Maybe options are unpopular due to their reputation of being complex. Or due to their lack forex 20 pips per day strategy horse support by most trading software tools.
Options 101 Options are explained on many websites and in many trading books, so here’s just a quick overview. The premium is the price that you pay or collect for buying or selling an option. It is far less than the price of the underlying stock. Major option markets are usually liquid, so you can anytime buy, write, or sell an option with any reasonable strike price and expiry date. Out-of-the-money options can not be exercised, at least not at a profit.
But they are not worthless, since they have still a chance to walk into the money before expiration. By reversing the formula with an approximation process, the volatility can be calculated from the real premium. This implied volatility is how the market expects the underlying to fluctuate in the next time. That’s all basic info needed for trading options. By the way, it’s interesting to compare the performances of strategies from trading books.
While the forex or stock trading systems described in those books are mostly bunk and lose already in a simple backtest, it is not so with option systems. They are more complex and more difficult to trade, and you need a Nobel prize winning formula to calculate a value that otherwise would simply be a difference of entry and exit price. 100 you can buy only a few shares, but options of several hundred shares. And unlike a stop loss it’s a real risk limit. Stock profits just depend on rising or falling prices.
Option profits can be achieved with rising volatility, falling volatility, prices moving in a range, out of a range, or almost any other imaginable price behavior. And you pay no exit commission for an expired option. Due to the premium, options can still produce a profit to their seller even if the underlying moves in the wrong direction. Hacker ethics requires that you not just claim something, but prove it. This is a very simple option trading system. It randomly writes call or put options and keeps the positions open until they expire.
You can see that most trades win, but when they lose, they lose big. It seems that options, at least the tested SPY contracts, indeed favor the seller. This is somewhat similar to the positive expectancy of long positions in stocks, ETFs, or index futures, but the options seller advantage is stronger and independent of the market direction. It might explain a large part of the positive results of option systems in trading books.
Functions for options We can see that options trading and backtesting requires a couple more functions than just trading the underlying. Unlike historical price data, options data is usually expensive. In backtest mode it’s loaded from the above data set, in live trading mode it’s loaded from the broker. The option chain is a list of all available option contracts of the selected underlying, with all available strike prices and all expiration dates. The image displays 54 contracts, but this is only a small part of the option chain, since there are many more expiry dates and strike prices available. The SPY option chain can contain up to 10,000 different options.
Entry, stop, or profit limits would work as usual, they now only apply to the option value, the premium, instead of the underlying price. Backtesting option strategies Here’s an easy way to get rich. Open an IB account and run a software that records the options chains and contract prices in one-minute intervals. That’s what some data vendors did in the last 5 years, and now they are dear selling their data treasures. Due to the slow differential equation solver and the huge number of options, the script needs several hours to complete. The blue line are the artificial option prices, the black line are the real prices purchased from an options data vendor, both for 3-weeks SPY contracts with 10 points spot-strike distance.
You can see that the prices match quite well. There are some tiny differences that might be partially random, partially caused by anomalies in supply and demand. Option strategies, especially options selling, are more likely to be profitable than other strategies. Algorithmic option strategies are a bit, but not much more complex than strategies with other financial instruments. In the next article we’ll look more closely into option values and into methods to combine options for limiting risk or trading arbitrary price ranges. How you trade them is up to the real strategy.