Strategies

The New York Stock Exchange (NYSE) matches buyers and sellers of stocks.  An auction system, high buy and low sell being matched by Specialists.  Trades taking place when the two agree on price, one coming to the other.

Market orders mean agreeing to the best price at that moment in time.  The moment in time the Specialist gets the order, not the moment in time it was placed.  Market orders are a truly scary thought.  I’ve heard countless stories dealing with market orders, all of them horror stories!

An orderly market requires a relatively equal number of buyers and sellers in a close proximity of price.  Trading halts when an order imbalance occurs.  The Specialist’s job entails filling market orders fairly.  They need time to determine the price for matching market buys with market sells.  In an effort to be fair, trading might also halt pending news.  Most major announcements come before or after the opening bell.

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The NASDAQ market works differently.  Unlike the NYSE’s trading floor, the NASDAQ trades stocks electronically.  And unlike the NYSE Specialist system, the NASDAQ uses Market Makers.  The Market Makers create a fair and orderly market by bidding and/or offering.  They try to buy stock at their bid or sell stock at their ask.  They try to make the Bid/Ask spread like the option Market Makers.  They are not required to be on the floor of an exchange.  With limitless location possibilities and only the volume and size of trades to deal with, most NASDAQ stocks have large numbers of Market Makers.  It takes commitment to be a NASDAQ Market Maker.  It’s not a part time job.  It also takes an inventory of stock to trade from.  This calls for large sums of money.

Option Market Makers are like a blend of the NYSE Specialist and the NASDAQ Market Maker.  Options trade on an actual exchange like the NYSE, but Market Makers offer liquidity with ready Bids and Asks.  The major difference lies in the number of possibilities.  You either buy stock or you sell it.  Option trades include both buying and selling, both puts and calls, with countless strike price choices.

Option Market Makers don’t start with a large inventory, they create the option contracts as buyers and sellers appear.  They would just as soon not ever own stock.  If they do, it means the buyers and sellers of options are not in equal proportion.  Their profit comes from buying at bid and selling at ask, called the Bid/Ask spread.  Option Market Makers buy and sell numerous option contracts, not always the same ones.  Through the use of Delta, Market Makers and option traders are able to remain basically market neutral or completely hedged.

Delta is a measurement of change in an option compared to the change in the underlying.  Delta is also the measurement of relativism between option contracts.  This relativism is what Market Makers use to hedge.  They try to remain at Zero.  Neutral.

To show how Market Makers trade Delta Neutral, let’s make some assumptions.  Let’s say an in the money (ITM) call has a Delta of .75, an at the money (ATM) call has a Delta of .50, and an out of the money (OTM) call a Delta of .25.  If a retail investor buys an ATM call from the Market Maker, the Market Maker is now short a Delta of 50.  Remember 100 shares per contract, means .50 x 100, so the decimal is dropped..  If someone then sells two OTM calls to the Market Maker, the Market Maker is then buying a total Delta of 50.  So selling -50 Deltas and buying +50 Deltas, equals zero Deltas.  Therefore the Market Maker is considered Delta Neutral.  A snapshot risk free trade.  Snapshot, meaning at the instant the trade takes place.  Technically, the risk is the Gamma, the change of Delta.

Puts are measured in negative Deltas.  This can be quite confusing.  Delta measures the change in the option verses the upward movement of the underlying.  So if your stock moves higher, the put would move lower.  Disturbing as it seems, two negatives make a positive.  If the stock price drops, with a negative Delta, the put option increases.

Selling a call option with a Delta of .50 and buying a put option with a Delta of -.50, the net effect is zero.  Buy 20 options with Delta of .75 sell 60 contracts with a Delta of .25, Neutral.  Long 20 contracts with a Delta of .75 = + 15000, selling 60 times .25 = -15000.  15000 minus 15000 equals nothing.  Hedged or Delta Neutral.

Some stocks went up.  (Hopefully yours.)  Some stocks traded lower.  Some stock prices stayed the same.  (A few flat lined dead on arrival, many roller coasted up and down back to the starting point.)

I was just recently in Las Vegas, for business of course.  I enjoy going by the gaming tables.  Market research, crowd psychology.  Seeing how people bet their cash.  Well chips anyway, if bettors had to use real money, they might recognize how much money they just lost.

Ever watch people learning to play craps?  They’ll use real money.  Haven’t they heard of paper trading?  Maybe because the pit boss and the other casino employees are always willing to help.  Lots of assistance available to make a bet.  No matter what color the chips.

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Gambling and specifically craps have much in common with options: complex risk reward curves.  Since the IRS doesn’t allow deducting crap table loses from your income taxes, why would anyone want to throw dice.  They can bet options, I mean trade options.

Many amateur options traders invest as if they were at a casino.  No regards for the odds, just mesmerized by the big potential payoff.

Anyone who has been around Wall Street any length of time knows there isn’t many “sure things.”  Truly, time’s passing is the only safe bet.

In this example we will trade based on Theta alone.  We will consider the other “Greeks” asleep.  In reality, they are NOT dormant.  The fact is, you could set your trades up to minimize their effects.  Remember it’s best not to awaken a sleeping giant if at all possible.

Our hypothetical example will be four At the Money (ATM) options on a single stock:

One month option = $ 1.00
Two month option = $ 1.41
Three month option = $ 1.73
Four month option = $ 2.00

With these hypothetical examples, let’s enter a simple time or calendar spread.  We will buy the four month option for $ 2.00 while simultaneously selling the one month option for $ 1.00.  Our net cost would be $ 1.00 ($ 2.00 less $ 1.00).  Again for demonstration purposes we will not take commissions nor the bid/ask spread into consideration. And also ignore strike prices as well.

If everything remained the same except for time’s passage, after one month the option we sold (short position) would be worthless to the buyer.  An At the Money (ATM) option has no value at expiration.  A $ 1.00 profit to us, offset by the $ .27 loss on our four month turned three month option, brings our position value to $ 1.73.

Anyone who can find situations where all the variables remain constant for one month deserves to make 73% on their money.

In our perfect example situation, we could now sell another one month option for another Dollar. After the second month, the option we originally bought would have lost half its time, but only $ .59 of its value.  Now priced at $ 1.41, the income would be equal to its original cost, $ 2.00.  Our cost would be zero.  Our profits infinite.

Closer to expiration, owning options costs more.  Inversely, selling options closer to expiration can pay more.

If the one month ATM option is $ 1.00, and the four month equals $ 2.00, then the nine month option would be priced at $ 3.00.  Continuing forward, the 16 month option’s price would be $ 4.00 and $ 5.00 would buy the 25 month option.

If we could sell one month of time for $ 1.00, we could pay for the 16 month option in four months.  Giving us a year of potential for free.

Please don’t base trades on any one option pricing component, while ignoring the others.  You’ve been given enough information to be dangerous.  If you trade with blinders on, you tend to get blind sided.

Knowledgeable traders earn the right to have less money at risk and greater potential for profits.  Knowledge comes with experience, and experience comes with time, regardless of real chips or paper trades.

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