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July 26, 2011

Back to Basics: Part II

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 3:27 pm

Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are conversant 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 suffice it to say it is one of the three pricing factors and probably the most familiar to traders.

The price influence, time, is easily understood; in part because it is the only one of the forces restricted to unidirectional movement. The core 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 price influence is perhaps the most important. It is without question the most neglected and overlooked component: implied volatility. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to 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 wax and wane as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should direct their attention to understanding the impact of each of these options pricing influences. The options markets are ruthlessly unforgiving to those who choose to ignore the impact of the valuation metrics that underpin daily life in their world.

July 21, 2011

Back To Basics: Part 1

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 9:36 am

In an attempt to understand the complexities of the world they observed in daily life, ancient Babylonian philosophers considered all things to be constituted of one or more of the four classical elements of: earth, air, water, and fire. In this world view, the natural environment was considered to consist of various objects composed of varying portions of each of these fundamental elements or forces. While modern atomic theory has supplanted this early concept, these historic constructs can provide a helpful organizational structure within which to consider the importance of fundamental primal forces impacting various option trade structures.

Similar to the early view of the Babylonians, the options world is ruled by three primal forces consisting of: price of the underlying, time to options expiration, and implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces has when designing the anatomy of the options trade under consideration.

For the new options trader, the impact of these three fundamental forces may be confusing and the magnitude of the influence of each on the profitability of trades is easily underappreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders come from the universe of stock traders where “only price pays” the initial reluctance to consider additional factors impacting a trade is easily understood.

In order to help understand the initially confusing manner in which options respond to their milieu, it is helpful to dissect an option’s price into its two components: extrinsic value and intrinsic value. Remember that the quoted price of an option reflects the sum of the intrinsic (if any) and extrinsic values. Intrinsic value of an option is that portion of the premium which is in-the-money and is impacted solely by the price of the underlying. Extrinsic value is also known as time premium (or less generously “sizzle” as opposed to “steak” of the intrinsic value) and is impacted by both time to expiration and IV.

July 14, 2011

The Family of Wing Spreads

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 10:48 am

The Butterfly and Condor Clans
We have previously introduced the large and diverse option family of the range bound structures and visited in some detail two of the less frequently discussed trades, the double calendar and the double diagonal. Since attracting attention to the lesser known brethren of the family, the branch representing the wing spreads has made its impatience for the spotlight to be known and is demanding its usual disproportionate quota of attention. So it shall be.

This more visible portion of the clan retains the characteristic defining points of family identity: a variably large range of profitability with regard to price of the underlying and the theta positive blood type. In addition, this branch has additional characteristics of being vega negative and having the individual option positions selected from a single expiration date. To review, lest they feel slighted by not being introduced once again, the specific names of the individual family members of this branch are: butterfly, iron butterfly, condor and iron condor.

Butterfly, Iron Butterfly, Condor and Iron Condor
The nomenclature of the family is more complicated than necessary; the positions are more similar in make up than the individual family members would like to admit. The fundamental defining structure of this group is to be found in the butterfly . It is from this basic structure that the individual members of the wing-spread-family of option strategies have evolved.

Butterflies and Iron Butterflies

Butterflies
Butterflies in their classic form, whether in puts or calls, are constructed with the anatomy of 1/-2/1. The concise description is to “sell the body and buy the wings”. This structure finds its evolution from the combination of a bull and bear vertical spread. It is in the butterfly that this branch of the family generally finds both its most profitable trades based on percentage returns and its narrowest zones of profitability.

Iron Butterflies
The butterfly can be constructed in puts, calls, or both puts and calls. When constructed in both puts in calls, the appellation “iron butterfly” is used. This general organizational structure applies throughout this branch of the family; structures composed of both puts and calls are termed iron. Put and call butterflies are debit transactions while the iron butterfly is a credit trade.

Unconventional Butterflies
The remaining members of this branch of the family can be most easily viewed from an organizational standpoint as butterflies with cosmetic surgery of varying degrees. The first step in the gradual transmogrification is to separate the two short strikes of a classic butterfly from the 1/-2/1 anatomy to the 1/-1/-1/1 framework. This produces the entity of a split-strike butterfly. Some would consider this newly modified entity to be a condor, the result of the next to be described modification in our collection of wing spreads.

The Split-Strike Butterfly
As compared with a butterfly structure, the split-strike butterfly has the primary effect of broadening the price range of the underlying over which the position is profitable. As in life in general, increases in yin are irrevocably linked to decreases in yang. Benefits accruing to the trade from this modification and widening of the zone of profitability are accompanied by reduction in the maximum potential extent of profitability.

Condors and Iron Condors
The final step in our structural manipulation of the butterfly is the condor and its most frequently encountered variation, the iron condor. In the shorthand in which we have described the anatomy, the condor could be written as 1/-1/-/-/-/-/-1/1. The iron condor could be designated as 1/-1/-/- (put segment) and -/-/-1/1 (call segment).

Condors vs. Iron Condors
The condor is a debit transaction and the iron condor is a credit trade. This final step in the modification has the major effect of broadening yet again the profitable range of prices over which the underlying can oscillate and remain profitable. The broadening of the profitability range is once again accompanied by reduction in the maximum achievable percentage profit.

Each of the condor family members has certain important characteristics arising from the specific components and the manner in which they are combined within the complete position. The trader must be aware of these specific points of distinction.

There will be more discussion to follow on the specifics. Each of these spreads is the subject for extensive and detailed discussion.

July 7, 2011

The Naked Call

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 10:47 am

We recently took a look at the naked put; let’s take a look at the same strategy on the call side of the equation, the naked call. The naked call is defined as an option strategy where an option player sells (writes) call options without owning the underlying security. Some may refer to this strategy as an “uncovered call” or “short call.”

The goal of the naked call is for the trader to collect premiums if the option expires worthless. A trader could sell an out-of-the-money (OTM) naked call each month and pocket premiums, provided the stock price either stays flat or drops. This process could continue as long as the stock remains below the strike.

The Specifics
The maximum gain for selling a naked call is limited to the premium received for the call option. That said, the loss potential is unlimited – as the stock can rise indefinitely. If the underlying stock’s price is above the strike price at expiration, it will result in the trader having to sell the stock at the strike price (which will be lower than the market price).

A loss can occur if the stock price rises. If the price of the underlying stock is greater than the short call’s strike price plus the premium received at expiration the option should be bought in to close the trade. Otherwise, when the option is assigned and a short-stock position is acquired, further losses are possible. On the flip side, the maximum profit is achieved when the underlying stock is less than or equal to the strike price of the sold call at its expiration.

An Example
For this specific example, we will take a look at General Electric (GE) – which is trading slightly above $19 at the time of writing. An August 20 call carries a bid price of 27 cents. If the stock remains below the strike price by expiration, the call expires worthless and the call seller keeps the $0.27 in premium (less any commissions). The problem is if the stock rallies through the strike price at expiration, the call will be assigned, resulting in a short sale of 100 shares at $20. With the stock at $23, that would represent a loss of $3 a share, or $300. Subtract the $27 received in premium and the total loss comes to $273.

With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A, perhaps, safer way to structure a trade with a similar risk profile is to sell a call credit spread. We’ll have a short blog posting on this in the future. For those interested in learning all the ins and outs of credit spreads, contact us about our online content in the Students section of the Market Taker webite. http://markettaker.com/contact_us/