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September 29, 2011

Risk:Reward Is Not Static

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

Several groups of option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or failure of movement in price of the underlying.  Examples of such strategies include naked option sales and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three primal forces, the initial risk:reward calculus often changes dramatically.  The successful option trader needs to be aware of these changes, because the risk to extract the last bit of potential profit is often dramatically out of proportion to the magnitude of the profit he seeks to capture.

Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller.  This trader has chosen to write out-of-the-money puts, the October $90 strike, on XYZ which currently trades at $100.  His risk in the trade is that he is obligated to buy XYZ at the strike price at any time between opening the trade and October expiration.  For taking the risk of writing these puts, his account receives a credit of $1 and margin is encumbered based on SEC rules.  The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.

As October expiration approaches, the stock remains at the $100 level and the market price of the puts he has sold decreases as a result of time (theta) decay.  As the price of the puts decreases and the profits increase, the risk:reward increases.  As the price declines below the often used 20% re-evaluation benchmark of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial and may no longer be appropriate given the reward.

The experienced option trader in such trades often finds the opportunities to deploy capital in other trades to be much more attractive than to remain in the existing position.

September 15, 2011

Expiration Week: Butterflies

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 1:34 pm

One of the major differences in option trading as opposed to equity trading is the impact of time on the various trade vehicles. Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an

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option premium goes to 0 at the closing bell on expiration Friday.

While this decay of time premium to a value of 0 is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in the same month. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the beast becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.

September 8, 2011

Selling Puts: Naked or as a Spread

One of the bullish strategies in the arsenal of an options trader is that of selling puts. The sales can be accomplished either as naked sales (aka selling “cash secured” puts

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when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or for “those in the know” simply selling a put spread).

The sine qua non of this position is that of being short puts. As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of variable degree in the price of the underlying. The magnitude

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of the “deductible” for the policy is determined by the strike price the trader has sold.

For example, the trader who sells a $55 strike put to another trader holding an underlying currently trading at $60 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible. In return for issuing this insurance policy (in option lingo known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions. The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased. In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used similar strategy is to sell a put spread. In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price. However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance. The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options. Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread. In this case, the Black Swan risk is crisply defined to

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the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin encumbrance. However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure. This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable; if you know the road map it is much easier to arrive where you want to be.