On Tuesday the market had a moment of panic that resulted from the false information disseminated on the hacked AP twitter account that there were two explosions at the White House and the President was injured. Of course, this information was not true. However, as a result of the initial tweet, the market sold off sharply. Within minutes it was made known that the tweet was false and the market rose back up to where it was trading moments before as if nothing ever happened. This quick, but big, move is being called a “flash crash” by many writers in the financial media.
Tuesday’s flash crash provides five lessons for option traders.
Lesson 1: Protecting with options can be better than using a stop. Traders with bullish positions in the market who had protective stop losses on were the big losers in the flash crash. They sold their longs at a low price that existed only temporarily. It was an extreme whipsaw, that should have never happened—but it did. The whipsaw really hurt traders who thought they were being conservative by using a stop loss. If instead they had protective puts, or an otherwise limited risk option position, they would not have endured any losses.
Lesson 2: I Repeat, protecting with options can be better than using a stop. Indeed, some of the stop losses may have been filled at the absolute worst possible price. The way a stop works is that if the market either trades at or is offered below the stop price, a market sell order is triggered. Probably many of those orders executed far below the stop price. It’s not hard to imagine that many of the orders were filled at the absolute bottom price of the day. And what if the story turned out to be true and the market continued lower? For one, those stops could have been executed even worse! But traders protecting with options would have been protected the whole way down.
Lesson 3: Have your profit-taking orders in at all times. Traders with bearish positions had an excellent chance to steal a profit out of the market Tuesday—at least, those who had profit taking orders in. If you were long puts and had an order to sell those puts in the market on Tuesday, you probably would have gotten filled and locked in your profit.
Lesson 4: Don’t believe everything you hear. That one is pretty self-explanatory. In this world of electronic media, this stuff is bound to happen.
Lesson 5: Be quick! Traders who were quick on the draw could have banked some quick (and potentially big) profits on the AP’s bogus tweet. When something like that happens, whether it’s true or not, there is bound to be some immediate selling. The first guy to buy puts makes a bunch of money (presuming he’s quick on the exit too). The last guy locks in a loss.
The most important asses a trader has is knowledge. Take opportunities like this to learn from the market and make money off it with what you learn.
With the market threatening to move lower after a bullish run to start the year and earning’s season upon us, it might be a good time to talk about put options. If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.
A lot of traders especially those who are just learning to trade options can be smitten by put options especially buying the shortest-term, or front month put for protection. The problem, however, is that there is a flaw to the reasoning of purchasing front-month puts as protection. Front-month contracts have a higher theta (time decay) and relying on front-month puts to protect a straight stock purchase is not necessarily the best way to protect the stock. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.
Although front month options are often cheaper, they are not always your best bet. The idea may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his or her position; but sound reasoning does not always lead to good practice. Here’s an example.
We will use a hypothetical trade. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months as the trader wants to allow the news events to move the stock higher.
Being a smart options trader, our stock trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money October 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would create a big dent in the initial outlay of cash. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.
If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops. Buying the put is a hedge and and a solid insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.
Purchasing a Call vs. Bull Call Spread
With the market moving higher at unprecedented levels recently, it probably made sense to have at least a moderately bullish bias towards many stocks. The market is due for some type of pullback but whose to say it won’t continue on its bullish pace. Is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a couple. One that may be a better option compared to the rest is the bull call spread. To learn to trade this strategy and more in detail please visit our website for details.
When implementing a bull call, a trader purchases call options at one strike and sells the same number of calls on the same company at a higher strike with the same expiration date. Let’s use Apple Inc. (AAPL) which is currently trading around $435 as an example. In this case you would purchase May calls at the 435 at-the-money strike at the ask price of $18. You would then sell the same number of May calls with a higher strike price, in this case 455 at the bid, $10.
The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that he purchased one May 435 call and sold one May 455 call resulting in a net debit of $8 (that’s $18 – $10). The difference in the strike prices is $20 (455 – 435). He would subtract 8 from 20 to end up with a maximum profit of $12 per contract. So if he traded 10 contracts, you could make $12,000.
Although he limited his upside, the trader also limited the downside to the net debit of $8 per contract. To simply breakeven, the stock would have to trade at $443 (the strike price of the purchased call (435) plus net debit ($8)) at expiration.
Advantage versus Purchasing a Call
When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the at-the-money May 435 call he would have paid $18. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.
By implementing a bull call spread, traders can hedge their bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.
Dan mentioned recently in a blog that VIX (CBOE Implied Volatility Index) was hovering around a six year low. With the market seemingly on the edge lately due to global events like North Korea and Cyprus, it is important for option traders to understand one of the most important steps when learning to trade options; analyzing 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 process making some trades losers from the start.
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 20 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 stock prices in the past, implied volatility (IV) looks forward. 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 20implied 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.
Implied volatility and historical volatility is analyzed by using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are misinterpreted by new or less experienced option 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 where the story ends. 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.
Finally, 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 known as the skew 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 different. 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 which is precisely what every trader needs!
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.