Testimonials

February 2, 2012

Trading Option Strangles 101

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 8:18 am

 We have discussed the straddle options strategy in the past, a 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 investor 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 (as in the straddle), the investor 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, a trader pays a lower initial premium. However, this comes with a caveat – the stock will have to make a much larger move than it would if a straddle were employed. The investor is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price.

The Particulars
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 breakevens, 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 an investor can take on a strangle is the net premium paid.

Example Trade
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 (February 2012) is trading at around $456. The trader would buy both a March 460 call and an March 450 put. For simplicity, we will assign a price of $10.00 (rounded down for the call and up for the put) for both – resulting in an initial investment of twenty bucks for our investor (which is the maximum potential loss).

Should the stock rally past $460 at expiration, the 450 put expires worthless and the $460 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 $26, the profit is $6 (intrinsic value less the premium paid).  The same holds true if the stock falls below $450 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 twenty dollars, or $2,000 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.

 Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 26, 2012

Stop Loss or Trailing Stop?

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 11:21 am

Some may hear the terms trailing stop loss and stop loss order and wonder exactly what these are and how a stop loss can enhance a trading strategy. Well, fret no more – that is what we will discuss in this blog entry. Let’s start with the basics, defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it’s a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let’s take a look.

Stop Loss Example
A trader could purchase a stock for $15.00 and set a stop-loss order at $13.50. This means that the position will be closed at the market price once the stock drops below $13.50, simple right? It is called a stop loss order because it rather simply stops the investor from taking any more losses. Many investors have a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are made.

Trailing Stop Loss Example
A trader  chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is breached. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss, then, can be used very effectively in profit taking. And it may sometimes require an adjustment. Let’s revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let’s say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 19, 2012

Bull Call Spread vs. Purchasing a Call

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 10:38 am

Bull Call Spread vs. Purchasing a Call
Let’s say that you have a moderately bullish bias toward a stock and the overall market is slightly bullish. Is there a way that you can take advantage of this investing scenario while limiting risk? Certainly, there are a few. One that is often superior to the rest is the bull call spread.

Definition
When executing a bull call, you purchase call options at one strike and sell 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 $430 as an example. In this case you would purchase February calls at the 430 at-the-money strike at the ask price of $14.45. You would then sell the same number of February calls with a higher strike price, in this case 450 at the bid, $6.25.

The Math
Your maximum profit in the bull call spread is limited, you can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that you purchased one February 430 call and sold one February 450 call resulting in a net debit of $8.20 (that’s $14.45 – $6.25). The difference in the strike prices is $20 (450 – 430). You, therefore, subtract 8.20 from 20 to end up with a maximum profit of $11.80 per contract. So, if you traded 10 contracts, you could make $11,800.

Although you limited your upside, you also limited the downside to the net debit of $8.20 per contract. To simply breakeven, the stock would have to trade at $438.20 (the strike price of the purchased call (430) plus net debit ($8.20)).

Advantage versus Purchasing a Call
When trading the long call, your downside is limited to the net premium paid. If you simply purchased the at-the-money February 430 call you would have paid 14.45. The potential loss is, therefore, greater when employing a call-buying strategy. If you move to a call with a longer time frame to expiration, you would pay even more for the option. This would also increase your potential loss per option.

Conclusion
By implementing a bull call spread, you have hedged your bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no fool-proof ways to make money by using options. However, knowing your strategy is a good way to limit losses.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 12, 2012

Buying Call Options Rather Than Stock for AAPL

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 8:44 am

 You have your eye on a stock, a very high-valued stock like Apple (NASDAQ: AAPL ). You believe that this stock, despite its high price, continues to have tremendous upside potential. The problem is that you don’t want to shell out $420 for one share of the search giant. What can you do to maximize your money and cash in on the perceived upside? Easy, buy a call option rather than the stock.

Quick Definition
For the uninitiated, a call option is a bullish strategy wherein a trader purchases the right (but not the obligation) to purchase a stock at a specified price within a specific time period. One advantage to buying a call option rather than purchasing a stock is that you can gain a much larger percentage return on your investment.

The Example
If you want to purchase 100 shares of AAPL stock at $420 it is going to cost you (100 X $420) $42,000.  However, let’s say that you decide to purchase 1 call option on AAPL (each option represents 100 shares) with a strike price of, say, 420 with a February expiration, which carries a price tag of $16.40. Rather than dishing out $42,000 for 100 AAPL stock shares, you instead pay $1,640 for the options – a rather nice difference of $40,360 that you can use for something else or to purchase other options.

The Money
The cost efficiency of purchasing call options can be far greater than simply purchasing shares of a stock, especially when you are dealing with high-priced stocks like AAPL. Remember that one option contract is the right to purchase 100 shares of a stock at that price. So, rather than purchasing 100 AAPL shares at $420 at the massive cost of (100 X $420) $42,000; you have dished out a more reasonable $1,640 for the transaction. Of course, this is the scenario if you want to simply be bullish on AAPL stock.

Conclusion
As you can see, it is possible to lay out far less money to purchase call options on a stock that to by the call itself. In fact, the earlier the expiration you choose, the lower the price you could pay. No matter what math you use, paying $1,640 is far better than paying $42,000 for the same product. What if you want to sell these options to someone who is willing to pay a higher ask price than you paid? That is another subject for another time. Remember, there is no fool-proof way to make money in the market – there is risk involved in any trading strategy. One way to make sure you maximize your cash is to make sure you study your subject, remember that knowledge is power. Please check out our special Online Education deal for Options Blog readers.

Edited by John Kmiecik

Senior Options Instructor

 Market Taker Mentoring

January 5, 2012

The Stock Repair Strategy

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 11:13 am
Stock Repair Options Strategy

It’s been a rough ride for a lot of investors. Some investors are waiting (patiently) for some of their losers to turn around. Some traders are buying at new, cheaper prices. But as experienced investors know, the market can always go lower, sometimes fast and furiously. There is one more alternative that can make sense in some cases: the stock repair strategy.

Introduction to the Stock Repair Strategy
The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits
There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy
Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example
An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next two months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the September options

The trader buys 1 September 60 call at 6 and sells 2 September 70 calls at 3. The spread is established cash-neutral.

Bought    1 Sep 60 call at 6
Sold         2 Sep 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. FIGURE 1 shows how the position functions if held until expiration.

(See Figure 1 above)

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy
The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Some stocks that have experienced recent declines may be excellent candidates for the stock repair. For others, the stock repair strategy might not be appropriate. For stocks that look like they are finished or may even head lower, the Stock Repair Strategy can’t help - just take your lumps! But for those that might slowly climb back, just partially, this can be a powerful option strategy to recoup losses fast.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 29, 2011

Butterflies and Weekly Options

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 9:43 am

The weekly options have been the topic of our blog for the last two weeks now.  Despite this topic being the trendy subject and in the forefront of many discussions, it is helpful to recognize the functional flexibility this dramatically shortened lifespan brings to a variety of strategies.

As an example, consider the case of a frequently traded spread vehicle, the butterfly.  For those first encountering this strategy, it is helpful to consider briefly its components. It is constructed by establishing both a credit and a debit spread sharing a central strike price.  It can be constructed in either all puts or all calls.

Butterflies can be designed to be either a non-directional or directional trade strategy.  Functional characteristics include: negative vega, variable delta and accelerating gamma and theta during its life span. In the case of the long standing monthly duration option cycles which had heretofore been available, these characteristics developed over weeks to months and reached their final expression during the week of option expiration.

These functional characteristics have limited the utility of butterflies over brief duration moves occurring early in the options cycle.  Many butterfly traders have had the experience of correctly predicting price action early in the cycle only to have the butterfly deliver little, if any, profit.

The short nine day duration of the weekly options has dramatically accelerated the pace of butterfly trading as the changes begin to occur literally over the extent of a few hours.  As such, it is possible to gain the advantage of this trade structure over brief directional moves or in the case of non-directional traders to have market exposure for briefer periods of time.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 22, 2011

Weekly Options Impact

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 12:55 pm

Options have traditionally traded in 12 cycles per year.  Since there are 52 weeks per year, most monthly cycles have had a life span of 4 weeks with the occasional 5 week cycle in order to make the math work out. In these multi-week cycles, each week tends to have its own personality and the tempo of price change would often accelerate as expiration approached.  This effect was at least in part the result of the non linear nature of the decay curve of extrinsic premium.  It is as if the option cycle began with a decay curve akin to an easy green ski trail and ends on a double black diamond slope.

For strategies that include a component of being short premium, the maximum potential total profit or loss is only achieved at expiration.  This effect is easily seen in the case of vertical spreads which only reach their maximum potential gain or loss at expiration or when the spread goes deep in-the-money or out-of-the-money.

CBOE introduced weekly options in 2005 on several broad indices and the launch was met with a tepid reception.  However, trading volume in weekly options contracts has recently exploded, additional indices and ETF underlyings have been added, and a number of actively traded equities have joined the family of weekly options.  An updated list of the rapidly increasing available weeklies can be found at this CBOE site: http://www.cboe.com/micro/weeklys/introduction.aspx

Weekly options are a rapidly evolving and changing part of the options world.  As an example of this rapid evolution, the new week’s options have begun to be offered on the Thursday of the week prior to expiration rather than the Friday as had been the case previously effective July 1, 2010.

The availability of weekly options has undoubtedly had a significant impact on a variety of strategies.  Their acceptance and increase in trading volume has been nothing short of stunning.  For example, the 390 and 395 call strikes in AAPL that will expire tomorrow, December 23, each have an open interest of around 10,000 contracts.

Are weekly options something that you can incorporate into your trading plan? You will have to decide for yourself.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 15, 2011

Implied Volatility and Historical Volatility

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 10:09 am

One of the most important steps in any option trade is to analyze 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 step making some trades losers from the get-go.

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 15 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 asset prices in the past, implied volatility (IV) looks ahead. 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 15 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.

Analyzing Volatility
Implied volatility and historical volatility is studied using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful visual aide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are  misinterpreted by novice 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 the end of the story. 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.

Lastly, 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 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 unique. 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.

Edited by

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 8, 2011

Fractal Position Management

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 10:11 am

Option traders manage risk. Want a job description? That’s about it. Every trade has a risk and reward associated with it. But because options are instruments of leverage, it is very easy to let risk get out of control, if you’re not careful. Traders must manage risk carefully, instituting tight reins their options, spreads and portfolio. The management technique of each is essentially the same because position management is fractal.

Something that is fractal has a recurring pattern that has continuity within its scale. For example, a tree is fractal. A tree has a trunk with limbs extending from it; limbs with smaller branches extending from it; smaller branches with yet smaller branches; and leaves with veins that branch off within each leaf. The pattern is repetitive within each iteratively smaller extension of the last. This is found in option position management too.

Individual options have risk that must be managed. They have direction, time and volatility risk which are managed by setting thresholds for each of the corresponding greeks which measure them. When individual options are a part of a spread, the resulting spread has these same risks of direction time and volatility. The spread’s risk must consequently be managed likewise. A trader’s complete option portfolio, which may be comprised of many spreads has systematic risk in accordance to the market. These risks are the same as for individual options or individual spreads: direction, time and volatility. Traders should treat their all encompassing portfolio as a single, macro spread and use the portfolio greeks to set parameters to minimize the total risk of the portfolio.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 1, 2011

Going Vertical in AAPL

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 9:51 am

One of the basic directional spreads in trading options is that of the vertical spread.  It is extremely versatile and represents a major building block of more complex spreads. It is so named because of the configuration of the position when overlain on the classic format for displaying option quotes.  In this format, the various strike prices for an option are arrayed vertically and the months available to trade are displayed horizontally.  This defined risk position consists of both a long and short position at different strike prices within the same expiration month.  It can be constructed in either puts or calls and the initial cash flow can be either a credit or debit.  Strike prices can be selected to produce either aggressive or conservative stances.

As an example, let us consider a vertical spread in market leader Apple (AAPL).  Current vital signs of the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.

For the trader who has a bullish thesis for the price action in AAPL into January expiration, a put credit spread can be established by selling the January 375 put and buying the January 365 put.  As this is written with 51 days to expiration, the maximum potential return is 38% and is achieved as long as AAPL remains above the short put strike of 375.  Maximum risk is defined by the long 365 put.

As contrasted to a naked put sale, this position has the following major differences: 1. Risk is crisply defined as opposed to the naked sale maximum risk of the underlying going to 0, and 2. Margin requirements for the position and hence yield are dramatically improved.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Older Posts »