Three- dimensional trading model, Related Articles
Those dimensions being: Direction.
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One needs to be aware of all three and an adept trader can trade all three simultaneously. Indeed, one must trade all three. The stock went higher and I still lost money! How did that happen?
Direction or the lack thereof : One must never forget that stocks not only go higher and lower they often move sideways. Sometimes for a great length of time. The savvy trader knows this and applies it continuously. This is also true for the market as a whole if one is trading index options such as SPX.
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That said, there are three directions we must have a view on to trade. Up down or sideways. A continued run up to the summer and then a collapse, for instance.
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Or grinding three- dimensional trading model for a few months and then a strong rally, as another example. But, one must have a view on direction or find another product to trade. However one divines this opinion, technical analysis, fundamental research, whatever, it is the first consideration 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.
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Do you expect the stock to move post 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 fifty cents 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 in fact that I can be wrong and still make or lose less money! Say I am bullish and I do an options back spread long 10 out of the moneys 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 24 official option a long volatility trade I play close attention to the relationship between implied and historical volatility. I want a stock where options board implied is lower than the historical.
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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 option kg and diagonal.
If I believe a stock will stay flat and then move then I am looking to buy a horizontal same strike calendar spread. I want my near term short leg to expire worthless and then the market to move in the direction of my long leg. 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 will always be greater than that of the July. 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 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.
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This can even create free options! In future columns Three- dimensional trading model will discuss various option strategies in greater detail. Sign up for our FREE newsletter and receive our best trading ideas and research Leave this field empty if you're human:.