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Option Trading has always been a challenge to traders because of all the variables and complexities that make it up. To simplify the process some educators have reduced it down to prescriptive approaches. This can work well if the market holds a level course and does not change but that is not reality. The market does however go in trends for a while and so systems can work well for a while and then with no explanation fall apart. The more sophisticated option traders contrive complicated spread strategies to try and reduce the risk factors but they also give up a lot of potential premium in favor for reduced risk. I feel that if traders can read a chart and see the opportunity develop, they ought to be able to play for the maximum returns. That may not always follow the prescriptive formulas. The challenge is that option trading data comes in tables and spreadsheet format and is difficult for most folks to read. To venture away form a prescriptive formula is intimidating at best and dangerous at worst. The X Factor was developed to illustrate what otherwise would be a wall of data. The option chain rendered by most data providers is a maze of data that most folks ignore, going instead to their formula dictated strike and month. There are so many features built into the X Factor, but I will just show you one way it can help train the option trader to evaluate different strike price activity. It can help you to find out which options have worked best in the past with a particular stock when they might be used appropriately. Out of the money plays are much poo pooed because they have no intrinsic value. The case for using them is when premium is over priced near the money and you have a clear pattern which suggests fairly quick action. You effectively take a lowered valued position in anticipation that a move in your favor will bring it into the range of the over priced premium. You get a position that can actually accelerate its growth curve as the stock moves. In the Money options actually grow at a increasingly slower rate as they go deeper in the money. If you ride an Out of the Money option into The Money, you can get bonus points as the time value inflates. Here is a recent move in Krispy Kreme Donuts KKD. On August 6th KKD reaced down and bounced off a recent support line. It also reached down for the recent low to test and confirm the support. This was a sign of full confirmation of the support line and so a Bracket Trade was set up. KKD closed @ 42.65 with a high of 42.83. If KKD moved up through 42.90 the next day it would signal a bullish entry. If it moved down, there would be an alert @ 41.70 to signal that it was testing the low of the day again. That would also set up a Bracket Trade. The next day KKD moved up through the bullish entry point an at 42.94 the trade was executed. Now this was the right entry point and if you were buying stock it was clear and simple. But to trade options you must make several more decisions any of which could be disastrous to the option trade if it is wrong. In a runaway bull market you can just about throw any bullish option on the board and make money but don't think market makers are in business to make you money. You must decide whether to Buy or sell Premium, go In / At /or Out of the Money and how much time. Normal trading is complex and often deceptive. So we look at the X Factor to SEE what the option pricing is instead of the Wall of Numbers that we get from an options chain. The strikes are made up of a line for the calls and a line for the puts. The white line is the current price of the stock or At the Money. For this example I want to track the behavior of the September 35, 40, and 45 calls if it moves up. The current prices are as follows. The light green line shows the Fair Value of the options and you can see that the options are a little more expensive than the price suggested for the fair value. If the options are very expensive then buying them can be a big mistake but here they are not too bad. When stocks move up, the volatility usually goes down which lowers time value and can hurt you r option position even if it is moving in your favor so you have to be careful not to pay too much. I also want to price the slightly in the money Aug 45 puts to sell. They are Bid $2.25 and have a fair value of $2.05 so I can sell at a premium. Over the next 9 days KKD moves up strongly pausing only slightly as it approached resistance. The formation of the first red candle signals a tightening of stops and protecting profits. Expiration day was August 15th so the 45 puts expired in our favor for $ 2.25. The second red day takes us out of the bullish options when it crosses our stop at $48.85. Now a comparison can be made of the various trades. The X Factor shows the current price of the Stock and the options noted by the vertical yellow lines. The stock has gained $5.89 in value and all of the options have made money. The deep in the Money September 35 calls gained $5.10 for a 61% return. The September 40 calls gained $ 4.80 for a 105% return. The September 45 calls which were a bit out of the money gained $ 3.35 for a return of 268%. The total dollar profit was more for the more expensive options but the rate of return was less because you were paying to lower the risk. If the stock moves in your favor and reaches the target area in a reasonable time, the out of the money positions will almost always have higher rates of returns. Out of the money options can hurt you if the move does not happen soon because they are made up of time only. But because of the smaller out lays that too is less painful. To make this technique work you must be able to accurately identify significant price support and resistance. You must also recognize the pattern and the like;y target of any price action. You must also have an idea of how long it may take to reach thhe target. WOW, more complicated? Yes. More profitable if you can read the chart? Oh Yea! Prescriptive option strategies? Can be very good but it is also 'dicey' and frustrating when it quits working. Sometimes it will be In the Money, some times Out of the Money and some times it does not matter. Learning to picking the appropriate strike, month and side of the trade… priceless. Ryan Litchfield with Better Trades
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