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May 31, 2012

Back to Basics: Part 1

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 11:20 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, learning about options and 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

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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.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 24, 2012

Learn to Adjust Option Positions

Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into winners. Given that, it’s easy to see why it’s important to learn to trade and adjust options positions.

Adjusting 101

Adjusting options positions is a technique in which a trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market physiology changes and the original trade no longer reflects the trader’s thesis. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.

This seems like a very obvious rule. And at the onset of any trade, it is. If I’m bullish, I’m going to take a positive delta position. If I think a stock will be range-bound, I’d take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.

Gamma

Gamma—particularly negative gamma—is the cause of the need for adjusting.

Gamma definition: Gamma is the rate of change of an option’s (or option position’s) delta relative to a change in the underling.

Oh, yeah. And, just in case you forgot…

Delta definition: Delta is the rate of change on an option’s (or option

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position’s) price relative to a change in the underlying.

In the case of negative gamma, trader’s deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).

Wrap Up

Therefore, traders must learn to adjust options positions, especially income trades, in order to stave off adverse deltas created by the negative gamma that accompanies income trades.

Edit by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 17, 2012

Option Gamma and AAPL

The trifecta of option greeks are delta, theta and vega. But the next most important greek is gamma. Options gamma is a one of the so-called second-order options greeks. It is, if you will, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Using options gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using gamma:

When you buy options you get positive gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL June 540 long call that has a delta of 0.48 and gamma of 0.008 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive gamma is a good thing.

When you sell options you get negative gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative gamma is a bad thing.

Start by understanding options gamma from this simplistic perspective. Then, later, worry about working in the math.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 10, 2012

Trading with Delta on AAPL

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 10:31 am

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

Delta is arguably the most heavily watched Greek especially by individuals learning to trade options. It offers a quick-and-dirty way of telling us what to expect from our option positions as we watch the price action of the

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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 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 hold static, 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.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 3, 2012

Selling AAPL Puts: Naked or as a Spread

One of the bullish strategies in the arsenal of an options trader is that of selling puts. Many traders have have heard of this strategy but are unfamiliar with the nuances and need more options education before possibly implementing them. The sale can be accomplished either as naked sales (aka selling “cash secured” puts 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 of the “deductible” for the policy is determined by the strike price the trader has sold.

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AAPL. A trader who sells a $590 strike put to another trader holding an underlying currently trading at $585 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 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.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring