September 2, 2010

Math Club Talks Options

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 1:28 pm

One of the hallmarks of option trading is its extreme flexibility in both the initial construction of positions and in the ability to mutate forms to accommodate the evolution of a trader’s thesis regarding the impending behavior of the underlying.  The trader who limits his world to that of simply trading equities and ETF’s can only deal in terms of short or long and the change of a thesis often requires starting anew in the position.  The option trader can usually accommodate the newly developed thesis much more fluidly, often with minor surgery on the position in order to achieve the right fit with the new world view.

One concept with which the trader needs to be familiar in order to orchestrate the necessary transmogrifications is that of the synthetic relationships.  This concept arises from the fact that appropriately structured option positions are virtually indistinguishable in function from the corresponding long or short equity/ETF position.  One approach to remembering the relationships is rote memorization of the relationships.  I find remembering the mathematical formula and modifying as needed to be much more useful.

For those who remember high school algebra, the fundamental equation expressing this relationship is S=C-P.  The variables are defined as S=stock, C=call, and P=put.  This equation states that stock is equivalent to a long call and a short put.

Using tenth grade algebraic rearrangements of this equation, the various equivalency relationships can easily be determined. Remember that we can maintain the validity of the equation by performing the same action to each of the two sides.  This fundamental algebraic manipulation allows us, for example, to derive the structure of a short stock position by multiplying each side by -1 and maintain the equality relationship.  In this case (S)*-1 =(C-P)*-1 or –S=P-C; short stock equals long put and short call.

Such synthetic positions are frequently used to establish positions either ab initio or to modify existing positions either in whole or part.  And you thought Math Club was only to meet girls.

Bill Burton

Writer, MTM

August 25, 2010

Accelerating To Warp Speed

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 5:14 pm

The weekly options have been the topic of our blog discussions over several weeks now.  Despite this topic being the trendy subject and in the forefront of many discussions, it is helpful to recognize the functional flexibility this dramatically shortened lifespan brings to a variety of strategies.

As an example, consider the case of a frequently traded spread vehicle, the butterfly.  For those first encountering this beast, it is helpful to consider briefly its anatomy and physiology.  It is anatomically constructed by establishing both a credit and a debit spread sharing a central strike price.  It can be constructed in either puts or calls or even in both, in which case it acquires the appellation of an iron butterfly.

Butterflies can be designed to be either a non-directional or directional trade vehicle.  Functional characteristics include: negative vega, variable delta, and accelerating gamma during its life span. In the case of the long standing monthly duration option cycles which had heretofore been available, these characteristics developed over weeks to months and reached their final expression during the week of option expiration.

These functional characteristics have limited the utility of butterflies over brief duration moves occurring early in the options cycle.  Many butterfly traders have had the experience of correctly predicting price action early in the cycle only to have the butterfly deliver little, if any, profit.

The short 9 day duration of the new weekly options has dramatically accelerated the pace of butterfly trading as the physiologic changes begin to occur literally over the extent of a few hours.  As such, it is possible to gain the advantage of this trade structure over brief directional moves or in the case of non-directional traders to have market exposure for briefer periods of time during the rapid evolutionary cycle.

Bill Burton

Market Taker Writer

August 11, 2010

Buckle Your Seatbelt

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 2:11 pm

My last several options blogs have been about the rapid and dramatic interest in and activity with the weekly options.

The full impact of this weekly options in the options market is not yet known.  For the covered call writer, the rapid theta decay of weekly options presents a potential opportunity to collect additional premium over 52 weekly cycles as opposed to the historically available 12 monthly cycles.

Another theoretical result of the tremendous volume of weekly options traded, there is early evidence of a weekly “pinning” effect.  Remember that option strike pinning is usually a relatively weak force that heretofore had characteristically been seen the week of options expiration.  This phenomenon refers to the tendency for an underlying to close at or close to an option strike price when no other strong directional trends are in play.

Finally, as Adam Warner has pointed out, these options may well reinforce a directional trend that develops after the weekly option premium sellers have taken their positions.  Because there is little premium with which to offset adverse directional moves, and also because these short dated options have abundant gamma, premium sellers could be forced to defend their position thus causing exacerbation of directional moves.

Remember that the ancient Chinese character for danger and opportunity is the same.  We are dealing with the new arrival of powerful forces which have the potential to change the landscape of the options world.

Bill Burton, MTM Writer

August 6, 2010

MTM Joined Blog Catalog

Filed under: Uncategorized — Dan Passarelli @ 10:31 am

We at MTM are proud to announce that we have joined Blog Catoalog http://www.blogcatalog.com/directory/business/investing/

Thanks for reading!

July 29, 2010

The Only Constant Is Change

Filed under: Options Education — Tags: , , — Dan Passarelli @ 9:24 am

Options have traditionally traded in 12 cycles per year.  Since there are 52 weeks per year, most monthly cycles have had a life span of 4 weeks with the occasional 5 week cycle in order to make the math work out. In these multi-week cycles, each week tends to have its own personality and the tempo of price change would often accelerate as expiration approached.  This effect was at least in part the result of the non linear nature of the decay curve of extrinsic premium.  It is as if the option cycle began with a decay curve akin to an easy green ski trail and ends on a double black diamond slope.

For strategies that include a component of being short premium, the maximum potential total profit or loss is only achieved at expiration.  This effect is easily seen in the case of vertical spreads which only reach their maximum potential gain or loss at expiration or when the spread goes deep in-the-money or out-of-the-money.

CBOE introduced weekly options in 2005 on several broad indices and the launch was met with a tepid reception.  However, trading volume in weekly options contracts has recently exploded, additional indices and ETF underlyings have been added, and recently a number of actively traded equities have joined the family of weekly options.  An updated list of the rapidly increasing available weeklies can be found at this CBOE site: http://www.cboe.com/micro/weeklys/introduction.aspx

Weekly options are a rapidly evolving and changing part of the options world.  As an  example of this rapid evolution, the new week’s options have begun to be offered on the Thursday of the week prior to expiration rather than the Friday as had been the case previously effective July 1, 2010.

The availability of weekly options will undoubtedly have significant impact on a variety of strategies.  Their acceptance and increase in trading volume has been nothing short of stunning.  For example, the 260 and 270 call strikes in AAPL that will expire tomorrow, July 30, each have an open interest of around 10,000 contracts.

The future isn’t what it used to be.

Bill Burton

Writer, Market Taker Mentoring LLC

July 23, 2010

Where’s the Pony?

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 12:20 pm

Time to expiration, price of the underlying, implied volatility, historical volatility, puts, calls, delta, gamma, theta, vega, in the money, at the money, out of the money, intrinsic value, extrinsic value, higher commissions, egregious bid ask spreads, no options traded on a stock with a beautiful technical set up, multiple potential beasts and physiologies, LEAPS; why would one even bother with options?  If I retain a shred of rationality, an open question to be sure, there must be some reason to complicate my life with these additional variables.

Ronald Reagan was fond of making a point with the story of the 8 year old boy who while visiting his grandfather’s farm fell into a pile of horse manure.  When his father found him a short while later, the boy was smiling ear-to-ear and happily shoveling away the muck.  When asked why, the son replied: “With this much poop, there must be a pony in here somewhere.”  Option trading is gaining popularity because the pony hidden beneath the pile of muck is (drum roll please): risk control.

Traders new to options often incorrectly focus on the ability to leverage positions, but in his classic summarization of this approach Jared Woodard opines:

But leverage, as anyone who’s followed the fate of the investment banks knows, is just a means for magnifying outcomes.  A leveraged risk-taker will experience more glorious wins and more disastrous losses, like a deranged person who shouts both poetry and obscenities (instead of whispering them quietly to himself, like the rest of us).

There are other logical and valid reasons for using options as one’s investment vehicle of choice to be sure, but the singular advantage of options is risk control.

Bill Burton,

Writer, Market Taker Mentoring LLC

July 9, 2010

Going Vertical in AAPL

Filed under: Options Education — Tags: , — Dan Passarelli @ 3:48 pm

One of the basic directional spreads in trading options is that of the vertical spread.  It is extremely versatile and represents a major building block of more complex spreads. It is so named because of the configuration of the position when overlain on the classic format for displaying option quotes.  In this format, the various strike prices for an option are arrayed vertically and the months available to trade are displayed horizontally.  This defined risk position consists of both a long and short position at different strike prices within the same expiration month.  It can be constructed in either puts or calls and the initial cash flow can be either a credit or debit.  Strike prices can be selected to produce either aggressive or conservative stances.

As an example, let us consider a vertical spread in market leader Apple ( AAPL ).  Current vital signs of the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility which is trading in the 59th percentile of its historic range.

For the trader who has a bullish thesis for the price action in AAPL into August expiration, a put credit spread can be established by selling the August 250 put and buying the August 240 put.  As this is written with 44 days to expiration, the maximum potential return is 51% and is achieved as long as AAPL remains above the short put strike of 250.  Maximum risk is defined by the long 240 put

As contrasted to a naked put sale, this position has the following major differences: 1. Risk is crisply defined as opposed to the naked sale maximum risk of the underlying going to 0, and 2. Margin requirements for the position and hence yield are dramatically improved.

July 6, 2010

Up And Down With Volatility: AAPL For The Teacher

Filed under: Options Education — Tags: , — Dan Passarelli @ 9:00 pm

Implied volatility is a major determinate of the magnitude of the extrinsic option premium.  Considered together with time, these two factors act in concert to define the pricing of the time value (extrinsic value) of options.

Two characteristics of implied volatility are reproducibly reflected in option pricing: 1.The inverse relationship of price of the underlying security, and 2.The correlation of implied volatility with the rapidity of the price movement. The largest movements in implied volatility are therefore to be expected in a rapid downward price move of the underlying security.

Because vertical volatility skew results in an array of implied volatility values it is helpful to consider the generally accepted reference point. This benchmark value of implied volatility is the average of the implied volatility values for the at-the-money front month strikes in all but the last week of the options cycle.

It is always helpful to return to these basic concepts when significant movement occurs in order to be certain the conceptual relationships are maintained.  Departure from the expected behavior is often an important clue to something nefarious afoot, as it was in the famous Sherlock Holmes investigation of the disappearance of the race horse, Silver Blaze, wherein the critical clue was that of the dog who didn’t bark.

Last Tuesday sell off in AAPL proves to be instructional when considered in light of the effects on implied volatility.  AAPL closed Monday at $268.30 and the IV was 35%.  AAPL gapped down Tuesday morning and by 1:00 PM was trading at $256.91 with option implied volatility of 40%. On the basis of Monday’s closing price and implied volatility values, this price represented a move of greater than 2 standard deviations.

IV responded as predicted by the usual relationship. The dog barked.

Bill Burton

Writer, Market Taker Mentoring LLC

June 30, 2010

Juicing Volatility in AAPL – An Analysis

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 8:06 am

The initial months of this year have been characterized by a low implied volatility (IV) environment in virtually all underlying securities.  This milieu ended suddenly and abruptly on the recent “flash crash” and IV generally remains significantly elevated above its recent nadir.

An example of the recent rise in IV can be seen in Apple ( AAPL ).  This underlying spent most of 2010 with options trading at IV’s of 30 percent or below.  The options have recently begun trading in the range of an IV of 35 percent and higher–even as high as 54 percent. Today’s pop up to the 45 level is becoming not so uncommon.

For the trader who is bullish on AAPL the stage is set for a return to lower levels of IV. When that happens, traders need to be on guard. It is important to recognize that positions characterized by being long volatility (positive vega trades, for example- long calls) will likely be negatively impacted by increasing prices since IV is generally inversely related to price.

Option strategists wanting to take a bullish position in AAPL may want to consider trade structures which offset much, if not all of the impact of decreasing IV.  In optionspeak, this can be described as reducing the vega of the position. Such strategies could include buying a vertical debit call spread as opposed to a single-legged long call position. This technique is referred to as volatility hedging. More on this in future blog posts.

June 17, 2010

The Two Faces Of Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 9:46 am

In Roman mythology the god of beginnings and endings, Janus, is typically portrayed having two heads, each facing in opposite directions. His countenances are displayed in this manner so that he can observe the past as well as the future.  The two types of option volatility, historical volatility and implied volatility, also reflect this dual perspective.

Historical volatility, also termed statistical volatility by some writers, is a simple mathematical calculation of the demonstrated volatility over various periods of time, hence the name historical volatility. While the precise method of calculation of historical volatility can be argued endlessly, it represents an objective and reproducible measurement that requires only the input of the variable of price movement.

Implied volatility is to be distinguished from the mechanical precision of historical volatility.  Implied volatility is the nexus point at which the raw emotions of the human brain so evident in trading meet the mathematical precision of the historical volatility. Of the three primal forces impacting option price, implied volatility is the only factor subject to cerebration. As a malleable and subjective input factor, it is reflective of both general market sentiment and the subjective evaluation of potential future volatility and direction of the specific underlying. As such, it is a forward-looking evaluation as opposed to historical volatility which is well, historic.

While this distinction may seem arcane and of academic interest only, it is decidedly not. Failure to consider the current position of implied volatility will routinely negatively impact trades and is the most frequent cause of paradoxical behavior of option prices

Bill Burton

Writer, Market Taker Mentoring LLC

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