Using options gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using gamma:

When you buy options you get positive gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL June 540 long call that has a delta of 0.48 and gamma of 0.008 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive gamma is a good thing.

When you sell options you get negative gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative gamma is a bad thing.

Start by understanding options gamma from this simplistic perspective. Then, later, worry about working in the math.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Delta is arguably the most heavily watched Greek especially by individuals learning to trade options. It offers a quick-and-dirty way of telling us what to expect from our option positions as we watch the price action of the underlying.  Calls have positive deltas, as they typically move higher on a rise in the stock, and puts have negative deltas, as they typically move lower when the stock rises.

While some investors view delta as the percentage chance an option has of expiring in-the-money, it is really more of a way to project expected appreciation or depreciation.  A delta of 50 for an AAPL call suggests the option should move 50 cents higher when the AAPL jumps a dollar, and lose 50 cents for every dollar loss in AAPL.

But delta is only foolproof when all other factors hold static, which is rarely the case (and certainly never the case for time decay).  If an option is moving more (or less) than its delta would suggest, it is likely because other variables are shifting.  For example, buying demand might be pushing implied volatility higher, raising the price of the options.  Still, this king of all Greeks is a good starting point for gauging how your options are likely to move.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

The sine qua non of this position is that of being short puts.  As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of variable degree in the price of the underlying.  The magnitude of the “deductible” for the policy is determined by the strike price the trader has sold.

Here is an example using AAPL. A trader who sells a $590 strike put to another trader holding an underlying currently trading at $585 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible.  In return for issuing this insurance policy (in option lingo known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions.  The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased.  In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used similar strategy is to sell a put spread.  In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price.  However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance.  The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options.  Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread.  In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin encumbrance.  However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure.  This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable; if you know the road map it is much easier to arrive where you want to be.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

The qualities that you will need to succeed in my opinion are a commitment to success, having a options trading plan and the most important, mastering your emotions—or the psychology of options trading. I believe that options trading is the hardest job in the world (quite possibly the best, but the hardest). That’s why it will probably take you a lot longer than you think before you really get a solid grip on it.

So let’s first talk about your commitment to success. This essentially sounds like the easiest of the three qualities to master doesn’t it? Why does anyone want to become a options trader in the first place? Probably, because they want to become wealthy and very successful. Who isn’t committed to that, right? All you need is some money, charts, and a platform and you are on your way. Almost everyone says they are committed but most people are not because when they find out options trading is work—and it is. They tend to lose their focus and their original goals when the going gets though.

If you are committed to success then you must be committed to reaching your goals. The most important part of having goals is to write them down. If you never write them down they are simply just dreams. We don’t want to dream we are a great trader we want to realize that we are! Only about 2% of Americans write down their goals. Is it really shocking to know that most people never achieve what they want out of life? As “corny” as it may seem, when you write something down no matter what, your thoughts are transformed from the subconscious to the conscious and are now tangible. Your goals have become something you can see and say out loud. If you never write them down they never exist outside of your thoughts.

Let me leave you with this before I end this introduction on how we are going to build a great options trader out of you. I think everyone can agree whether you are a beginning options trader or a more experienced options trader that there are several key components you will need to do to become a standout. Having said this I also know that most of you will not be committed to do this at first. I know I wasn’t. I thought to myself I am too smart and I know how to options trade. I knew it wouldn’t be easy but I was unprepared for the results that followed. I’ll give you a hint, they weren’t good. After I decided to fully commit myself and write down my goals did my results finally change. Let’s face it; options trading is a realm like no other. Options trading looks easy and which in turn makes you lazy to work at it. Be committed to your success and write down your goals right from the start will only help you achieve the success you are after that much quicker.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

The obvious starting point for a trader to fade this fall is to take a positive-delta position. This is fancy options speak for a bullish trade. There are lots of different ways to take a bullish stance given all the various types of option-trading strategies out there. So, the question really is: Which is best?

There are a few major considerations here. First, traders must strive to maximize reward by minimizing risk. In order to do so, option traders must define their expectations. Am I looking for an extreme turn around? A mild retracement? A dead-cat bounce? The more a strategy can be tailored to expectations, the more risk can be controlled and reward can be maximized.

Next traders need to consider implied volatility. This is where option traders can get an edge in their options positions. If implied volatility is high (overpriced), option traders should consider option-selling strategies. If implied volatility is low (underpriced), option traders should consider option-buying strategies.

In the current market scenario we have a situation where if the turmoil in the Europe and Spain subsides, the market should rally somewhat, but it’s not likely to go to the moon. Further, with the levels and implied volatility of individual stocks at inflated levels, it’s easy to find overpriced options. Any clever fader trader should be looking for put credit spreads to sell. Put credit spreads have positive delta and take a short position on implied volatility. Great candidates for this sort of play are AAPL, GOOG, PCLN, et. al. Traders are best off staying away from bank stocks and precious metals that might be adversely affected by European instability.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish AAPL traders. Traders who are extremely bullish on AAPL get more bang for their buck buying short-term out-of-the-money calls. Less bullish traders my 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 and the trader is bullish just to a point, the trader might sell a bull put spread, and so on.

The differences in options strategies, no matter how apparently subtle, 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 nuance. Traders need to consider the following criteria:

• Directional bias
• Degree of bullishness or bearishness
• Conviction
• Time horizon
• Risk/reward
• Implied volatility
• Bid-ask spreads
• Commissions
• And more

Carefully selecting 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. Be sure to spend time optimizing your options strategies over the next few weeks to build the habit.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

The maximum profit is the premium received for the put. The maximum profit is achieved when the underlying stock is greater than or equal to the strike price of the sold put. Though this allows for a lot of room for error (The stock can be anywhere above the strike at expiration), note that the maximum loss is unlimited and occurs when the price of the underlying stock is less than the strike price of the sold put less the premium received. So, executing this trade in the right situation is essential. To calculate breakeven, subtract the premium received from the sold put’s strike price.

The Example
For our example we will use Apple (AAPL). For this example we will assume the stock is trading around $625 a share. A trader sells the April 615 put, which carries a bid price of $10.00 (rounded to make the math a bit easier). Should AAPL stock be trading above $615 a share at expiration, the April 615 contract will expire worthless and the trader will keep the premium collected. (Do not forget to take any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls?

If AAPL falls to, say, $600 at expiration, the put would expire in-the-money and would have to be purchased back to avoid assignment. This could cost the trader a rather hefty sum. Assigning values, our investor collected $10 in premium. The 615 put expired with $15 in intrinsic value. The trader loses the $15, less the $10 premium collected results in a loss of $5, or $500 of actual cash.

Why Sell Naked Puts?
We have already discussed the profit potential of selling naked puts, but there is another reason to do so – owning the stock. Selling naked puts is a good way to purchase at a specific price by choosing a strike near said target price. Should the stock price drop below the put strike and the puts are assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the premium is pocketed at expiration.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

One helpful organizational concept of financial risk is to consider that risk comes in two categories. The usual type of risk analyzed by the filigreed bell shaped curves of a Gaussian (log normal) distribution and the familiar gently oscillating movements of magnitude describable terms of 1, 2 or even perhaps 3 standard deviations. The other general category of risk is characterized by the unforeseen events that result in “sea change” alterations of the financial landscape. It is this category of risk to which Nassim Taleb has drawn attention in his books regarding the lack of predictability of consequential rare events.

How does this impact the world of the trader and the utility of options? The inescapable fact is that all funds invested in the market are totally at risk at all times and that comfort that price stops will reliably be elected at or close to their set points is illusory. From this concept, the ability to control stock with far less invested capital becomes inescapably attractive.

Such is one core function of options; control of stock with commitment of far less capital than outright purchase. To take a straightforward example, shares of AAPL which has taken center-stage on many traders and investors radars, currently trades around $610. To control 100 shares by outright stock purchase would require $61,000. A substantially delta equivalent position using deep in-the-money calls, the April 500 strike, could be purchased for approximately $11,275. As is characteristic of a deep in-the-money option, there is very little eroding time premium for which the trader is paying.

Should Armageddon arrive unannounced, which position is better: the total loss of the value of the stock position or the vaporization of the moneys paid for the option?

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring LLC

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique akin to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives.

With 12 monthly cycles, there historically have been only 12 of these final weeks per year in which premium sellers have seen the maximum benefit of their core strategy. The advent and widespread use of weekly options has changed the playing field. Options with one week durations are available on SPX and OEX indices. For variety, they also come in flavors of a mini contract (SPX) and European style (OEX). These options have been in existence since October 2005 but only in the past 12 months have they gained widespread recognition and achieved sufficient trading volume to have good liquidity.

Standard trading strategies employed by premium sellers can be executed in these options. The advantage is to gain the “sweet spot” of the time decay of premium without having to wait through the entirety of the 4 to 5 week option cycle. The party never ends for premium sellers using these innovative vehicles.

Traders interested in using these weeklies MUST understand settlement procedures and be aware of last days for trading. An excellent discussion of details is provided on the CBOE website: http://www.cboe.com/micro/weeklys/introduction.aspx

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring