More Tips For Beginners
Len answers questions from members about establishing a trading account, spread trading, delta-neutral trading, and the meaning of open interest.
Q: What type of broker should I deal with? Is a general discount brokerage fine, or should I deal with a firm that specializes in options?
A: If you’re going to be trading options, I definitely recommend trading at a firm that specializes in options. At this time there are only a handful of online brokerages specializing in options. I cannot recommend a specific broker in this column, but I can say that it’s definitely worthwhile for you to ask other options traders for their recommendations as well as to evaluate options brokers advertising in publications such as Barrons.
Q: How do you open an account?
A: Most online brokerages make it easy to open an account. You just click the “Open an Account” link in their Website and begin filling in the required information and click-signing agreements. Then they usually require a signature or two on real paper, so there will be instructions on how to print out the necessary forms and where to sign. You will send these papers in with your check or other instructions on how your account will initially be funded.
Q: What are the margin requirements like? How much capital should I start off with?
A: I recommend starting off with at least $10,000, and closer to $50,000 if possible. At $10,000, you’re going to be under pressure to make your first few trades winners, so that you start out building your account. Try to keep your trades small at first – I mean really small (e.g., $1,000 in each trade), and keep at least half of the account in cash at all times. If your account does go south at first, try to fight the tendency to get careless and take more risks with the remainder. The market brings new opportunities every week – sometimes exceptional ones – and if you still have some cash, you’re there to participate and fight back.
When buying options, the margin requirements are zero; you just have to pay for the options in full. Requirements are very reasonable in equity and index options when shorting covered options (that is, when the options you’re selling are not naked). Margin requirements for selling naked options on low-priced stocks or indexes are reasonable (although you won’t be able to do it with just $10,000). Requirements for selling naked options on high-priced stocks or indexes are out of sight. Some brokerages charge higher then the exchange minimum requirements for naked options. (It’s their prerogative to do so.) If you plan on selling naked options, you should ask the brokerage about their margin requirements up front.
Q: I’m learning about delta neutral straddle positions and delta neutral adjustments. However, before I begin, I need to complete my understanding on this trading style. Is there a course on delta neutral trading? How can I find good stocks for delta neutral trading?
A: I don’t know of a course on delta neutral trading. However, I might be able to impart the kernel of this technique to you right here. You begin by opening a long straddle in an asset whose implied volatility is low (i.e., cheap options), or a short straddle (or strangle) in an asset whose implied volatility is high (i.e., expensive options). (Please note that the later would be naked writing, and for this, the investor would need to thoroughly understand the risks.) In the absence of any directional bias with regard to the underlying, you would open this position “delta neutral” by selecting the appropriate quantities and strikes of each leg in such a way as to create a position that, theoretically, gains or loses nothing with a small change in the price of the underlying.
(At the risk of seeming obvious, options analysis software is needed for modeling and “what-if”ing positions this way. I can’t imagine trying to do delta neutral trading without options analysis software.)
Over time, the underlying naturally moves away from the starting place, throwing your original position out of balance. A small amount of delta should probably be tolerated, because the transactions costs associated with keeping the position perfectly delta neutral would eat away at profits. However, when delta moves an uncomfortable distance from zero, the trader may need to consider adjusting the position.
There are many ways of adjusting the position. A small adjustment can be make by simply buying or selling one or more contracts of the same options you already have in the existing legs. A larger adjustment can be made by closing one or both legs and re-opening one or both legs at a new strike (or strikes). If you do this, you may want to consider changing expiration months as well, perhaps to give yourself more time.
There is no science about deciding which kind of adjustment is best in any particular circumstance. The correct adjustment to make is the one that leaves you completely comfortable with the new position, going forward.
Note that in the case of being long a straddle, technical traders might want to leave an imbalanced position alone if they felt that the strong leg of the straddle (and delta as well) favors of a new trend in the underlying. On the other hand, pure volatility traders will want to adjust.
Your position may be closed when implied volatility returns to “normal” levels, as judged by viewing a historical volatility chart. Hopefully, you will be posting a net profit, if not too many adjustments were necessary during the life of the position.
To find good stocks or indexes for delta-neutral trading, you need some kind of system for screening and finding assets whose implied volatility is extremely low or high right now. Some options-oriented Websites provide this kind of service for a reasonable fee. It can also be found in the software and services my own company provides.
Q: What is the difference between open interest and volume for calls and puts? Which of these two numbers should I place more emphasis on?
A: Open interest is the total number of contracts outstanding. To illustrate, say a new standard option contract becomes available. At first, its open interest is zero, naturally. Suppose you put in a buy order and I put in a sell order (both of us to open new positions, obviously). We make the trade. Now, open interest is one, because there is one contract open – you have the option to buy (presuming it’s a call) and I’ve got the obligation to supply, if called upon, the underlying.
Now suppose more buyers and sellers come in, each side opening new positions, just as we did. This will make open interest go higher, as new contracts are opened.
However, if someone with a long position comes in with an order to sell, and gets matched up with someone with a short positions who is buying to close, open interest will go down after they trade, because contracts are being canceled out.
If someone who is closing his or her position gets matched up with someone who is opening a position, open interest remains unchanged. To help picture this, suppose you and I are the only parties who have a position in an option. You’re long one contract and I’m short one. Therefore open interest is one. What if you sold your contract to an interested third party? Now, you’re out of the position, the third party is long one contract, and I’m short one contract. Open interest is still one.
Volume is simply the number of contracts traded that day. Both volume and open interest are indications of the depth of a market. Neither is more important than the other. However, volume could be considered a more immediate indication of liquidity. A high open interest simply says that a large number of contracts have traded during the life of the option, and that there is a potential for these open contracts to translate into more volume as traders unwind their positions. (Note the word “potential”, because traders do not have to unwind their positions if they don’t want to. They may hold until expiration and then exercise.)