It’s been a good run this year so far. The market is up over 17 percent as I write this post. Many traders would say that market conditions are not fundamentally much different than they were on January 1. But the market apparently is not aware of that fact. Most of the professional traders I’ve talked to are looking for a market pullback, if not a bonifide retracement.
But, do you know what these same bear market seeking traders are not doing? They are not getting short. That’s right. These smart money traders who believe the market is too high and should come down won’t touch a put with a 10-foot pole. Why? There is no bear market technical set up.
In order to properly craft a downside option trade, the bear market set up has to be there. Right now, we have an SPX chart that has no resistance to speak of. There are no lower lows. There are no signs of being strongly over extended with any indicator. There are no bear market patterns. Technically, there is no reason to sell.
Of course, that is not to say these traders are buying however. They are trading very cautiously, as if they are planning which block to remove from an already rickety Jenga tower.
This, I believe, is one of the reasons why we’re seeing such weird VIX trading lately. Typically VIX and SPX move in opposite directions. Or at least, 87 percent of the time they do, historically. But not lately. We’ve seen plenty of times over the past few weeks where as the market rises, so does the VIX. Why? I think it’s because when the market rises, the smart money doesn’t step in and put their money down on stocks. They instead buy limited-risk calls and keep the bulk of their cash in a protected money market account. One could look at a call as a hedge. Traders can hedge against missing out on a rally, while keeping most of their cash safe by buying a call instead of buying stock.
So, when is it time to get short? When will there be a REAL bear market? We’ll have to wait for the technicals to give us something to trade. IF, and when, that happens, it could be a doozie.
There are quite a few 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 lack of movement in price of the stock. Examples of such strategies include the sale of naked options and vertical spreads.
As the positions “mature” by virtue of various combinations of changes or lack of change in these three main forces, the initial risk:reward calculation often changes and sometimes even dramatically. The successful trader with a proper options education is aware of these changes, because the risk to gain the last bit of potential profit is often dramatically out of whack to the magnitude of the profit he or she seeks to obtain. 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 sell out-of-the-money (OTM) puts, the June $385 strike, on AAPL which currently trades at $440 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 June expiration. For taking the risk of writing these puts, his account receives a credit of $1.10 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 June expiration approaches, the stock remains at the $440 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 will many times take profits and find opportunities to invest his or her money in other trades that appear to be much more attractive from a risk/reward standpoint than to remain in the existing position.
There is no doubt we have discussed straddles in the past in this blog. A straddle is an option 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 trader 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 (which makes up a straddle), the trader 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 (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.
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 breakeven points, 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 a trader can take on a strangle is the net premium paid.
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 is trading at around $432 after a volatile couple if weeks. The trader would buy both a June 435 call and a June 430 put. For simplicity, we will assign a price of $13 for both – resulting in an initial investment of $26 for our trader (which again is the maximum potential loss).
Should the stock rally past $435 at expiration, the 430 put expires worthless and the $435 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 $3 (intrinsic value less the premium paid). The same holds true if the stock falls below $430 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 $26, or $2,600 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 but as always, a traders needs to decide how he or she will manage the position.
Making stock option picks with huge profit potentials, whether the market is up or down, depends on diligent market research and a thorough understanding of stock option fundamentals.
Finding profitable trading opportunities can be tough. But you don’t have to do all the work yourself. Some professional trader services, such as Market Taker’s Group Options Coaching, make stock option picks that they share with protégés, saving individual traders time and effort.
But whether you do your own research or rely on a seasoned professional for your stock option picks, its essential to understand some basic facts about options trading.
Making stock option picks based on individual stock assessment requires an understanding of specific fundamental parameters. Traders may learn how to read an annual report and 10K stockholders report for income statements, past earnings, sales, assets, new products, and overall industry trends.
Stock option picks based on technical analysis is essential for success and requires the investor to examine the historical price movement and volume in order to determine price patterns and extrapolate future price movements. The single most important technical analysis technique is the simplest: Support and resistance lines. Specifically, horizontal support and resistance lines at the same price level in two or more time frames.
Stock option picks based on broad market analysis examines overall activity based on performance indices. Is the overall market bullish (moving up), bearish (moving down) or neutral (moving sideways)? The broad market will affect individual equities.
Stock option picks based on psychological market indicators attempts to interpret the facts and gauge whether a change from bullish to bearish (or vice versa) is in the wind. Successful options traders are frequently contrarians who buy puts in a bullish market and purchase calls in a bearish market — against convention.
Bottom line, a lot goes into stock option picks. The help of a professional with experience in “putting it all together” can make the process easier and can result in better trade ideas with greater profit potential.
If you have been on an options trading floor, you may have heard comments like these for example. “What’s your delta of of the Cubs winning today?” (not good of course) or “What’s the delta the broker comes back and buys more of these?” Option traders have probably used the word delta in this context every single day of their life and if you learn to trade options like a professional, you may too.
It’s the “traders’ definition” of delta—that is, delta is the likelihood of an option expiring in-the-money. Though this definition actually has a few mathematical and theoretical shortcomings, making it not entirely technically correct, every professional option trader I know or Dan knows thinks about delta this way. Many if not most traders borrow the concept of delta being the likelihood of success and adapt into their every-day speech.
The idea is every option has an associated delta figure attached to it. Like, at the time of this writing, the Google Inc. (GOOG) May 830 calls have a 0.30 delta. That means that they change in value 30 percent like the GOOG stock. But it can also be interpreted by traders to mean that the GOOG May 830 calls have a 30-percent chance of expiring in-the-money.
This practical and “traders” use of delta helps guide traders’ expectations and helps them make better trading decisions by factoring probability into their decision-making process. I encourage retail traders to think about option delta this way. You should start today and see if it affects how you think about options and the possible different strategies that can be implemented. I’m 100 delta that you’ll be happy you did.
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.