Six Ways to Trade

I reread McMillan on Options, Second Edition (Wiley Trading)
over the weekend. My edition is ten years old so I don’t know if he still uses the trading systems that he writes about there. There is a lot of detailed good information there. To quote the master,  you have to predict something in order to put on a trade.

Predict Price Direction

If you predict price direction then that tells you what options to buy or sell depending on your risk profile. For example, if you think that the Dow is going to drop some more you could:

• sell DIA short or
• sell a call and buy a put which is a synthetic short stock position.
• Or you could buy 10 at the money puts and sell some in the puts to pay for them.
• you could sell calls.

Options are so flexible that you can express any opinion with any degree of risk that you want to take. The way to decide, I think, is to look at the payoff graphs and see what the losses are like if you are wrong.

Predict Volatility Direction

He talks about traders who are tired of trying to predict price direction, so they trade volatility trying to take price direction out of the mix. If you think that volatility will collapse, say after an earnings announcement, then you can sell a combination around the current stock price. I did this yesterday by selling the First Solar (FSLR) March 155 call and the March 115 put. They announce earnings after the close today. I also sold the Flowserve (FLS) March 55 call and March 40 put. They announce earnings tomorrow.

So these are short term delta neutral trades, if the price doesn’t move too much.

I will give the post mortem on them in a few days.

You can take this further, try to increase the range over which the price doesn’t move by constructing a gamma neutral and delta neutral trade Gamma is the rate of change of delta with a small price change of the underlying.. That gives you more time to wait for the volatility to change in the direction that you are betting. If you are looking for volatility to drop, you sell an April combination symmetric around the price of the stock and buy March options at the wings. Done in the right proportions, this will be both delta neutral and gamma neutral. The months have to be different for the trade to work.

All the possibilities makes my head swim,.