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Trading Options in Three Dimensions

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Be sure to consider direction, time, and velocity when trading options.

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It is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.
– Philip Fisher (1909)

Those words of old wisdom illustrate why one must approach trading options three dimensionally. Those dimensions are direction, time, and velocity. One needs to be aware of all three, and an adept trader can trade all three simultaneously. Indeed, one must trade all three.

Too many times in my mentoring career, I have heard a novice trader say, "I was sure the stock was going higher so I bought calls. The stock went higher and I still lost money! How did that happen?" Simply put, that was because only one dimension -- direction -- was considered. Let's examine all three and see how we can apply them.

Direction (or the lack thereof): One must never forget that stocks not only go higher and lower; they often move sideways -- and sometimes for a great length of time. The savvy trader knows this and applies this knowledge continuously. This is also true for the market as a whole if one is trading index options such as SPX (INDEXSP:.INX). That said, there are three directions we must have a view on to trade: up, down, and sideways. It's also possible to think up first and then down or vice versa. An example of this would be a continued run-up to the summer and then a collapse, or grinding sideways for a few months and then a strong rally. But, one must have a view on direction or find another product to trade. No matter how a trader divines this opinion -- whether by technical analysis, fundamental research, or anything else -- it is the first thing to consider when trading options. One must also always consider that one could very well be wrong. That is why I never advise trading options outright but always trade in the form of a spread. This is simply good risk management.

Time (duration): This one is difficult. A trader has to consider not only the "when," but the "how long." Do you expect the stock to move after an event, such as an earnings report? Or do you expect the stock to maintain a trend or break through technical levels of resistance or support? A short-term move would suggest using near-term options.

Velocity: How fast is the anticipated move going to happen? Will the stock gap there? Will it move $.50 at a time or will it just go there drip by drip? Also, where do I think the implied volatility is headed? A strong down move tends to increase implied volatility and a strong up move tends to crush it. This means that I can be wrong and still make (or lose less) money! Say I am bullish and I do an options back spread (for every 10 out of the money contracts I am long, I am short 1 in the money as a hedge) and the stock tanks. The increase in implied volatility can largely offset the directional loss in the calls. When entering a long volatility trade, I play close attention to the relationship between implied and historical volatility. I want a stock where the implied is lower than the historical. Volatility has a strong tendency to revert to the historical mean.

Having it both ways (or first this, then that): A great way to trade both directions with controlled risk is by using calendar spreads, both horizontal and diagonal. If I believe a stock will stay flat and then move, I am looking to buy a horizontal (same strike) calendar spread. I want my near-term short leg to expire when it is worthless and then the market to move in the direction of my long leg. Let's say I believe the market will continue higher and then have a classic summer correction. I would sell a just out of the money May put and buy a same strike July put. The decay of the shorter term May put will always be greater than that of the July put. I would also do this if I felt that volatility would increase, as longer dated options are more volatility sensitive than shorter dated options. A more directional way is to trade a diagonal calendar -- that is, short near-term at or just out of the money, and long a farther term farther out of the money option. Preferably for even money or a small debit. This can even create free options! I don't care if you're bullish or bearish; free options are nice to have.

Today, I'd like us all to think of trading options in three dimensions.

In conclusion: Remember, it is never only the "what" in options trading; it is also the "when" and how fast or slow it gets there!

This article by Randall Liss, the author of The Liss Report, was originally published on See It Market.
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