Compared to trading equities, there are so many more option strategies available to an option trader. But more importantly: Do you know why there are so many different types of options strategies? This is the real root of our discussion and why getting a proper options education can help a trader better understand all of those strategies and when and how to use them.
Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish NFLX traders. Now that the stock has recently gapped up big after earnings and has broken through several resistance areas and is now trading around its all-time high, there are traders who continue to be extremely bullish on the stock. Some option traders want to get more bang for their buck and buy short-term out-of-the-money calls. This might not be the most prudent way to capture profits but that is a discussion for another time. Less bullish traders might buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high (which it currently is not but it has been rising) and the trader is bullish just to a point, the trader might sell a bull put spread (credit spread), and so on.
The differences in options strategies, no matter how apparently minor, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position and, in turn, structure a position that addresses each difference. Traders need to consider the following criteria:
Degree of bullishness or bearishness
Carefully defining your outlook and intentions and selecting the best options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners, or taking losses bigger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. With summer coming soon and supposedly the slow markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit!
Option traders have to manage risk. Want a job description? That’s about it. In fact that is a job description for every trader; even ones that don’t trade options. Every trade has a risk and reward associated with it and traders must realize that especially when first learning how to trade. Because options are instruments of leverage, it is very easy to let risk get out of control, if you’re not careful. Traders must manage risk carefully, instituting tight leashes on their options, spreads and portfolio. The management technique of each is essentially the same because position management is fractal.
Something that is fractal has a recurring pattern that has continuity within its scale. For example, a tree is fractal. A tree has a trunk with limbs extending from it; limbs with smaller branches extending from it; smaller branches with yet smaller branches; and leaves with veins that branch off within each leaf. The pattern is repetitive within each iteratively smaller extension of the last. This is found in option position management too.
Individual options have risk that must be managed. They have direction, time and volatility risk which are managed by setting thresholds for each of the corresponding “greeks” which measure them. When individual options are a part of a spread, the resulting spread has these same risks of direction time and volatility. The spread’s risk must consequently be managed likewise. A trader’s complete option portfolio, which may be comprised of many spreads has systematic risk in accordance to the market. These risks are the same as for individual options or individual spreads: direction, time and volatility. Traders should treat their all encompassing portfolio as a single spread and use the portfolio “greeks” to set parameters to minimize the total risk of the portfolio.
If you are a hockey fan, you probably know that we are getting ready to start the NHL playoffs. Teams are gathering information about their opponents and trying to gain the upper hand over them which ultimately could lead to a victory. Just like in option trading, a well though out and well kept watch list can help a trader in a variety of ways including scoring profits. First and foremost it can help keep track of the underlyings and keep them all in one place so it is easy to reference them. Potential trade opportunities are often discovered by scanning and searching charts and options from stocks that are on a watch list just like determining potential strengths and weaknesses of a hockey opponent. Here are a couple of ways a trader might go about building a watch list or creating a better one.
If a person is relatively new to trading there are probably a few stocks that he or she is familiar with. To gather more names to add to the list, a trader can scan through an index (like the S&P 500 for example) and find more stocks to potentially add to the list. Some of the stocks listed may not be conducive for a variety of reasons. It makes perfect sense to check out the symbols and see if the charts and the options are at acceptable levels for the trader’s personality and plan. Things a trader might want to consider when deciding whether to put a stock on his watch list are the stock price, the stock’s volatility, option prices, bid/ask spreads and option volume just to name a few. When this process is complete, a trader should have a decent watch list in which to work with. This list may grow and sometimes shrink over time depending on the trader.
There are numerous trading services (free and paid) out there that not only might introduce traders to stocks to add to the watch list which may lead to potential trade opportunities. The Market Taker Live Advantage Group Coaching is one such service that MTM offers. As mentioned above, the reason a watch list is created in the first place is to find potential trades. A service can not only introduce traders to new symbols but also provide trade ideas that can turnout to be profitable. But if the trade concept is unclear or deviates from a trader’s plan regardless of the source, it should be avoided until the concept is understood. In any case, if the trader thinks there may be an opportunity on the stock in the future it can be added the list.
Once a trader has a watch list of stocks, it may be prudent to separate the list into different categories. There can be a list for stocks that are ready to trade now or very soon. Keeping this list the shortest might make sense for a couple of reasons. First a trader should probably not be trading more stocks than he or she can handle and secondly if there are too many on this list, some trade ideas might get lost in the mix. A short list makes it easier to monitor potential trade opportunities. There can also be a category for stocks that have trade potential in the near future (a day to a week for example). This list can be monitored maybe a little less frequently than the previous list. Another category to consider for the watch list are stocks that have no potential now but may in the future. For example, maybe a stock is trading in the middle of a channel and if it ever trades down to support a bullish opportunity may arise. Stocks should be moved up and down in these different categories as needed.
These were just a few ideas about how a trader can go about developing and monitoring a watch list and searching for potential trade opportunities. The most important part about having a watch list is not how it was acquired but that there is one. A well-refined and updated watch list can yield plenty of potential money making opportunities in option trading. Go Blackhawks!
With Alcoa expected to announce their earnings this coming week and a plethora of companies shortly afterwards, it is probably a good time to review how an option price can be influenced.
Perhaps the most easily understood of the option price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.
The option price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.
The third option price influence in relation to earnings season is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we will be in the midst of earnings season soon, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium.
The value of implied volatility is generally inversely correlated to the price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price like a quarterly earnings announcement. In addition, FDA decisions, potential takeovers and sometimes product announcements can also effect the implied volatility and option prices just to name a few more.
New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these option price influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over earnings season.
In my opinion, one of the most helpful things to do to improve your option trading or any type of trading is to review your trades. You need to pretend that you are the late, great Roger Ebert of option trading and give your trades a thumbs up or down. This is a fantastic way to gauge how you are developing as a trader and incorporate it into your trading plan. A lot of option traders are disheartened when they examine their profit and loss statements, but this can be deceiving. Why? Many good trades lose money and a lot of bad trades make money. Your goal as an option trader is to follow your trading plan and take the best trades that make sense to you and put the odds are your side for a successful trade. Easier said then done you might say but reviewing your trades is a very important step to take in order to become consistently profitable and putting the odds on your side.
Capture Your Trades
The first thing an option trader should consider doing is to capture his trades with some type of screen capture software. Every trader should have this in his or her trading plan. There are a plethora of options out there and many are free. An option trader should have a record of the chart, option chain, implied volatility and any other tangible that may be pertinent to the trade. If the trade is in effect for several days, screens shots can be taken periodically to help a trader understand what is happening on the charts and to the options. Once the trade is exited, screen shots should be taken again to compare the start and end of the trade.
Now that the option trader has the concrete evidence in his hands or on his computer, it’s time to look at the damage or lack there of. When reviewing your trades, it is advantageous to do this part after the close of the market so full attention can be on the reviewing process. Label the chart and option chain with what strategy was used. Where did the trading plan call for entry, stop and target? Then where was the trade actually entered and exited? Were there any discrepancies? If there were, a trader needs to find out why and correct them in the future.
Correct and Make Adjustments
If the trade suffered a loss in particular, and the trading plan was followed, was it just part of the odds or is there something that can be done to improve the odds for next time? It really doesn’t matter what the violation or mistake was, it just needs to be recognized and taken into account for next time. Sometimes the loss is not the fault of the trader but many more times it probably was. Changes and adjustments both mentally and physically need to be made and corrected to improve trading performance. Once a trader has recognized and corrected his errors and adjusted the trading plan, trading can become a whole lot easier.
Reviewing your trades like Roger Ebert used to review movies for so many years can be an essential ingredient to becoming the option trader you want to be. The key to becoming successful and growing as an options trader is to learn to acknowledge your winners, but cherish and learn from your losses because that is what will make you profitable in the end. You will absolutely learn more from your losses than from your winners… thumbs up!
A collar strategy is an option strategy that can particularly benefit investors. In this blog we have a lot more options education for traders and less for long-term investors so here is a strategy both can consider. A collar is simply holding shares of stock and buying a put and selling a call. Usually both the call and the put are out-of-the money (OTM) when establishing this option combination. A basic single collar represents one long put and one short call along with 100 shares of the underlying stock. A collar strategy is frequently implemented after stock (investment) has increased in price. The main objective of a collar is to protect profits that have accrued from the shares of stock rather than increasing returns. Is that an option strategy you might consider? Let’s take a look.
Why a Collar?
Since the market has been on a rather a bullish run and there are a plethora of stocks that have increased in value and it might be a good time to talk about some strategies that can help protect those gains. One option strategy is to buy a put. The investor has some protection for the unrealized profits in case the stock declines. The other part of the combination is selling the OTM call. By doing this, the investor is prepared to sell his or her shares of stock if the call is exercised because the stock has moved above the call’s strike price.
The advantage of a collar strategy over just buying a protective put is being able to pay for some or the entire put by selling the call. In essence, an investor buys downside stock protection for free or almost free of charge. Until the investor exercises the put, sells the stock or has the call assigned, he or she will retain the stock.
Volatility and Time Decay
Even though implied volatility (IV) has been really low over the last several months in the market, volatility and also time decay are not usually big issues when it comes to a collar strategy. The simple explanation is because the investor is long one option and short another so the effects of volatility and time decay will generally offset each other.
An investor could have bought 100 shares of Delta Air Lines (DAL) in October of last year for about $32 a share. At the time of this writing the stock has climbed to about $46 a share and the investor is worried about the current market conditions being extended to the upside and protecting his unrealized gains. The investor can utilize a collar strategy.
The investor can buy a April 43 put for 0.90. If the stock falls, the investor will have the right to sell the shares for $43. At the same time the investor can sell a April 48 call for 1.00. This will make the trade a net credit of 0.10 (1 – .90). If the stock continues to rise, it can do so for another $2 until the stock will most likely be called away from him.
Three Possible Outcomes
The stock finishes over $48 at April expiration. If this scenario happens, another $2 per share is realized on the stock and $10 on the net credit of the combination is the investors to keep.
The stock finishes between $43 and $48 at April expiration. In this case, both options expire worthless. The stock is retained and the $10 net credit is the investors to keep.
The stock finishes below $43 at April expiration. The investor can sell the put option if he wishes to retain the stock or exercise the right to sell the stock at $43. Either way the $10 net credit is the investors to keep.
The nice thing about a collar strategy is that an investor knows the potential losses and gains right from the start. If the stock climbs higher, the profits may be curbed due to the short call but if the stock takes a dive, the investor has protection due to the long put and protection might not be such a bad idea if the market corrects itself. Even an investor can benefit from some options education!
Implied volatility (IV) has been relatively low in the market until recently. With recent downturn in the market, some implied volatility levels have increased of of their recent lows. Implied volatility by definition is the estimated future volatility of a stock’s price. More often than not, IV increases during a bearish market (or a sell off like we have been seeing) and decreases during a bullish market. The reasoning behind this comes from the belief that a bearish market is more risky than a bullish market. The jury is still out on whether this current bullish market can continue through the summer but regardless, now may be a good time to review a strategy that can take advantage of higher implied volatility even if it doesn’t happen this week. Option traders need to be prepared for all types of trading environments.
Reasoning and Dimensions
Selling bull put spreads during a period of high implied volatility can be a wise strategy, as options are more “expensive” and an option trader will receive a higher premium than if he or she sold the bull put spread during a time of low or average implied volatility. In addition, if the implied volatility decreases over the life of the spread, the spread’s premium will also decrease based on the option vega of the spread. Option vega measures the option’s sensitivity to changes in the volatility of the underlying asset. The implied volatility may decrease if the market or the underlying moves higher.
Outlook and the VIX
Let’s take a look at an example of selling a bull put spread during a time of high implied volatility. In this recent environment, the CBOE Market Volatility Index (VIX) has recently moved from just below 14 percent to about 17 percent in about two weeks which was accompanied by a decline in the market over that same time period. The VIX measures the implied volatility of S&P 500 index options and it typically represents the market’s expectation of stock market volatility. Usually when the VIX rises, so does the implied volatility of options. Despite the drop, let’s say a trader is fairly bullish on XYZ stock. With the option premiums increased because of the implied volatility increasing, a trader decides to sell a bull put spread on XYZ, which is trading around $53 in this example.
Selling the Spread
To sell a bull put spread, the trader might sell one put option contract at the 52.5 strike and buy one at the 50 strike. The short 52.5 put has a price of 1.90, in this example, and the 50 strike is at 0.90. The net premium received is 1.00 (1.90 – 0.90) which is the maximum profit potential. Maximum profit would be achieved if XYZ closed above $52.50 at expiration. The most the trader can lose is 1.50 (2.50 – 1.00) which is the difference between the strike prices minus the credit received. The bull put spread would break even if the stock is at $51.50 ($52.50 – $1.00) at expiration. In other words, XYZ can fall $0.50 and the spread would still be at its maximum profit potential at expiration. If the VIX was still at 12 percent like it had been previously, the implied volatility of these options could be lower and the trader might only be able to sell the spread for 0.90 versus 1.00 when it was at 18%. Subsequently the max loss would be 0.10 higher too. In addition, if the IV decreases before expiration (like it has been known to do if the underlying rises), the spread will also decrease based on the option vega which could decrease the spread’s premium faster than if the IV stayed the same or if it rose.
When examining possible option plays and implied volatility is at a level higher than normal, traders may be drawn to credit spreads like the bull put spread. The advantage of a correctly implemented bull put spread is that it can profit from either a neutral or bullish move in the stock and selling premium that is higher than normal.
For the most part, option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.
The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.
The trader’s objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.
What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.
To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.
One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!
A question I often get in Group Coaching and one that is probably not discussed enough when learning to trade options is that of the various settlement issues. Many option traders limit their universe of option trading to two broad categories. One group consists of individual equities and the similar group of exchange traded funds (ETFs). The other group is composed of a multitude of broad based index products. These two groups are not entirely mutually exclusive since a number of very similar products exist in both categories. For example the broad based SPX index has a corresponding ETF, the SPY.
The first category, the individual equities and ETFs, trade until the close of market on the third Friday of each month for the monthly series contracts. These days there are more and more ETFs and equities that also have weekly settlements too. These contracts are of American type and as such can be exercised by the owner of the contracts for any reason whatsoever at any time until their expiration. If the contract is in-the-money at expiration by just one cent, clearing firms will also exercise these automatically for the owners unless specifically instructed not to do so in many cases. The settlement price against which these decisions are made is the price of the underlying at the close of the life of the option contract.
When this first group we are discussing settles, it is by the act of buying or selling shares of the underlying equity/ETF at the particular strike price. As such, the trader owning a long call will acquire a long position in the underlying and the owner of a put a short position. Conversely, the trader short these options will incur the offsetting action in his account. Obviously, existing additional positions in the equity/ETF itself may result in different final net positions.
The second category, the broad based index underlyings, are also termed “cash settled index options”. This category would include a number of indices, for example RUT and SPX. As the name implies, these series settle by movement of cash into and out of the trader’s account. The last day to trade these options is the Thursday before the third Friday; they settle at prices determined during that Friday morning. Like ETFs and equities, these index options also have weekly settlements as well.
One critically important fact with which the trader needs to be familiar with is the unusual method of determining the settlement price of many of the underlyings; it is NOT the same as settlement described above. Settlement for this category of underlyings has the following two characteristics important for the trader to understand: 1.The settlement value is a calculated value published by the exchange and is determined from a calculation of the Friday opening prices of the various individual equities, and 2. This value has no obligate relationship to the Thursday closing value for the underlying.
Many option traders choose never to allow settlement for the options they hold, either long or short. For those who do allow positions to settle, careful evaluation of the potential impact on capital requirements of the account must be a routinely monitored to avoid any surprises. When in doubt the best way to go is to ask your broker how they will handle settlement for your particular situation and and tell you what alternatives you might have.
Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.
The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.
Taking the above paragraph into context, one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.
What many traders fail to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.
Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock is trading at $128 and purchases 3 March 130 call options. Each call contract has a delta of +0.40. The total delta of the position would then be +1.20 (3 X 0.40) and not just 0.40. For every dollar AAPL rises all factors being held constant again, the position should profit $120 (100 X 1 X 1.20). If AAPL falls $2, the position should lose $240 (100 X -2 X 1.20) based on the delta alone.
Using AAPL once again as the example, lets say a trader decides to purchase a March 130/135 bull call spread instead of the long calls. The delta of the long $130 call is once again 0.40 and the delta of the short $135 call is -0.22. The overall delta of the position is 0.18 (0.40 – 0.22). If AAPL moves higher by $3, the position will now gain $54 (100 X 3 X 0.18) with all factors being held constant again. If AAPL falls a dollar, the position will suffer a $18 (100 X -1 X 0.18) loss based on the delta alone.
Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.