There is plenty of talk and rumors about a possible take-over in BlackBerry Limited (BBRY). That being said, let’s look at an made-up example of a take-over and a way to use options to capture the possible move. A $50 stock is rumored to be taken out at $55. Looks like a nice spec trade right? You go to the option chain to look for some calls to buy and you notice that the options have gotten pretty expensive. Implied volatility has skyrocketed. Sometimes implied volatility can make options so expensive that even if the trade goes your way the profit is just not there–but the risk is. So, what’s an options trader to do?
One solution can be to buy a bull call spread instead of the outright call. The rationale? It’s called hedging–hedging volatility premium. Whenever you buy options, you’re getting long implied volatility. If implied volatility is expensive, the options are expensive too. And if implied volatility subsequently falls after you make the trade, those options drop in value too. So, what if you both buy and sell an option to create a spread? Let’s look at the two legs of a bull call spread
Bull Call Spread – Long Leg
A bull call spread is when a trader buys one call and sells another that has a higher strike price. Look at it as two trades. The long call would be the one you might buy if you were to spec on the take-over stock. In the case of a take over, this call likely has high implied volatility as the market scrambles to buy up calls, making it pricey.
Bull Call Spread – Short Leg
Because there is a target price in which the take-over target is expected to be bought, you only need exposure up to a certain point–the take-over price. Why not sell a call at or above the expected take-over price? You’re not giving up upside. But you are taking in (expensive) premium to hedge the (expensive) premium you’re buying with the long call leg. It’s a perfect spread.
Let’s look at this in terms of absolute risk. A stock currently trading for $50 is rumored for take over at $55. News is expected within a couple of weeks.
Buy 1 Sept 50 call at $4
Sell 1 Sept 55 call at $2
Net debit $2
Max loss = $2 (That’s better than just buying the 50 calls outright)
Max gain = $3 (That’s the $5 spread minus the $2 premium)
Break even = $52 (That’s $50 strike plus $2 spread premium)
Here the max loss/max gain ratio of the spread is 2:3. The max loss/max gain ratio of the outright call would be 4:1 (Remember, you expect the stock only to rise to $55). The spread looks better so far. Let’s look at the break evens. The spread break-even is $52. The outright call’s break even is $54. Better still.
With all option strategies, there are opportune times when they offer an advantage over an alternative strategy. Bull call spreads and take-over candidates are a natural fit. Traders always need to look for ways to construct the smartest position in terms of risk-reward.
Dan’s online Options Education series this month (August series) 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 breakeven trades and winners. Given that, it’s easy to see why it’s important to learn to adjust options positions.
Adjusting options positions is a technique in which an option trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market outlook or physiology changes and the original trade no longer reflects the trader’s thoughts. 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—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).
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. But remember, just because you can adjust a position doesn’t mean you should!
To find out more about next month’s topic and have access to the archived previous seminars including “Option Trade Adjustments” please visit Options Education.
Compared to trading equities, there are so many more option strategies available to an option trader. But more importantly: Do you know why there are so many different types of options strategies? This is the real root of our discussion and why getting a proper options education can help a trader better understand all of those strategies and when and how to use them.
Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish AAPL traders. Now that the stock has recently broken through several resistance areas, there are traders who continue to be extremely bullish on AAPL and want to get more bang for their buck and buy short-term out-of-the-money calls. This might not be the most prudent way to capture profits but that is a discussion for another time. Less bullish traders might buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high (which it currently is not but it has been rising) and the trader is bullish just to a point, the trader might sell a bull put spread (credit spread), and so on.
The differences in options strategies, no matter how apparently minor, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position and, in turn, structure a position that addresses each difference. Traders need to consider the following criteria:
Degree of bullishness or bearishness
Carefully defining your outlook and intentions and selecting the best options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners, or taking losses bigger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. With summer ending soon and supposedly the slow markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the fall season!
OK. I want to hire Ben Bernanke to run my PR (not that I have a PR guy, but if I did…). He’s a gosh-darn brilliant spin-doctor. What am I talking about? OK. Here’s the trading world we’re living in these days:
There is good economic news… The market goes up. It’s good news, after all!
There is bad economic news… The market goes up. The Fed won’t taper and will keep propping the market up!
How can you lose?!
These, of course, are famous last words. If I had a nickel for every time an over-confident novice trader told me how he just can’t lose… Well, let’s just say I’d have a lot of nickels.
The fact is you can lose. This market-news paradigm cannot last forever (and, yes. I know that right now I’m alienating those cocky, over confident novice traders. But I’m only trying to help you keep that money you’ve made with your “can’t lose system”!)
The market simply can’t keep going up forever with disregard to economic news. Sorry. It just can’t. At some point, it is time to pay the piper.
Be the piper.
It’s all timing. Early in my career, I worked (as a clerk, before I became a floor trader) for a trading firm run by a brilliant man. In the 90s, his model said the market was over priced. There were internet companies that flat out told investors they would not make money in the foreseeable future that doubled, then tripled, then quadrupled in share price. Were they overpriced? Yes. But that didn’t stop the stocks from rising violently. But one day (as we market historians know) that bubble burst. After fighting the market for a few years, the boss was finally right. By that point, he’d lost millions and had to abandon his strategy and never recouped what he lost. Once his ship finally came in, he missed the boat.
So the question of the day is, when will this market pull back? We’re starting to see signs now. I was just chatting with a CME Group floor-trader friend of mine today. He told me about how the Fed Funds contract was pricing in higher interest rates in the near future. Translation: The fix is in! The Fed Funds contract is an excellent predictor of future interest rates. Higher interest rates means the market will end its climb to the nose-bleed seats and sit and rest.
Don’t get me wrong. I’m not necessarily predicting a bursting bubble like we saw with the internet stocks. I’m just saying the sweet ride long-term stock investors have enjoyed is coming to a close soon.
But, we’re option traders. What do we care?! Option traders can make money either way. Once the market starts pulling back, there are going to be call credit spread opportunities galore. The implied volatility will likely return some—probably to the mid-teens. And the market will probably drift somewhat lower—or at least not rise.
And so, we start to wait with a watchful eye. We start looking for some of these call credit spread opportunities now (like the WYNN trade John talked about in Group Coaching this week). And we wait as more set ups transpire.
Bernanke might not be long for being able to continue enjoying his cake, but we option traders can always get a piece of the pie.
One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Raquel Welch is still considered to be still quite attractive by many, her look is not the same as it was decades ago when she was known as a “bombshell”. 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 undeniable in the 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 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 strategy 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 same strike price constructed together in the same underlying in the same expiration. 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 characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread 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. Beauty is in the eye of the beholder!
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.