How I Think About Trading Options: Premium, Volatility, and Asymmetry
I got a question about adding to winners using options. I’ll cover the “adding to winners” part tomorrow — options are trickier that way. This will be a shorter piece.
Option Premium as Two Components
The idea: with options, I look at the option premium as the sum of two things.
Say we’re looking at one option priced at $5. That premium is:
- How much in-the-money value is there? That’s the intrinsic or inherent value.
- The volatility piece, combined with time value.
When I think about trading options, I’m thinking: which of these am I trading today?
If the option is in the money, I have intrinsic value. The delta should be increasing as the price goes up. But I also have the volatility component, in concert with theta.
Look at the knee of the theta chart — theta really starts to fall off a cliff around the 30-day mark. For my own tastes and preferences, and this comes from my days as a hedger — I was physically trained in commodities — we would often buy six-month call options to cover a runaway market. In the near term, we’d sell monthly expirations to offset the cost of that longer-term insurance.
That’s one way to get your calls or puts cheaper: sell calendar spreads. You have to marry that with the chart, obviously.
Reading the Chart, Not Just the Greeks
That’s how I started thinking about volatility together with intrinsic value.
At the beginning, you might be buying 25 deltas — they’re out of the money. Give yourself enough time. Zero DTE is a whole different topic. You need to be trading off the chart of the underlying security or futures contract.
When I look at an option, I have to ask: has the market spiked? The instrument itself might be four ATRs above the 20-day exponential moving average. Is it going to mean revert?
Mean reversion doesn’t necessarily mean I want to sell and go the other way. It could channel sideways and let the moving average catch up to the thing. It depends on how much of your gains you want to give back.
At that moment, I look at the volatility as much as the intrinsic value. Then I use that as the trigger. How much is the IV changing? When you look at the premium and take out the intrinsic value, what’s happening with the vol day after day — knowing that there’s theta?
If you go out far enough, the volatility should offset the theta. It doesn’t always. If you’re trading shorter term, theta is a much bigger issue. You need to use time stops.
My Preference: 90+ Days to Expiration
Even though you can say, “I’m risking half a percent of my account on this trade, I can let the thing go to zero” — I’m typically not built to let things expire worthless.
With options, I’m rarely buying anything with less than 30 days to expiration. Mostly 90-plus. I want to buy myself the time, because I know theta accelerates at the knee of the chart and starts to hurt me.
If the thing didn’t start working out in the first week, my timing is off. I come back to it, but I’m not going to sit and wait. So I might go look at a 120-day option, let it trade down to 90 days, and if something isn’t happening by then, I offset it.
I don’t care about the spread. I don’t care about whatever — that’s pennies on the dollar compared to what matters. If you have an option trading three bid, offered at 3.30, and it’s down to 2.70 after 30 days — I don’t care about a 30-cent spread. I care about not losing the 2.70.
If the market is 2.50 bid, 2.70 offered, I’ll take my 2.50. Don’t miss the forest for the trees. Who cares about the spread at that point? You’re not going to sit there trying to hit the mark or get the midpoint. That’s too anal. Your job is to manage risk.
If the thing didn’t work out — if it stalled or looks like it’s rolling over — you don’t necessarily have to go the other way, but you have to do what you have to do to protect your capital, even with options.
It’s popular on the internet for people to say, “Just buy your 25 basis points or 100 basis point risk unit and let the thing go. When you buy the premium, you have a built-in stop.” I understand all that. I figured it out when I was starting. But at the end of the day, your job is still to protect capital, no matter what asset class you’re trading.
Adding to Winners: Roll, Don’t Add
I’ll talk about this more tomorrow, but it’s difficult to add to winners with options.
I had a couple of really big trades this year. I caught Exxon in January. It was January 6th. The market was down, and coming into the close I bought a big position, thinking it was a retest. Sometimes you get lucky.
I bought the May 140s. The thing ripped. I took a bunch of money off along the way. Then the market peaked and consolidated. It looked like it was going to make another run. So instead of adding, I was really just buying — I had liquidated my first piece. I went out and bought the 180s, since that was only 20% above the market at that point.
I find it’s better to adjust and roll the position. Since there’s an expiration, you need to systematize a way to keep exposure but roll some of your capital out. It’s similar to what people do with property — they buy a house, fix it up, get it reassessed, borrow money out.
You can’t really borrow anything with options. But you have to think: I don’t know where the top is, so I need to finance out some of my gains. Or if it looks like it’s going to stall, sell a good chunk (if not everything), wait for a retracement to a moving average, and then look at a higher strike that would be cheaper. That way, even on the second piece, if you lose, you’re still a net winner across all your positions.
That takes timing. It took me a long time to understand it because there are so many moving parts, and I didn’t have the time.
When I Sell Winners
I get a lot of questions about how I look at options and when I sell.
I sell my winners — which are less frequent than my losers. I’m looking for three to one. I have really good friends — you know who you are — who say, “Sell at the double, finance out your cash, and free-roll the rest.”
I’m a working-class dog. I grew up waiting tables and cutting grass. I had a landscaping company. I’d go to work at Winged Foot and Quaker Ridge. At night I’d work at Glen Island Casino. When I go to work, I need to get paid. I don’t like the idea of selling at the double and free-rolling the rest.
With a stock or a future, if I can adjust my protective stop to breakeven as soon as reasonable, that’s different. With futures, it requires a lot more cash to put down. With options, I know the thing is going to expire, so I have to take action — sometimes before I want to. I have to read the tea leaves.
So: I offset usually at three to one. If I buy a $1 call — like those Exxons I paid 1 1/8 for, and I sold the first batch at $7 — that’s because the thing ripped. Normally, at seven to one, there’s no way I could lose money on that trade, no matter what happens to the rest.
The point: if I sell at three to one and the other half goes to zero, I’m still going to make money on the trade. That’s my working-class upbringing. I need to make something on my capital to make it worth my time.
The Real Point: Asymmetry
I’m going to keep harping on asymmetry, because if you’re a chart reader, you should be able to see on the chart whether there’s an asymmetric proposition.
If you know you’re going to risk five dollars a share, has the stock been 25 dollars higher than where you propose to buy it? If you can’t see that, who cares about two to one?
There are always two payoffs to every trade. The emotional payoff and the financial payoff.
I’m not trading to be right. I’m trading to make money. If you do the math right, when you focus on a five-to-one payoff, your accuracy rate can drop to 20% and you’ll still make money. You clearly can’t make a living at that rate — but the main thing is you’re not losing. And when you don’t lose, you don’t have to earn back.
Thanks for being here. Get your copy of The Inner Voice of Trading at TraderMindset.com. See you tomorrow.
