Options strategy - When stocks go opposite of your purchase?

Question

I'm a bit new to options and would like to ask for someone's strategy opinion. Lets say that you buy a call at an expiration date 2 months or so from now, and in a few days you see the stock go flat or even a little bit lower.

Would you buy more of the same options at a lower stock value to lower the option average cost (with the same expiration date). Or would you buy a put option hoping that it'll go lower. But you'll still have that call option.

Or if there's another strategy that most people do?

Thanks!

Answer 1

If you buy a call, that's because you expect that the stock will go up. If it does not go up, then forget about buying more calls as your initial idea seems to be wrong. And I don't think that buying a put to make up for the loss will work either, the only thing that is sure is that you will pay another premium (on a stock that could stay where it is).

Even if you are 100% sure that the stock will go up again, don't do anything, as John Maynard Keynes stated: "Markets can remain irrational longer than you can remain solvent".

My idea is: wait until the expiration date. The good things about options is that you won't lose more than the premium that you paid for it and that until it reaches its maturity you can still make money if the market turns around.

More generally, when you are purely speculating, adding to a position when it goes against you is called "averaging down". I sincerely discourage you to do that :

If the stocks goes in the wrong direction, that means that your initial idea was wrong in the first place (or you were not right at the right moment). In my opinion, adding up to a wrong idea is not the right thing to do. When you are losing, just take your loss and don't add up to your position based on your emotions.

On the other hand, adding to your position more when the stock goes in your direction is called "pyramiding" and is, in my opinion, a better way of doing things (you bought, you were right, let's buy more). But at some point you will have to take your profits.

There are plenty of other stocks on which you can try to invest and the market will still be here tomorrow, there will be other opportunities to make profits. Rushing things by constantly trying to have a position is not a good idea.

Not doing anything is also a strategy.

Answer 2

I would make a change to the answer from olchauvin:

If you buy a call, that's because you expect that the value of call options will go up.

So if you still think that options prices will go up, then a sell-off in the stock may be a good point to buy more calls for cheaper. It would be your call at that point (no pun intended).

Here is some theory which may help.

An options trader in a bank would say that the value of a call option can go up for two reasons:

1. because the underlying stock price goes up,
2. because implied volatility used to price the call option goes up.

The VIX index is a measure of the levels of implied volatility, so you could intuitively say that when you trade options you are taking a view on two components: the underlying stock, and the level of the VIX index.

Importantly, as you get closer to the expiry date this second effect diminishes: big jumps up in the VIX will produce smaller increases in the value of the call option. Taking this point to its limit, at maturity the value of the call option is only dependent on the price of the underlying stock. An options trader would say that the vega of a call option decreases as it gets closer to expiry.

A consequence of this is that if pure options traders are naturally less inclined to buy and hold to expiry (because otherwise they would really just be taking a view on the stock price rather than the stock price & the implied volatility surface).

Trading options without thinking too much about implied volatities is of course a valid strategy -- maybe you just use them because you will automatically have a mechanism which limits losses on your positions.

But I am just trying to give you an impression of the bigger picture.

Answer 3

Robert is right saying that options' prices are affected by implied volatility but is wrong saying that you have to look at the VIX index. For two reasons:

1) the VIX index is for S&P500 options only. If you are trading other options, it is less useful.

2) if you are trading an option that is not at the money, your implied volatility may be very different (and follow a different dynamics) that the VIX index.

So please look at the right implied volatility.

In terms of strategy, I don't think that not doing anything is a good strategy. I accept any point of view but you should consider that option traders should be able to adjust positions depending on market view.

So you are long 1 call, suppose strike 10. Suppose the underlying price at the time of entry was 10 (so the call was at the money). Now it's 9.

1) you still have a bullish view: buy 1 call strike 9 and sell 2 calls strike 10. This way you have a bull call spread with much higher probability of leading to profit. You are limiting your profit potential but you are also reducing the costs and managing the greeks in a proper way (and in line with your expectations).

2) you become bearish: you can sell 1 call strike 9. This way you end up with a bear call spread. Again, you are limiting your profit potential but you are also reducing the costs and managing the greeks in a proper way (and in line with your expectations).

3) you become neutral: buy 1 call strike 8 and sell 2 calls strike 9. This way you end up with a call butterfly. You are almost delta neutral and you can wait until your view becomes clear enough to become directional. At that point you can modify the butterfly to make it directional.

These are just some opportunities you have. There is no reason for you to wait. Options are eroding contracts and you must be fast and adjust the position before time starts eroding your capital at risk.

It's true that buying a call doesn't make you loose more than the premium you paid, but it's better to reduce this premium further with some adjustment. Isn't it?

Hope that helps. :)