Creating a Winning Trade

Creating a Winning Trade

We’ve just demonstrated with a real-life example that option trading requires more than a directional belief about the underlying stock. In other words, just because you may be bullish does not mean that buying calls is the right strategy to capitalize on that outlook. The reason is that long positions have a “point spread” built into them in the form of a time premium. If that time premium is too high, we can lose on the option even though the stock may rise. By using the Black-Scholes model, we could guess that it’s probably not wise to buy the $33,375 call when it’s priced at 80% volatility. Does this mean we should sell the call?

On the surface, many traders erroneously think that if the volatility ap­pears to be too high then we should simply be the sellers of the calls but that is not necessarily true. There are two main reasons. First, in this example, VIP appears to be priced at high volatility levels but it’s possible there is a good reason. If we sell the call and the stock price jumps much higher, we could end up with sizeable losses. So, we do not necessarily want to sell calls “just be­cause” volatility is high. Second, a high volatility does not equate to a bullish bias. It’s certainly possible that the market is equally negative on the stock. Remember, high volatility just means that the market is expecting large price swings in the future; volatility measurements do not take direction into ac­count but, instead, only the size of the price swings. So if the VIP $33,375 call appears to be priced high, it could be due to traders bidding up the price of the puts (as the price of puts rise so does the price of calls)[1]. Since we determined that volatility is exceptionally high, all we can really do at this point is decide to avoid the trade. We have tremendous insights into the price swings (volatility) that the market is expecting but nothing has been said about the direction. And it is this point that makes candlestick charting so important for option traders. If we can gain some insights into the direction of the stock, we can then deter­mine whether we wish to buy or sell the bet. Let’s see if we can use candlesticks to gain this critical additional information.