Remember that Option Trading is no more different than stock trading, in that one needs to first formulate an trade opinion, as part of an overall trading plan.
In this example, using TA, I see a possible bullish setup at this juncture. Obviously, one can include FA into consideration or use both TA and FA to decide if TLT will move up, down or sideways in the next 3 weeks.
As my trade opinion is that TLT will move higher than current price, I need to adopt appropriate Option Strategies that can offer an acceptable potential profits for some known associated risks of this position.
Note that Historical Volatility for TLT is now ~13%. It is at the low end of its HV. Option chain of Dec09 TLT also shows a similar Implied Volatility.
This is one possible setup employing ONE contract size :
Long TLT Dec 96 Call and pay a premium of $1.25 (known risk).
Short TLT Dec 96/94 Put and receive a premium of $0.67.
This entire position requires a capital outlay of $58 ($125 - $67) + commissions + $133 ($200 - $67) of margin requirement.
The maximum loss of this trade = $258 ($58 paid for this position + maximum loss of the $2 wide Short Put spread)
The maximum profit is unlimited !
GREEKS for this trade :
Delta = + 77.05
Gamma = + 11.45
Theta = - 1.40
Vega = + 7.09
Clearly, this is a +ve Delta setup, a Bullish position, which reflects the bullish opinion. If TLT moves up by $1, this position makes ~$77 and loses the same if TLT drops by $1. Of the remaining GREEKS, Gamma is the next most significant risk factor. It will fluctuate Delta more or less by ~15%; ie. quite quickly with TLT's price swings.
A short note on Implied Volatility. As TLT is now trading with HV of only 13%, TLT options are also relatively cheaper now than when TLT was at 36% volatility. Remember that option values are positively correlated to Implied Volatility. The lower the IV, the cheaper the option. It is unwise to buy options when IV is very high, such as those just before an earnings report.
The main reason that this delta is large is because of the choice of ITM 96 Call. Since TLT is currently at $96.40, this ITM 96Call has a delta of +0.54. The Short 96Put is also very near ATM and so yields another +0.47 deltas. Both these options combine to form ~ +1.00 delta.
You should realize now that Long 96Call + Short 96Put = a synthetic Long TLT stock !! You paid $58 capital to establish a position that almost mimics a Long TLT stock position, which otherwise would have cost $9,640 to buy the 100 shares.
This is the power of option leverage. But it is not free. There are trade offs.
a) this option expires in 20 days
b) $1 move in TLT yields ~$77 vs $100 if 100 shares of TLT was bought
c) this overall option position has a maximum risk of $258 ($200 + $58) vs maximum losses of $9640 if TLT stock price drops to $0. of cos, we dont expect this to happen. but even if TLT drops off $10, the losses would be $1000 if 100 TLT shares were purchased. in other words, the downside losses can be very damaging. but using this option position, the losses is capped at $258.
If you believe that TLT will move significantly to the upside within the next 3 weeks, then consider establishing this position, instead of outlaying $9640 to buy 100 shares of TLT when all you need is $258 to put on this option trade.
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