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October 25, 2012

Learn to Adjust Options Positions

Dan’s online Options Education series this month has all been all about helping traders learn to adjust options 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 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 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.

To find out more about next month’s topic and have access to the archived previous seminars including “Option Trade Adjustments” please visit

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Options Education.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 18, 2012

Weekly Options Impact and AAPL

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.

If you are just learning to trade options, 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. The new week’s options are offered on the Thursday of the week prior to expiration rather than the Friday.

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 635 and 640 call strikes in AAPL that were offered this morning and will expire next Friday, October 26, each

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have a volume of around 3,000 contracts today alone.

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

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 12, 2012

Volatility Events, Predictions and a Piece of Cake

Option trading is easy. Well, let me qualify that statement just a bit. To be fair, options are more complicated than more simple, linear assets like stocks. But there are some elements to options’ pricing that actually make them a little easier to trade from a valuation standpoint. To find out more about this feel free to visit the options information section of our website.

The most important thing to consider is predictability. You probably receive many unsolicited emails telling you how so-and-so can predict the market with 100% certainty and make you a billionaire overnight. On the other side of that coin, there is not a professor alive who will tell you that it is possible to predict the direction of the stock market with any statistical significance. The truth probably lies somewhere in the middle. But one thing for sure: predicting the direction of a stock is though, and you’ll be wrong often.

But, aside from directional implications of the underlying stock, there is an important pricing factor to options that is much more predictable: volatility shifts resulting from expected volatility events. All options have an imbedded component to their pricing relating to expected-future volatility. This is called implied volatility. It can be thought of as the expected future volatility implied by the market.

Sometimes volatility is quite predictable, and therefore, fluctuations in option prices resulting from implied volatility changes can be likewise predictable. So-called volatility events include earnings, Fed announcements, CPI, PPI, Retail Sales, Payrolls, GDP and more. Volatility events are often scheduled far in advance. Just google a financial calendar and see when CPI is scheduled to be released six months from now—you’ll easily find that information. Unemployment figures are always the first Friday of the month. And so on.

When volatility events are imminent, options get more expensive. Why? Hedgers and speculators brace for a potential move by buying options, creating price-pressuring demand. Look at a chart of implied volatility for a typical stock option class and take a look at its value in the few days leading up to earnings. Typically, it will increase right before earnings. Then afterwards, it tends to fall right back to its normal range.

Scheduled volatility events help option traders analyze the ebb and flow of option premium levels with the precision of predicting the moon cycle. But all volatility events are not predictable—only those that are regularly scheduled. Sometimes, volatility events come out of nowhere. Takeovers, CFOs cooking the books, these sort of things can take a trader by surprise.

Though not all volatility events are predictable, the fact that some are provides great value to option traders. Imagine knowing that a stock

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would almost always rise at a certain date every quarter! This makes option trading a little easier than stock trading in my opinion. Maybe not quite a piece of cake; but still advantageous over trading stocks.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 4, 2012

Trading AAPL Option Strangles 101

We have discussed the straddle options strategy in the past, a strategy that traders  can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the investor is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (as in the straddle), the investor purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money, a trader pays a lower initial premium. However, this comes with a caveat – the stock will have to make a much larger move than it would if a straddle were employed. The investor is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. If this all sounds confusing to you, I would invite you to checkout the Options Education section on our website.

The Particulars
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven).  If at expiration, the stock has advanced or dropped past one of these breakevens, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss an investor can take on a strangle is the net premium paid.

Example Trade
To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing (October 2012) is trading at around $670. The trader would buy both an October 675 call and an October 665 put. For simplicity, we will assign a price of $12.50 for both – resulting in an initial investment of twenty-five bucks for our investor (which is the maximum potential loss).

Should the stock rally past $675 at expiration, the 665 put expires worthless and the $675 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $29, the profit is $4 (intrinsic value less the premium paid).  The same holds true if the stock falls below $665 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial twenty dollars, or $2,500 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited which can be very rewarding.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring