatility, at This looked like an opportunity for buying put options.
Our choices were July or October, so we focused on October. By buying options with a lot of time to go, and planning to sell them while they still had a lot of time to go, we would minimize the effect of time decay.
With our entry, stop and target prices worked out, the next step was to calculate potential reward and risk. There is no substitute for it. The magenta line is as of two months in the future, on June The reason for plotting the curve as of June 25 is to take into account the time decay that will occur in the two months we plan to hold the options.
This demonstrates that using options far out in the future results in very little time decay in the early days of their lives. This is marginal at best. We prefer a reward to risk ratio of 3 to 1 or better. Before we pass on this trade though, we need to take volatility into account. If it did come to pass that this stock dropped substantially, we would expect implied volatility to rise. We looked at this stock in the first place because it appeared on a scan for stocks at their volatility low points.
This is a much better proposition. Close but no cigar. In summary, we examined a proposed trade that had possibilities as a bearish bet on a stock at a major resistance level. We took into account the likely amount of a drop in the stock price, compared to the distance from the current price to the resistance level.
In terms of the stock price alone, the ratio seemed favorable. Next we estimated the time frame in which that drop could be expected to happen. Finally, we factored in the estimated effect of a likely increase in implied volatility.
With that done, we could get a good reading of the best-case reward vs the worst-case risk. In the end, the trade was marginal, so we passed this time. Without doing the full analysis, we might well have taken a trade that would be a poor use of our funds. Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk.
The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter.
Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.