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July 26, 2012

Risk: Reward is Not Static on AAPL

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 11:06 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 trader with a proper options education is 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 August $510 strike, on AAPL which currently trades at $570 in this example. His risk in the trade is that he is obligated to buy AAPL at the strike price at any time between opening the trade and August 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 August expiration approaches, the stock remains at the $570 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 options 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 19, 2012

Expiration Week: Butterflies

One of the major differences when learning to trade options 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 option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring