Testimonials

December 29, 2011

Butterflies and Weekly Options

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 9:43 am

The weekly options have been the topic of our blog for the last two 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 strategy, it is helpful to consider briefly its components. It is constructed by establishing both a credit and a debit spread sharing a central strike price.  It can be constructed in either all puts or all calls.

Butterflies can be designed to be either a non-directional or directional trade strategy.  Functional characteristics include: negative vega, variable delta and accelerating gamma and theta 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 nine day duration of the weekly options has dramatically accelerated the pace of butterfly trading as the 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.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 22, 2011

Weekly Options Impact

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 12:55 pm

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 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 has undoubtedly had a significant impact on a variety of strategies.  Their acceptance and increase in trading volume has been nothing short of stunning.  For example, the 390 and 395 call strikes in AAPL that will expire tomorrow, December 23, each have an open interest of around 10,000 contracts.

Are weekly options something that you can incorporate into your trading plan? You will have to decide for yourself.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 15, 2011

Implied Volatility and Historical Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 10:09 am

One of the most important steps in any option trade is to analyze implied volatility and historical volatility. This is the way option traders can gain edge in their trades. But analyzing implied volatility and historical volatility is often an overlooked step making some trades losers from the get-go.

Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of a stock with another stock or to the stock itself over a period of time. For example, a stock that has a 15 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 now is more volatile than it was when its historical volatility was, say, 20.

In contrast to historical volatility, which looks at actual asset prices in the past, implied volatility (IV) looks ahead. Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock’s options. For example, the market (collectively) expects a stock that has a 15 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile.

Analyzing Volatility
Implied volatility and historical volatility is studied using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful visual aide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are  misinterpreted by novice traders.

Volatility chart practitioners need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” price. In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.

But that is not the end of the story. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sale; if it is below its normal level it may be a good buy.

Lastly, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was typically in the past, the stock is now more volatile than normal.

If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can capitalize on the disparity by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.

The Art and Science of Implied Volatility and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are shown here. But there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is unique. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade.

Edited by

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 8, 2011

Fractal Position Management

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 10:11 am

Option traders manage risk. Want a job description? That’s about it. Every trade has a risk and reward associated with it. But 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 reins 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, macro spread and use the portfolio greeks to set parameters to minimize the total risk of the portfolio.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 1, 2011

Going Vertical in AAPL

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 9:51 am

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.

For the trader who has a bullish thesis for the price action in AAPL into January expiration, a put credit spread can be established by selling the January 375 put and buying the January 365 put.  As this is written with 51 days to expiration, the maximum potential return is 38% and is achieved as long as AAPL remains above the short put strike of 375.  Maximum risk is defined by the long 365 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring