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July 24, 2014

Earnings Season and Option Prices

With earnings season in full gear and major players like LinkedIn and Tesla ready to announce soon, it is probably a good time to review how an option price can be influenced.

Perhaps the most easily understood of the option price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The option price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third option price influence in relation to earnings season is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we are in the midst of earnings season, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these option price influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over earnings season.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 17, 2014

ITM Put Option

Filed under: Options Education — Dan Passarelli @ 2:42 pm

There is always potential for the market or individual stocks to move lower. In fact many option traders never even think about bearish strategies. Option traders know that stocks and markets do not always go up, but many will wait until they think the decline is over to once again look for a bullish strategy instead of taking advantage of bearish opportunity at hand. Understanding put options is a must for option traders but I am often asked how to choose strike prices. There are several different options to consider and here are a few things to consider specifically based on an expected small move in the underlying. But first let us take break down the anatomy of a put option.

A buyer of a put option has the right, but not the obligation to sell shares of underlying stock at a certain price on or before an expiration day. The price at which the buyer can sell the shares is called the strike price. There are many strike prices and expirations to choose from which can be overwhelming for a trader. When expecting a stock to make a small move especially if the stock is lower in price, it may be advantageous for the trader to select an in-the-money (ITM) put option. An ITM put option is a put with a strike price that is higher than the stock’s current price. Before going further, here’s a look at a possible scenario where buying an ITM put might be warranted.

An ITM put option can be used to capture a relatively small move lower. Suppose an option trader is watching a $10 stock in a downtrend. The stock then rallies higher and now he thinks it is a good time to enter a bearish position with a put option. He surmises the stock might be able to drop about $0.50.

A critical point about capturing this potential $0.50 move down revolves around option delta. Option delta is the rate of change in the option’s value relative to the change in the stock price. Puts have a negative option delta because if the stock rises, puts will lose some of their value. Since puts give the owner the right to sell stock, puts gain value as the stock falls. In this example, the trader is expecting only a $0.50 move lower. Buying an ITM put that has a higher option delta will profit more than a put with a smaller option delta if the anticipated move comes to fruition.

With the stock trading just under $10, the option trader looks at the 10 and 12 strike puts. The 10 strike puts have an option delta of about -0.55 and the 12 strike puts have an option delta of about -0.90. This means that for every $1.00 the stock moves down, the 10 strike put’s premium should increase by $0.55 and the 12 strike put’s premium should increase by $0.90 all other factors held constant. The reverse is also true. If the stock moves higher by $1.00, each put would lose value in the amount of their deltas. Since the expected move is only $0.50, half the deltas would be gained or loss depending on the direction of the stock.

Final Thoughts…

Buying an ITM put option is not always the best way to capture a stock’s move lower, but when it comes to profiting on a perceived small move, an option trader should consider a put option with a higher option delta and do so with the satisfaction of knowing their loss potential is limited to the cost of the put option.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 10, 2014

Option Delta and Option Gamma

The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.

ATM, ITM and OTM

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 2, 2014

A Butterfly Spread to Lock in Profits

There are several ways to make adjustments or lock in profits on a profitable long call or long put position. One of my favorites has to be converting the option position to a long butterfly spread. It may sound funny, but probably the hardest part about an option trader converting his position to lock in profits with a butterfly spread is getting to a profitable position in the first place; the rest is relatively easy! Let’s take a look at a scenario and an outlook in which this butterfly spread can be considered.

Butterfly Spread on BIDU

Let’s assume an option trader has been watching Baidu Inc. (BIDU) stock and noticed the stock pulled back slightly from the uptrend in which it has been trading. When Baidu stock was trading around $175 in the middle of June, he decides to buy the July 175 call options for 7. Lo and behold about a week later the stock moves higher and it’s trading around $185. The $185 level is potential resistance for the stock because is has previously traded to that area twice before and the trader is concerned it might happen once again. The trader thinks there may be a chance that Baidu stock may trade sideways at that level. Converting a long call position to a butterfly spread is advantageous if a neutral outlook is forecast (as in this case). A long butterfly spread has its maximum profit attained if the stock is trading at the short strikes (body of the butterfly) at expiration.

The option trader is already long the July 175 call which constitutes one wing of the butterfly so he needs to sell two July 185 calls which is the body of the butterfly and where the option trader thinks the stock may trade until expiration. $185 represents where the maximum profit can be earned at expiration. A July 195 call (other wing) would need to be purchased to complete the long call butterfly spread.

The original cost of the July 175 call was 7. The two short July 185 calls sell for 5.25 a piece and the long July 195 call costs 2. The converted 175/185/195 long call butterfly spread produces a credit of 1.50 (-7 + 10.50 – 2). Now here’s a look at the possible scenarios that could happen and some possibilities that can be considered.

 Take Profit

With Baidu stock trading around $185, the July 175 call option has increased in value to 11.25. That means the trader can sell the call and make a profit of $4.25 (11.25 – 7). Certainly this is a viable option and should be considered on some of the contracts before adjusting the position.

Maximum Loss

Maximum loss for a long butterfly spread is realized if the stock is trading at or below the lowest strike (lower wing) or at or above the highest strike (higher wing). In this case the maximum loss is not a loss at all but a credit of $1.50. In essence, the original $7 potential risk from buying the July 175 call is now erased and has turned into a guaranteed profit even if Baidu stock completely collapses. If the stock continues to move higher and past the 195 strike at expiration, the maximum loss is still achieved; albeit a $1.50 profit. But more could have been made by simply keeping the original position intact. That is why it may be prudent if there is more than one contract (long call) to maybe not convert all the positions to a butterfly spread, particularity if the trader thinks that the stock can still climb higher. Keeping the long call would have more profitable if this scenario played out.

Maximum Profit

Maximum profit is achieved if the trader is right and stock closes right at $185 at expiration. The current profit on the trade is $4.25 as discussed above. If Baidu stock continues to trade sideways or ends up at $185 at expiration, that $4.25 profit has now grown to an $11.50 profit. The maximum profit for a butterfly spread is derived from taking the difference between the bought and sold strikes which in this case is $10, and adding premium received from converting the position to a butterfly spread ($1.50). Not too bad of a result if Baidu stock trades sideways or ends up at $185 at expiration. It seems pretty clear that the long butterfly spread is very beneficial when a sideways outlook is forecast after the long option has profited.

As long as the strike prices align with the trader’s outlook, converting a long call or a long put to a butterfly spread can be very effective after gains are realized. If there are multiple contracts, it allows an option trader to take profits now and also potentially earn more if the stock essentially goes nowhere and ends up close to the short strikes at expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring