If you are like a lot of other option traders, you probably avoided trading Apple Inc. (AAPL) during its recent earnings announcement. Now that the volatility event is over, you might be looking to take an option position. Even though the company announced its earnings, there may still be some volatile action ahead. Here are a few thoughts that should be considered on AAPL or any other position you may enter.
Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely in many instances. Much of this advantage comes from the ability to control positions that are equivalent to stock with far less capital outlay.
However, a less frequently discussed aspect of risk control is the ability to moderate risk by the careful and precise use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear by any means.
As a direct result, it may not be obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software that most brokers have is essential to plan the trade and decide the appropriate time at which to place a time stop.
As a simple example, consider the case of a short position in AAPL established by buying in-the-money December 530 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -540 for approximately $25,000 as I write this.
At the time of this writing, the stock is trading around $522; these puts are therefore $8 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $525 at expiration. The options expiration risk is $20,000 or more. However, if the trader takes the position that the expected or feared move will occur quickly—long before expiration—he could implement a time stop as well.
Using a stop to close the position if the stock gets to $525 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t totally eroded away.
Options offer a variety of ways to control risk. An option trader needs to learn several that match his or her risk/reward criteria.
In the last couple of months, the market has shown some good movement. The S&P 500 and Dow set their all-time highs and then promptly moved lower. Washington struggled to find common ground which in turned partially shutdown the government and moved stocks all around. Now we are in the middle of earnings season and the roller-coaster ride may continue. 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. An option trader needs to look back at the last couple of months of option trading to see how volatility played a crucial part in option pricing and how it will help them going forward.
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 30 historical volatility is less volatile than a stock with a 35 historical volatility. Additionally, a stock with a historical volatility of 45 now is more volatile than it was when its historical volatility was, say, 30.
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 20 implied 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. A recent example of the implied volatility increasing was the debt ceiling crisis. There was some concern that the government would not hammer out a compromise and thus default which put fear into the market and increased implied volatility.
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.
Regular users of volatility charts 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 sell; if it is below its normal level it may still 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 like an expected earnings announcement or a general fear of the economy. 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 and that is precisely what every trader needs.
Just a heads up…there is another government deadline coming early next year that might provide for another implied volatility skew. Get ready!
It wasn’t so much the lack of information, or the connectivity, or even the incredibly low transaction costs; it was the silence. That deafening silence.
When I left the trading floor (for the first time) and began trading as a retail trader, there were a lot of changes I had to get used to. But really it was the silence and lack of communication that was the toughest thing.
On the trading floor, when some market-moving news came out I could hear the roar from the SPX pit, just 100 feet away, erupt in a flurry of activity. That’s when I knew something was going on it was time to trade ‘em up.
There was a lot of support on the trading floor among my peers too. If I ever had any question (really, about anything trading related) I had 1,000 of my closest trader-friends standing around me that I could ask. There was safety in numbers. But sitting alone in my office behind my computer after leaving the floor made it a lot harder. No information from the crowd. No support group. I was going it alone and that’s how I felt: Alone.
This is also some of the feedback I get from my students over and over again. It’s hard to go it alone. So we at Market Taker Mentoring are creating an Elite Trader Community just for our traders: just for YOU.
In a few weeks, we’ll launch a state of the art Trader Community. I can’t show you anything from it yet (It’s still TOP SECRET!). But we’ll be unveiling it in just a couple weeks. So keep an eye out for more information.
In the meantime, we could use your help. We’d really appreciate if you fill out this super short, 5-question survey below…
CEO, Market Taker Mentoring, Inc.
Create your free online surveys with SurveyMonkey , the world’s leading questionnaire tool.
A few weeks ago we talked about traders really being committed to reaching their trading goals. This time we’ll go over why an options trader needs a trading plan and a few general guidelines. If you really want to improve your trading in heading into this fall trading season, you should absolutely to do this but be forewarned; this is the part nobody wants to do. Most options traders think that their trading plan is in their head and that all they need is a proper options education. “I know what I need to do when I need to do it” most beginning and some veteran options traders will exclaim. If it was just that easy, everyone would be a great options trader. Unfortunately it is not. That is specifically why you need a written options trading plan. Just because you know what to do doesn’t mean you will do it. And that is the key!
Before you even begin to write your options trading plan, you must take an inventory of yourself. What are your strengths and weaknesses? You must take the time to truly examine yourself and be honest about whom you are. Your options trading plan must match your personality. You will probably discover more about yourself that you were bargaining for.
The first thing you need to do to start your options trading plan is to write down your goals like we talked in a previous blog. Once you do this, it brings everything into perspective. The same reason you need to write down your goals is the same reason you need to write down your options trading plan-so your thoughts are transformed from the subconscious to the conscious. It does not matter if you write the plan on a nice piece of paper or a cocktail napkin. It just needs to be written down in your own words.
The next section of your options trading plan will be money management. This is one of the most crucial and often overlooked components of successful options trading. How much are you going to risk per trade? What are your weekly or monthly profit targets? What are the maximum losses you are comfortable with on a daily, weekly or monthly basis? All of these questions need to be answered right in this section. A great tip for this money management section is to not worry about monetary goals at first. Concentrate on taking and managing the best possible trades and then after some consistency has been established goals can be set.
Strategies will be the next component of your options trading plan. This will be the meat and potatoes of the plan so to speak. A thing to consider is to start with relatively a few simple strategies (long calls and puts) and master them before you write in more complex option strategies into your plan. You need to describe in as much detail as possible the strategy you intend to use. You will probably be making constant changes to this part until you get exactly what you want.
The last section will be the follow up and review. This is when an option trader needs to print out the charts and the option chains and review them. Did I follow my written options trading plan like I said I would? This needs to be done when the market is closed so all your attention can be on the review. You must keep a trading journal and must always acknowledge your winners and more importantly learn from your losing trades. Understanding and watching how the options change in regards to time and the underlying is a big bonus that can be also gained by observing past trades. This in my opinion is invaluable for progressing as an options trader.
Feel free to use this as a general outline of an options trading plan to get you started. If you need more help or more direction, feel free to contact me.
At first, options can be a very complex entity to understand. But if a trader looks at things from a fundamental perspective, it may become clearer. The options world is ruled by three basic forces consisting of: price of the underlying, time to options expiration, and implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces has when designing the architecture of the options trade under consideration.
For the new options traders, learning about options and the impact of these three fundamental forces may be confusing and the magnitude of the influence of each on the profitability of trades is easily under-appreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders start out as being stock traders where “only price pays” the initial reluctance and hesitation to consider additional factors impacting a trade is easily understood.
In order to help understand the initially confusing manner in which options respond to their outside and inside forces, it is helpful to breakdown an option’s price into its two components: extrinsic value and intrinsic value. Remember that the quoted price of an option reflects the sum of the intrinsic (if any) and extrinsic values. Intrinsic value of an option is that portion of the premium which is in-the-money and is impacted solely by the price of the underlying. Extrinsic value is also known as time premium and is impacted by both time to expiration and IV.
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.