post The Importance of Having an Underlying Stock View

There was a breed of trader that in times gone by would trade options excluding any fundamentals or research, and based purely on the mathematical model and adaptation thereof. However, as options and stock markets became more competitive, and the spreads narrowed, the so called risk free options income was no more.

In truth, this competition reflects the perfection of markets; all the more prevalent in markets reliant on technology for their research and implementation.

 The tide has turned and the options trader intent on survival will do well to resort to undertaking research on their underlying stock instruments. Certainly opportunities will present themselves that are mathematical gifts, however by analogy, the same is true of the most common of two horse races and yet totalizator agencies are only too keen to these seemingly gratuitous prices. They do so due to the underlying realties in the real world that defy the pricing model. So it is with options and their underlying stock instruments.

 When the collective knowledge of the stock market insists upon a premise, this may well suggest that fundamentals and research are responsible, and that art should imitate life instead; the model has failed. At any length, it is far more secure a seat to occupy when the underlying stock is well understood. It is only then that an options trading strategy can be executed with confidence, for all that is needed for success is the rational application of informed reason.

Any system that is adopted will only perform for a certain period of time, and so it is research, and knowledge of the fundamentals that will serve as a hedge against ignorance, and a barrier to financial demise. This is most relevant with respect to the subjection of many, to a mindset of undivided attention, paid to annualized returns of available option strategies, with none paid to the workings beyond the corporate veil.

 When an informed opinion on a stock is arrived at, and it lends itself to an options writing trading strategy, some circumspection ought to be applied to any reversion to an annualized return options strategy. For example, in order to exploit the acceleration of time decay, the choice of options strike to write will depend on a view of the underlying stock. If low volatility is expected, the greatest annualized return will be provided by at-the-money options, and under this objectivity, research, and authoritative view of the stock, one would not easily expect the threat of early exercise, and so the return can be calculated excluding the risk of being exercised.

 Ideally, written options will be most effective at the point where the stock will reside in the future. Particularly when stock markets rise, they routinely do so at a slower rate to that when they fall, and so volatility invariably falls in a rally. Still, the market will incorporate this incident into its pricing and it will only be the knowledge of the underlying fundamentals that will give the trader any tangible edge on the competition. Similarly, when the underlying stock is expected to suffer a retracement, an educated view will enable a trader to write put options at exceptionally high volatility and still retain confidence that value has been captured.

“Scientia est potentia” – knowledge is power.

At Wealth in Options we focus primarily on buying puts and calls, but an understanding of the writing of options is important for option trading strategy as we are on the other side of the trade.

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