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Technology Stocks : IFMX - Investment Discussion -- Ignore unavailable to you. Want to Upgrade?

To: Raven McCloud who wrote (10658)	5/2/1998 1:47:00 AM
From: Robert Graham	Read Replies (1) \| Respond to of 14631

I do not understand the "shorting" game. I do understand the concept and mechanics, but I have never tried and do not yet understand the practical aspects behind such a trade in order to manage the risks intelligently. I am still learning about options for there is allot to learn here. I do find that options are a different animal than the underlying stock in how it trades and responds to the price changes in the stock which is not linear. Options respond more to the concept of volatility, and in an actual sense, the anticipated volatility of the stock, besides responding to the price changes of the stock. The anticipated volatility of the underlying stock is called the implied volatility of the option. I know "volatility" and "price change" sounds the same but it is different with respect to options. For instance, in many cases volatility as it is priced into the option has no directional component to it. For an extreme example, I have noticed times that when the price of the stock unexpectantly drops through the floor, the option may not follow the stock for a period of time and remain close to the price it had before the drop. In this case the option players are expecting the price of the stock to rebound. This is the way the option player thinks in their trading of options. The implied volatility of the option that its price is based on is the volatility of the underlying stock currently anticipated by the option traders, and this volatility conceptually does not have any directional component to it. Options plays on news of course will have more of a directional component to its pricing. I still find in this case the directional component will vary with respect to a change in the underlying depending on timing and what is happening to the price of the underlying stock. Also this implied volatility has a relatively short time frame to it as compared with the expiration date of the option. For instance, when I play stocks that are in a good uptrend, I find that unless the stock swings about allot on a daily basis, the option may not reflect the price movement of the stock even though the current trend that has been established can carry this stock a few points per week. I find this true with the options I play in this situation which expire about one month out. So if I am careful, I can purchase the option at what I would consider a discount. The premium based on the underlying volatility of the stock can expand near the beginning and ends of the stocks short term cycles. So I have made mistakes in my timing and this increase in the premium irrespective of the change in price of the stock saved me more than once from a loss. Many "nickle and dime" public speculators play options due to the low entry fee which makes up a large part of the option plays in the market. This crowd is very reactive and their concept of volatility when purchasing the option appears to be: "I will buy this cheap option now because I think this stock will go "up". Their definition of up is very loosley connected with any concrete idea on what this actually means in terms of the amount of the change expected and the time span this will occur in. They "feel" that the stock will go "up" real "soon" now. So the real-world characteristics of options can and do differ from what the option pricing models are using. It is important to understand these differences. The shorter term the option trade is, the more weight the volatility aspect of this formula will impact the price of the option. In the case of very short term trades like day trades of options, the trader's primary focus is to anticipate the change in implied volatility of the option. One way in doing this is looking at the option series to see the pattern of prices the option series have with respect to how each strike price relates to the current price of the stock. There is based on option pricing models a pattern this should take given factors like the time to expiration of the option, how the strike price of the option compares to the current price of the stock, the underlying volatility of the stock (beta), and even the current interest rates. If the option series on a stock does not fit this pattern, then this is called a volatility skew. So one way ot play this is to place trades that will profit when the options that are priced outside of this pattern come back into the pattern defined by the option pricing model you are using. This is using the option pricing model more rigorously. I have recently run into a MM on the Toronto Options Exchange. I do not think he knows what is coming up for him when I start plying him with questions. For instance, I want to know more about how options MM hedge their positions. This is important particularly since the option market is a relatively illiquid market for many options. I do know the hedge their open positions through the purchase or sale of stock, and through the purchase or sale of a series different from the option they are hedging their position in. They only partially hedge their positions. So if the price were to uncharacteristically change in price my a wide margin, they would get burned. This is why gaps in the underlying stock can be either an option MMs dream play or their nightmare depending on which side of the gap their open position is on. Since they are there to make a market which requires them to be able to take the other side of a given transaction, they do not have as much control over the position they find themselves in. But they do have control over how they handle their position in hedging and how they fo about closing their open position at a future date. As you see, this is currently my favorite subject. Any comments welcome. Bob Graham