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 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.

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  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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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.

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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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Tuesday’s flash crash provides five lessons for option traders.

Lesson 1: Protecting with options can be better than using a stop. Traders with bullish positions in the market who had protective stop losses on were the big losers in the flash crash. They sold their longs at a low price that existed only temporarily. It was an extreme whipsaw, that should have never happened—but it did. The whipsaw really hurt traders who thought they were being conservative by using a stop loss. If instead they had protective puts, or an otherwise limited risk option position, they would not have endured any losses.

Lesson 2: I Repeat, protecting with options can be better than using a stop. Indeed, some of the stop losses may have been filled at the absolute worst possible price. The way a stop works is that if the market either trades at or is offered below the stop price, a market sell order is triggered. Probably many of those orders executed far below the stop price. It’s not hard to imagine that many of the orders were filled at the absolute bottom price of the day. And what if the story turned out to be true and the market continued lower? For one, those stops could have been executed even worse! But traders protecting with options would have been protected the whole way down.

Lesson 3: Have your profit-taking orders in at all times. Traders with bearish positions had an excellent chance to steal a profit out of the market Tuesday—at least, those who had profit taking orders in. If you were long puts and had an order to sell those puts in the market on Tuesday, you probably would have gotten filled and locked in your profit.

Lesson 4: Don’t believe everything you hear. That one is pretty self-explanatory. In this world of electronic media, this stuff is bound to happen.

Lesson 5: Be quick! Traders who were quick on the draw could have banked some quick (and potentially big) profits on the AP’s bogus tweet. When something like that happens, whether it’s true or not, there is bound to be some immediate selling. The first guy to buy puts makes a bunch of money (presuming he’s quick on the exit too). The last guy locks in a loss.

The most important asses a trader has is knowledge. Take opportunities like this to learn from the market and make money off it with what you learn.

Dan Passarelli

CEO

Market Taker Mentoring

A lot of traders especially those who are just learning to trade options can be smitten by put options especially buying the shortest-term, or front month put for protection. The problem, however, is that there is a flaw to the reasoning of purchasing front-month puts as protection. Front-month contracts have a higher theta (time decay) and relying on front-month puts to protect a straight stock purchase is not necessarily the best way to protect the stock. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.

Although front month options are often cheaper, they are not always your best bet. The idea may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his or her position; but sound reasoning does not always lead to good practice. Here’s an example.

We will use a hypothetical trade. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months as the trader wants to allow the news events to move the stock higher.

Being a smart options trader, our stock trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money October 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would create a big dent in the initial outlay of cash. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.

If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops. Buying the put is a hedge and and a solid insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Definition
When implementing a bull call, a trader purchases call options at one strike and sells 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 $435 as an example. In this case you would purchase May calls at the 435 at-the-money strike at the ask price of $18. You would then sell the same number of May calls with a higher strike price, in this case 455 at the bid, $10.

The Math
The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that he purchased one May 435 call and sold one May 455 call resulting in a net debit of $8 (that’s $18 – $10). The difference in the strike prices is $20 (455 – 435). He would subtract 8 from 20 to end up with a maximum profit of $12 per contract. So if he traded 10 contracts, you could make $12,000.

Although he limited his upside, the trader also limited the downside to the net debit of $8 per contract. To simply breakeven, the stock would have to trade at $443 (the strike price of the purchased call (435) plus net debit ($8)) at expiration.

Advantage versus Purchasing a Call
When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the at-the-money May 435 call he would have paid $18. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.

Conclusion
By implementing a bull call spread, traders can hedge their bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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 20 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 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 20implied 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 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.

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 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 sale; if it is below its normal level it may 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. 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 which is precisely what every trader needs!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Quick Definition
A call option is a bullish strategy where 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. To learn more advantages, please check out the Options Education section on our website.

The Example
If you want to purchase 100 shares of AAPL stock at $450 it is going to cost you (100 X $450) $45,000.  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, 450 with a May expiration, which carries a price tag of $22. Rather than shelling out $45,000 for 100 AAPL stock shares, you instead pay $2,200 for the options – a pretty sunstantial difference of $42,800 that you can use for something else or to purchase other options.

The Money
The cost savings 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 $450 at the massive cost of $45,000; you have dished out a more reasonable $2,200 for the transaction. Of course this is the scenario if you want to be simply bullish on AAPL stock.

Conclusion
As you can see, it is possible to spend 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 $2,200 is far better than paying $45,000 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 is used correctly.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

The IV of each of the various available options for a given underlying is not usually constant for each individual strike price and expiration cycle.  The IV can and often does vary between individual strike prices within the same cycle; this variation is termed vertical skew.  In addition, IV often varies at the same exact strike price when considered between various expiration cycles; this variation is termed a horizontal skew.

To review briefly, remember that option prices depend largely on the three variables:  time to expiration, price of the underlying, and IV.  The only one of these factors not immediately accessible to anyone with a quote screen and a calendar is IV.  It is by changes in the magnitude of IV that future events of potential major import to the price of the underlying are expressed.

As an example of the information that can be gained by considering skewed values for IV is the stock AFFY.  This biopharmaceutical stock is represented in upcoming expiration cycles of: April, May, July, October, January 2014 and January 2015.  Considering the example of the 3 strike call, the IV for these various months at the time of this writing are:  222, 189, 171,131, 137 and 110 respectively.

The company just announced a significant reduction of their workforce due to an ongoing investigation surrounding one of their product. The options markets are pricing a substantial probability of a significant price move earlier than later.  These types of IV spikes are typically seen in biotech stocks ahead of significant FDA decisions or product investigations like in this instance.

The bottom line for an option traders is to make sure they know how the IV might influence their decision making and understanding why there are discrepancies in the first place.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Options trading is greatly affected by implied volatility. At its most basic level, when the VIX is low, it tends to mean lousy options trading.

Option traders are not incented to trade when the VIX is low. Traders generally don’t want to sell options when premiums are so low. There is no reward and still there is always the specter of the risk of an unexpected market shock. And, option traders don’t want to buy options either. Why? Because when the VIX is low, the VIX low is for a reason: Because market volatility is low. Why would traders want to buy options (and endure time decay) is the market isn’t moving?

And so, as always, the devil is in the details. Right now, there actually exists a somewhat atypical pattern in many stock options. Many stocks have their implied volatility trading decidedly below historical volatility levels. Though this volatility set up can be seen here and there at any given time, it is more common than usual. That means cheap volatility trades (i.e., underpriced options) are more abundant.

Stocks like CRM, C, GE, F, and even the almighty AAPL all have implied volatility below their historical volatility.

That means that even though overall stock volatility (as measured by historical volatility) is low, the options are priced at an even lower level. That means time decay is very cheap per the level of price action in these stocks. And, implied volatility in these stocks (and probably the VIX as well) is likely to rise to catch up to historical volatility levels—assuming the current price action continues as it is.

So, traders should be careful not to sell too many option spreads (i.e., credit spreads) at these fire-sale levels. Instead, traders should look to positive vega spreads (i.e., debit spreads), at least until implied volatility rises offering worthy premiums to option sellers.

Dan Passarelli

CEO

Market Taker Mentoring