Jul 29, 2016
By: Josh Fabian
Trading can involve a lot of calculating. Some of those calculations are more challenging than others. And it seems like Murphy’s Law that those more challenging calculations are needed during “fast market” conditions. Over the years we have come up with some shortcuts tastytraders may find useful.
One standard deviation
We sell a lot of options around an asset’s expected move. The expected move formula can be challenging. One way to make it easier is to use the following:
First, divide IV by the square root of 360 divided by the number of days to expiration for which you want to calculate the expected move. The slide below contains the square root for numbers 1 - 5.
Next, multiply that figure by the asset’s current price. That is the one standard deviation expected move.
Buy or sell
Another common challenge can be when to buy or sell spreads. We discuss selling spreads for credits most of the time; however, there are conditions under which buying a debit spread is the higher probability trade. At tastytrade, we make the decision between selling for a credit or buying for a debit, based on IV rank (IVR). If IVR is over 50% we sell credit spreads. When IVR is under 50%, we buy debit spreads.
Understanding delta is crucial for trading options. Delta tells us a lot about an option. For example, if you want to know the probability of an option expiring out-of-the-money, delta can tell you. An option’s delta is roughly equal to the probability of an option expiring in the money. For example, a 16 delta option has an 84% probability of expiring out-of-the-money. If we want to know the probability of an asset touching the price of an option, simply multiply delta by two. That 16 delta option just discussed has a 32% probability of being touched.
We can also use delta for hedging. An option’s delta represents the equivalent number of shares in its underlying asset. Therefore, selling a 16 delta put is like being long 16 shares of stock. If we want to hedge that 16 delta put, we could short 16 shares of the underlying stock.
Ever wonder what would happen to a position if volatility moved one direction or another? Vega is “your guy.” An example will help illustrate:
Option price = $1.00
Vega = .05
IV = 15
If IV moved up to 16, we can expect the price of that option to increase in value by a nickel. By the same token, if IV fell by a point, we could expect that option’s value to fall to $0.95. Simply take the POINT (not percentage) change in IV and multiply that by the option’s vega to understand how changes in volatility affect option prices.
When markets trade fast, calculations may become very challenging. Hopefully, these shortcuts will help with that challenge.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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