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April 15, 2014

Ever Consider a Bear Put Spread?

The market has been on quite a run lower lately since the S&P 500 hit its all-time high earlier this month. Maybe the market will reverse and move higher at some point but traders need to be prepared like Boy Scouts just in case there is another move lower not only now, but for in the future as well. Options give traders a plethora of options so to speak for a trader with a bearish bias. Bearish directional option strategies are certainly an option but sometimes buying a put option can be a little bit more risky than maybe a trader wants because of potential price swings. A bearish option trader may want to be a little more cautious especially in this current volatile atmosphere.

An Alternative

A better alternative than the long put may be to buy a debit spread (bear put). A bear put spread involves buying a put option and selling a lower strike put option against it with the same expiration. The cost of buying the higher strike put option is somewhat offset by the premium received from the lower strike that was sold. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The options trader will realize this maximum gain if the price of the stock is lower than the short put’s strike expiration. The most the options trader can lose is the cost of the spread. This maximum loss will occur if the stock is trading above the long put’s strike at expiration.

An Advantage

 An advantage of a bear put spread is that if the stock pulls back, the spread will lose less than just being long puts because of the spread typically has smaller delta and initial costs due to being long and short options. The trade’s delta is smaller because the positive larger delta of the long put option is somewhat offset by the smaller negative delta of the short put option. For example, what if XYZ stock is trading at $40 a share and an option trader purchases an ATM put option ($40 strike) with a delta of 0.50. For every dollar XYZ goes up or down, the put option should increase or decrease by $0.50. If a bear put debit spread was created by adding a short put with a lower strike price of 35 and delta of 0.20, the delta for the spread would now be 0.30 (.50 – .20). Now the spread would gain or lose $0.30 for every dollar the stock went up or down.

 Trade-Off

It is probably obvious to a great many of you how a smaller delta might be a disadvantage for the trade. If the trader is correct on the movement and the stock decreases in value, potentially a larger profit could be realized with just being long the put option because of the potential higher delta. But once again a trader needs to determine if a lower overall cost using the bear put and possibly a lower overall risk is worth the trade-off versus the long put.

Finally

Understanding current market conditions (especially now) and applying and managing the proper options strategy is crucial for success at all times. Deciding when to implement a bear put spread instead of buying puts for a bearish bias is just one example of this.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 10, 2014

Double Your Pleasure

With earnings season just kicking off once again, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options

The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future writings, the selection of strike prices and position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 3, 2014

Different Option Strategies on AAPL

Compared to trading stocks, there are so many more 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 reason 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 AAPL traders. The stock has recently moved higher after declines in January and February. There are traders who continue to be extremely bullish on AAPL as it heads closer to its earnings announcement and 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:

  • Directional bias
  • Degree of bullishness or bearishness
  • Conviction
  • Time horizon
  • Risk/reward
  • Implied volatility
  • Bid-ask spreads
  • Commissions
  • And more

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 spring hopefully ending soon (cold and snowy winter here in Chicago)and supposedly the volatile markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the summer season!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 27, 2014

Directional Butterfly

Many 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.

A Butterfly

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

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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

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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.

Directional Butterfly

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.

Final Thoughts

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!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 20, 2014

Aint’ Nothin’ Like the Real Thing, Baby!

When it comes to learning to trade, there really isn’t anything like the real thing. You can read hundreds of books, watch thousands of videos, but without having someone to show you the way to actually DO IT, learning to trade can be tough.

Imagine trying to learn a complex game like chess by reading a book or watching a video. You’ll get some good pointers, but can you really learn to master the game? There is logic, psychology, player interaction, time-tested moves and other intangibles that a book or video can only teach you so much about. You can practice playing the game over and over again as well, but without someone showing you move-by-move, piece-by-piece how to play the game, you’ll never achieve mastery of the game. You need someone to show you how to play, the way to counter certain moves, the way to set up attacks three moves ahead, the way to read your opponent.

That’s the way I learned to trade: Face-to-face, and often toe-to-toe, down on the trading floor. I learned the old fashioned way: By having people around me to show me how to do it. The benefit of being able to ask the experts standing next to me on the trading floor the burning questions that I needed answered. This helped me to reach the level of competency I need to become a successful a trader. It proved to be the biggest contributor to a long and rewarding trading career.

It’s hard for people to learn to trade without access to the knowledge center that I was fortunate enough to have which was smack dab in the middle of the trading floor; and I appreciated that. I consider myself extremely fortunate to have grown up in Chicago and to have gotten a break, getting a job on the trading floor after college. I was able to springboard that opportunity into a successful trading career. I get it. And that’s why, for two days, I am going to help recreate some of

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that experience for YOU.

We are planning an intensive (but fun) two-day class in Chicago. It will be held at the Chicago Board Options Exchange (CBOE), where I first learned to trade.

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We’ve got a GREAT curriculum planned and a really fun social event in the plans as well. Right now, this class has not been made officially public. We’re still in the final stages of planning and we’ll announce all the details next week. Right now, we’d like your input so we can finish off the amazing itinerary we have planned. Please help us create the kind of class you’d love to be a part of—your DREAM CLASS—by answering this short, four-question survey.

Dan Passarelli

CEO, Market Taker Mentoring, Inc.

Create your free online surveys with SurveyMonkey , the world’s leading questionnaire tool.

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March 13, 2014

AAPL Options and Moneyness

Dan Passarelli often uses the word “moneyness” and he even has a section about it in his books. Moneyness isn’t a word, is it? It won’t be found on spell-check, but moneyness is a very important term when it comes to learning to trade options. There are three degrees, if you will, of moneyness for an option, at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let’s take a look at each of these terms, using tech behemoth Apple (AAPL) as an example. At the time of writing, Apple was hovering around the $535 level, so let’s define the moneyness of Apple options using $535 as the price.

At-the-Money
An at-the-money AAPL option is a call or a put option that has a strike price about equal to $535. The ATM options (in Apple’s case the 535-strike put or call) have only time value (a factor that decreases as the option’s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time.

In-the-Money
An option that is in-the-money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of AAPL, ITM options include the 530 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.

A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, an ITM AAPL put carries a strike price of 540 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a March AAPL 545 put has a premium of $11.50 compared to a price of $7.95 for a March 540 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 515 call and AAPL closed at $520 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $515 a share.

Out-of-the-Money
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher

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than the market price of the underlying, and puts are OTM when their strike price is lower than the stock’s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.

If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.

Have a great week of trading!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 6, 2014

Weekly Options and Time Decay

There are so many different characteristics of options that I talk a lot about with my options coaching students. But one of the more popular subjects is that premium sellers see the most dramatic erosion of the time value of options they have sold during the last week of the options cycle. Most premium sellers strive to keep the options they have sold short (also known as options they have “written”) out-of-the-money (OTM) in order that the entirety of the premium they have sold represents time (extrinsic) premium and is subject to this rapid time decay.

With 12 monthly cycles, there historically have been only 12 of these final weeks per year in which premium sellers have

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seen the maximum benefit of their core strategy. The widespread use of weekly options has changed the playing field. Options with one week durations are available on several indices and several hundred different stocks. These options have been in existence since October 2005 but only in the past couple of years have they gained widespread recognition and achieved sufficient trading volume to have good liquidity. Further now, there are weeklys that go for consecutive weeks (1 week options, 2 week options, 3 week options, 4 week options and 5 week options) that were just late last year.

Standard trading strategies employed by premium sellers can be executed in these options. The advantage is to gain the “sweet spot” of the time decay of premium without having to wait through the entirety of the 4 to 5 week option cycle. The party never ends for premium sellers using these innovative methods. Of course there is a trade-off because the shorter the time there is left until expiration, the smaller the option premiums are compared to an option with a longer expiration. As option traders we are used to tradeoffs.

Traders interested in using these weeklys MUST understand settlement procedures and be aware of last days for trading. An excellent discussion of weeklies given by Dan Passarelli is available at Learn to Trade Weeklys.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 27, 2014

Naked AAPL Options

With March finally here, traders are still assessing when or if ever this market will have a correction like it had in January. That being the case, there are several option strategies that traders can consider depending on their outlook. Below is an explanation of a option strategy that may be right for you depending on your goals and trading personality. Regardless, understanding this option strategy is something all traders should and need to know even if they may never use it.

Let’s take a look at an option strategy that involves the selling of a put, often referred to as an uncovered put write or simply a naked put. A naked put is when a trader sells a put that is not part of a spread. This strategy is generally considered to be a bullish-to-neutral strategy. The maximum profit is the premium received for the put. The maximum profit is achieved when the underlying stock is greater than or equal to the strike price of the sold put. Though this allows for a lot of room for error (The stock can be anywhere above the strike at expiration), note that the maximum loss is unlimited and occurs when the price of the underlying stock is less than the strike price of the sold put less the premium received. So, executing this trade in the right situation is essential. To calculate the breakeven point, subtract the premium received from the sold put’s strike price.

The Example
For our example we will use Apple Inc. (AAPL). Apple shares have moved lower since the middle of February and are attempting to rally again. Now the trader thinks after this brief pullback the stock will once again continue to move higher. For this example we will assume the stock is trading around $525 a share at the beginning of March. A trader sells the April 500 put, which carries a bid price of $6 (rounded to make the math a bit easier) because there is an area of support at that level that the trader thinks will hold. Should AAPL stock be trading above $500 a share at expiration, the April 500 contract will expire worthless and the trader will keep the premium collected. (Do not forget to take any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls below that area of support?

If AAPL falls another $40 to $485 at expiration, the put would expire in-the-money and would have to be purchased back to avoid assignment. This could cost the trader a rather hefty sum. Assigning values, our investor collected $6 in premium. The 500 put expired with $15 in intrinsic value. The trader loses the $15, less the $6 premium collected results in a loss of $9, or $900 of actual cash.

Why Sell Naked Puts?
We have already discussed the profit potential of selling naked puts, but there is another reason to do so – owning the stock. Selling naked puts is a good way

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to purchase at a specific price by choosing a strike near said target price. Should the stock price drop below the put strike and the puts are assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the premium is pocketed at expiration. Traders should be aware of the risk when selling naked puts and that potential losses can be extreme when compared to other option strategies.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 20, 2014

Socrates and Another Famous Greek

We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work such as implied volatility, time decay, etc. Have you ever wondered how can you know how much an option is going to move with respect to say the underlying? Very simple – check out its delta.

Delta is arguably the most

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heavily identifiable Greek (unless you count Socrates or Aristotle) especially by individuals learning to trade options. It offers a quick and relatively easy way to tell us what to expect from our option positions as we watch the price action of the underlying. Calls have positive deltas, as they typically move higher on a rise in the stock, and puts have negative deltas, as they typically move lower when the stock rises.

While some investors view delta as the percentage chance an option has of expiring in-the-money, it is really more of a way to project expected appreciation or depreciation. A delta of 0.50 for an AAPL call suggests the option should move 50 cents higher when the AAPL jumps a dollar, and lose 50 cents for every dollar loss in AAPL.

But delta is only foolproof when all other factors are held constant, which is rarely the case (and certainly never the case for time decay). If an option is moving more (or less) than its delta would suggest, it is likely because other variables are shifting. For example, buying demand might be pushing implied volatility higher, raising the price of the options. Still, this king of all Greeks is a good starting point for gauging how your options are likely to move.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 13, 2014

The Olympics of Trading

The Winter Olympics in Sochi are currently in full swing and it can be quite enjoyable and patriotic to watch. But did you ever stop and think for a minute how these fantastic athletes got to be where they are? It took a lot of dedication, courage and a well though out plan to make it to their elite level. If that sounds familiar it should because those same attributes are what it takes to learn to trade and become a successful options trader.

You might be dedicated and have the courage to be an options trader, but do you have a trading plan that you follow? It is probably safe to say many option traders do not. Option traders spend a lot of time looking for solid trades that they often neglect probably the most important part: the management of the trade. If that is you take

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a little solace because you are not alone.

A simple way to combat this problem is by having a plan in place before even entering the trade. This is the psychological part of trading. Having a plan in place will remove emotions from getting in the way of decision making and possibly producing unwanted results. Should I stay in the trade or should I exit? Decisions like that should not be made after the trade is executed because many option traders can become too emotional when the trade is in progress especially when they are losing money on the trade. Here are a few things to consider about trade management.

Option traders should think about how they are determining their targets. Don’t forget to consider how the greeks and the implied volatility may be affected if the outlook or environment changes. In a volatile market like this, an options trader may need to make some adjustments especially about taking early profits or exiting for a loss.

Option traders should also think about how they will exit if their targets are not met. How will the exit or stop be determined? Once again, don’t forget to use the greeks and implied volatility in your methods because it could make the difference between profiting or losing.

All trading including option trading can be very difficult at times just like training for the Olympics and not having plan in place can make it exponentially more difficult. It helps to have courage and be dedicated to reaching your goals but a solid trading plan can go a long way towards potential success. Athletes that train without a plan are similar to option traders letting their emotions make decisions for them. Once there is well thought out plan in place and most importantly the plan is followed, an option trader removes unwanted emotions which can hinder his or her chances of being successful. You never know, you might just earn yourself a gold medal

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John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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