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Well it’s all about what happens to option price leading up to expiry. You see while probability of market reaching $63 for example may have been low, there is still risk of option price inflating to unacceptable levels based on smaller movement in market.
The market would have only had to shoot up to $60 or $62 within a short time frame and that $63 call would be showing a significant loss. From there market could well turn around, but you may not be able to afford to hold it that long to find out.
Holding $66 and $68 calls gives room to breathe even when market does not do what we want. If market made it up to $60 for example, we would have had to adjust a trade in $63 calls. The trade with higher strikes would not need that adjustment.
The Right Price
If you have a car to sell, you would have a fair idea of what is too low, what is fair and what is above market. The same goes with options. You have to know what is a good price and what is a bad one.
At time, Crude Oil calls were sold for a good price. Analysis showed volatility to be overvalued and therefore it would be right trade to make.
Pricing is a function of things such as time and volatility. These are factors all option pricing models use. The key is knowing how to interpret these models. Interpretation will tell you what is a good price and what is a bad one.
Effective trade management
In an ideal short option trade, there is no management required. The idea is to see option expire worthless without market ever getting near strike price. Things don’t always work like that however and that is why every trade needs a plan. Generally there are three actions you can take when premium goes against you: •One: stop trade out at a loss and walk away. Of course this requires you to set a stop loss level, preferably before you enter trade. •Two: roll position. This simply means closing existing trade and establishing a new short position with a higher strike price and/or a longer time to expiry. The key here is to decide when you should initiate a roll. It is best to agree on a price in underlying as a trigger. For example: “If market gets to $63, I will roll my $66 calls”. The trigger point can change as time passes since a rally of $5 today will affect options differently than a rally of $5 over next month. Additionally, choice of what to roll to should be subject to same requirements as above (i.e. right options at right price). •Three: establish additional positions to either decrease risk or increase potential return from total trade. One could easily write volumes on different strategies that could be implemented. However there is a simple premise here: if you want to add a position that will stand to cover any existing loss, you will be taking on extra risk. Also if you want to add a position that will hedge any further risk, it will come at a cost. It’s all a balance of risk and reward.
Now it is true you could follow all these principles and still lose money. There is risk in every trade no matter how well planned. However, following above guidelines (as we do at wit Option1 trading recommendations) can help move odds in your favour.
Written by Guy Bower & Murray Priestley, developers of Gold Options Made Easy – the Professionals Approach to Selling Options, www.GoldOptionsMadeEasy.com. Guy is a licensed trading advisor.