It seems like almost every other week in my Group Coaching class, a student will ask me about buying deep out-of-the money (OTM) options. Many option traders especially those that are new initially buy deep out-of-the-money options because they are cheap and can offer a huge reward. Unfortunately many times, these “cheap” options are rarely a bargain. Don’t get me wrong, at first glance an OTM call that costs $0.25 may seem like a steal. Since spring training is fast approaching, we can use a baseball analogy and say that if the trade works out, it could turn into a real homerun; maybe even a grand slam. But if the call’s strike price is say $20 or $30 (depending on the stock price) above the market and the stock has never rallied that much before in the amount of time until expiration, the option will likely expire worthless or close to it.
Many factors work against the success of a deep OTM call from profiting. The call’s delta (rate of change of an option relative to a change in the underlying) will typically be so small that even if the stock starts to rise, the call’s premium will not increase much. In addition, option traders will still have to overcome the bid-ask spread (the difference between the buy and sell price) which might be anywhere from $0.05 to $0.15 or even more for illiquid options.
Option traders that tend to buy the cheapest calls available are probably calls that have the shortest time left until expiration. If an OTM call option expires in less than thirty days, its time decay measured by theta (rate of change of an option given a unit change in time) will be often larger than the delta especially for higher priced and more volatile stocks. Any potential gains from the stock rising in price can be negated by the time decay. Plus each day the OTM call option premium will decrease if the stock drops, trades sideways or rallies just a tad.
A deep OTM call option can become profitable only if the stock unexpectedly jumps much higher. If the stock does rise sharply, an OTM call option can hit the proverbial homerun and post impressive gains. The question option traders need to ask themselves is how much are they willing to lose waiting for the stock to rise knowing that the odds are unlikely for it to happen in the first place? Trades like these have very low odds and may be better suited for the casino then the trading floor.
An option strangle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With an option strangle, the trader is betting on both sides of a trade by purchasing a put and a call generally just out-of-the-money (OTM), but with the same expiration. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this or any other option strategy sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.
An option strangle has two breakeven points just like the option straddle. 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 (for upside moves). 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 an option strangle is the net premium paid.
The implied volatility (IV) of the options plays a key role in an option strangle as well. With no short options in this spread, the IV exposure is concentrated. When IV is considered low compared to historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant which is certainly a bonus for long option strangle holders.
To create an option strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. An option trader may think Apple Inc. (AAPL) looks good for a potential option strangle since at the time of this writing, it is teetering around its all-time high at $120. With IV lower than HV and the trader unsure in what direction the Apple stock may move, the option strangle could be the way to go. The trader would buy both an March 125 call and an March 115 put. For simplicity, we will assign a price of 2.00 for both – resulting in an initial investment of $4 (2 + 2) for our trader (which again is the maximum potential loss).
Apple Stock Rallies
Should the Apple stock rally past the call’s breakeven point which is $129 (125 + 4) at expiration, the 115 put expires worthless and the $125 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example at expiration the stock is trading at $133 which means the intrinsic value of the call $8 (133 – 125), the profit is $4 (8 – 4) which represents the intrinsic value less the premium paid.
Apple Stock Declines
The same holds true if the stock falls below the put’s breakeven point at expiration. The put is in ITM and the call expires worthless. At expiration, if Apple stock is trading below the put’s breakeven point of the trade which is $111 (115 – 4), a profit will be realized. The danger is that Apple stock finishes between $111 and $129 as expiration occurs. In this case, both legs of the position expire worthless and the initial 4, or $400 of actual cash, is lost.
Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Profits and losses can be realized way before expiration and it is up to the trader to decide how and when to close the position. 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.
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 ABC Inc. (ABC) stock and noticed the stock pulled back slightly from the uptrend in which it has been trading. When ABC stock was trading around $175 in the middle of January, he decides to buy the February 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 ABC 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 February 175 call which constitutes one wing of the butterfly so he needs to sell two February 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 February 195 call (other wing) would need to be purchased to complete the long call butterfly spread.
The original cost of the February 175 call was 7. The two short February 185 calls sell for 5.25 a piece and the long February 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.
With ABC stock trading around $185, the February 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 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 February 175 call is now erased and has turned into a guaranteed profit even if ABC 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 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 ABC 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 ABC 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.
Several days ago, there was a rumor that Samsung was planning on acquiring smartphone maker BlackBerry Limited (BBRY) and the stock shot up over 25%. The rumors so far have failed to materialize. That being said, let’s look at an made-up example of a take-over and a way to use options to capture the possible move. A $50 stock is rumored to be taken out at $55. Looks like a nice spec trade right? You go to the option chain to look for some calls to buy and you notice that the options have gotten pretty expensive. Implied volatility has skyrocketed. Sometimes implied volatility can make options so expensive that even if the trade goes your way the profit is just not there–but the risk is. So, what’s an options trader to do?
One solution can be to buy a bull call spread instead of the outright call. The rationale? It’s called hedging–hedging volatility premium. Whenever you buy options, you’re getting long implied volatility. If implied volatility is expensive, the options are expensive too. And if implied volatility subsequently falls after you make the trade, those options drop in value too. So, what if you both buy and sell an option to create a spread? Let’s look at the two legs of a bull call spread
Bull Call Spread – Long Leg
A bull call spread is when a trader buys one call and sells another that has a higher strike price. Look at it as two trades. The long call would be the one you might buy if you were to spec on the take-over stock. In the case of a take over, this call likely has high implied volatility as the market scrambles to buy up calls, making it pricey.
Bull Call Spread – Short Leg
Because there is a target price in which the take-over target is expected to be bought, you only need exposure up to a certain point–the take-over price. Why not sell a call at or above the expected take-over price? You’re not giving up upside. But you are taking in (expensive) premium to hedge the (expensive) premium you’re buying with the long call leg. It’s a perfect spread.
Let’s look at this in terms of absolute risk. A stock currently trading for $50 is rumored for take over at $55. News is expected within a couple of weeks.
Buy 1 February 50 call at $4
Sell 1 February 55 call at $2
Net debit $2
Max loss = $2 (That’s better than just buying the 50 calls outright)
Max gain = $3 (That’s the $5 spread minus the $2 premium)
Break even = $52 (That’s $50 strike plus $2 spread premium)
Here the max loss/max gain ratio of the spread is 2:3. The max loss/max gain ratio of the outright call would be 4:1 (Remember, you expect the stock only to rise to $55). The spread looks better so far. Let’s look at the break evens. The spread break-even is $52. The outright call’s break even is $54. Better still.
With all option strategies, there are opportune times when they offer an advantage over an alternative strategy. Bull call spreads and take-over candidates are a natural fit. Traders always need to look for ways to construct the smartest position in terms of risk-reward.
The last several months, the market has shown some good movement with some wild swings. The S&P 500 and Dow set their all-time highs once again, and then promptly moved lower. Now we are about to start the next 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. High is giid for selling and low is good for buying option premium.
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.
Now you know a little more about how implied volatility can affect options, it is time to put that knowledge to use and get the edge in your trades!
With earnings season unbelievably upon us in a few short weeks, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.
Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options. The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.
Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in other words, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of the placement of the long strikes being closer to ATM, responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions has a negative impact on double calendars more strongly than it does on double diagonals.
If you have only traded a single-legged calendar or diagonal through earnings season even not during earnings season, it might just be time to give them a look. Maybe you have never traded a calendar or a diagonal. This might be the time to find out about these time spreads. Once a single position spread makes sense, a double might make even more sense and be more profitable too.
One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Cindy Crawford is still considered to be still quite attractive by many, her look (perceived beauty) is not the same or at least as youthful looking as it was decades ago when she was a top model and cover-girl. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.
While this decay of time premium to a value of zero is reliable and undeniable in the world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.
Some of the most dramatic changes in behavior can be seen in the trading strategy known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.
To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the same strike price constructed together in the same underlying in the same expiration. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.
The butterfly has the interesting characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week. Beauty is in the eye of the beholder and enjoy the New Year!
With the New Year just around the corner, it is time to reflect on the past year. Making a list of the positives and the negatives throughout the year, could be beneficial going forward. Just like in option trading, a well though out and well kept watch list can help a trader in a variety of ways including scoring profits. First and foremost it can help keep track of the underlyings and keep them all in one place so it is easy to reference them. Potential trade opportunities are often discovered by scanning and searching charts and options from stocks that are on a watch list just like determining potential strengths and weaknesses of a hockey opponent. Here are a couple of ways a trader might go about building a watch list or creating a better one.
If a person is relatively new to trading there are probably a few stocks that he or she is familiar with. To gather more names to add to the list, a trader can scan through an index (like the S&P 500 for example) and find more stocks to potentially add to the list. Some of the stocks listed may not be conducive for a variety of reasons. It makes perfect sense to check out the symbols and see if the charts and the options are at acceptable levels for the trader’s personality and plan. Things a trader might want to consider when deciding whether to put a stock on his watch list are the stock price, the stock’s volatility, option prices, bid/ask spreads and option volume just to name a few. When this process is complete, a trader should have a decent watch list in which to work with. This list may grow and sometimes shrink over time depending on the trader.
There are numerous trading services (free and paid) out there that not only might introduce traders to stocks to add to the watch list which may lead to potential trade opportunities. The Market Taker Live Advantage Group Coaching is one such service that MTM offers. As mentioned above, the reason a watch list is created in the first place is to find potential trades. A service can not only introduce traders to new symbols but also provide trade ideas that can turnout to be profitable. But if the trade concept is unclear or deviates from a trader’s plan regardless of the source, it should be avoided until the concept is understood. In any case, if the trader thinks there may be an opportunity on the stock in the future it can be added the list.
Once a trader has a watch list of stocks, it may be prudent to separate the list into different categories. There can be a list for stocks that are ready to trade now or very soon. Keeping this list the shortest might make sense for a couple of reasons. First a trader should probably not be trading more stocks than he or she can handle and secondly if there are too many on this list, some trade ideas might get lost in the mix. A short list makes it easier to monitor potential trade opportunities. There can also be a category for stocks that have trade potential in the near future (a day to a week for example). This list can be monitored maybe a little less frequently than the previous list. Another category to consider for the watch list are stocks that have no potential now but may in the future. For example, maybe a stock is trading in the middle of a channel and if it ever trades down to support a bullish opportunity may arise. Stocks should be moved up and down in these different categories as needed.
These were just a few ideas about how a trader can go about developing and monitoring a watch list and searching for potential trade opportunities. The most important part about having a watch list is not how it was acquired but that there is one. A well-refined and updated watch list can yield plenty of potential money making opportunities in option trading for 2015. Happy New Year!!
Looking for an options trading system to give to someone in need or for yourself this Holiday Season? Let the Market Taker Mentoring Trading Path be your options trading guide.
The MTM Trading Path
The MTM Trading Path is a simple, but powerful proprietary options trading system designed to be a veritable options trading guide that outlines a step-by-step a plan for options trading. There are a total of twelve steps in this options trading system which begins with observing the market and discovering opportunities.
Options trading is, of course, more involved than stock trading. Specifically, there are two steps in this options trading guide that are not in a conventional trading plan. These steps center around analyzing volatility and selecting among the various strategies.
An iron condor occurs when a trader combines a bear call spread and a bull put spread. It is essentially combining two credit spreads as one trade. The trade is executed by buying a lower-strike out-of-the-money put and selling an out-of-the-money put with a higher strike. Then the trader sells an out-of-the-money call with a higher strike and buys another out-of-the-money call with an even higher strike. Learning to trade more advanced option strategies like an iron condor is not essential for option traders but it can give you more means in which to possibly extract money from the market.
A short iron condor consists of four legs as described above and results in a net credit received. As for profit potential, the maximum potential profit is the initial credit received upon entering the trade. This profit will occur if the underlying stock price, on expiration date, is between the two middle (short) strikes.
One of the rationales behind selling an iron condor is implied volatility (implied volatility is – simply defined – the volatility component of an option price). When IV is inflated (meaning the implied volatility has pushed the option price higher) it lifts the premium values for option sellers. In addition, the profitable range on the short iron condor can be rather large depending on how it is implemented. Certainly the larger the profitable range, the smaller the maximum profit and the greater the risk. The smaller the profitable range, the larger the maximum profit will be and there will be less overall risk but there is less of a chance the underlying will remain in that range. Like many spreads in option trading, there is a trade-off.
One of the benefits of a short iron condor (and potentially options in general) is limited risk. For short condors, the maximum loss comes when the underlying stock price drops below the lowest strike (long put) or above the highest strike (long call). If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or the two higher-strike options) less the initial credit for entering the trade.
Being that earnings season is mostly behind us, it is not a major concern at this time. But when the season does return (and it will), it may be best to construct the iron condor to expire before the actual announcement. If not, then it may be best to exit the trade before the announcement especially if the trade is profitable up to that point.
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.