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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 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

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

November 10, 2011

Stop Me In Time

Filed under: Uncategorized — Tags: , , , , — Dan Passarelli @ 9:59 am

 Options offer a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely and to do so with surgical precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.

However, a less frequently discussed aspect of risk control is the ability to mitigate risk by the judicious use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.

As a direct result, it is not intuitively apparent the time course that the decay curve will follow.  A corollary of this is that option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.

As a simple example, consider the case of a short position in AAPL established by buying in-the-money November 390 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -608 for approximately $11,300 as I write this.

At the time of this writing, the stock is trading around $384.50; these puts are therefore $5.50 in-the-money.  Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $387 at expiration. The options expiration risk is $8,300 or more. However, if the trader takes the position that the expected/feared move will occur quickly—long before expiration—he could implement a time stop as well.

Using a stop to close the position if the stock gets to $387 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t wreaked too much havoc.

Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.

November 3, 2011

Juicing Volatility in Apple (AAPL)

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 10:27 am

Over half of 2011 has been characterized by a low implied volatility (IV) environment in virtually all underlying securities.  This milieu ended suddenly and abruptly on the recent sell-off that started towards the end of July and IV generally remains significantly elevated above its recent nadir due mostly to the European debt and banking crisis.

An example of the recent rise in IV can be seen in Apple ( AAPL ).  This underlying spent most of 2011 with options trading at IV’s of 30 percent or below.  Since August, the options have begun trading in the range of an IV of 30 percent and higher–even as high as 52 percent. Since its peak in October, IV has steadily declined to its current level of 32 percent at the time of this writing.

In October at the height of IV, traders need to be on guard and conscious of the fact that volatility could decline and possibly their long option premiums.  It is important to recognize that positions characterized by being long volatility (positive vega trades), especially long calls, will likely be negatively impacted by increasing prices since IV is generally inversely related to price.

Option strategists wanting to take a bullish position in AAPL may want to consider trade structures which offset much, if not all of the impact of decreasing IV.  In optionspeak, this can be described as reducing the vega of the position. Such strategies could include buying a debit call spread as opposed to a single-legged long call position. This technique is referred to as volatility hedging. More on this in future blog posts.

October 27, 2011

Option Delta and Apple (AAPL)

Filed under: Options Education — Tags: , , — Dan Passarelli @ 9:22 am

Option Delta and Apple ( AAPL )
Apple (NASDAQ: AAPL) sure is making a lot of news lately, what with the company’s earnings report and the introduction of the new Apple iPhone 4S. One may expect the Apple iPhone 4S to push the stock higher (after this dip), but some may believe the rebound will be still short-lived. Perhaps a smart move is to purchase a short-term, out-of-the-money option on the equity – let’s look for an option with a delta greater than 20 on Apple and see how the option could play out.

Option Delta and the Trade
First, let’s define option delta before we go into the option play. Option delta is a ratio that compares a stock’s change in price to the corresponding price change in said stock’s option. For this example, we are going to use the Apple November 425 call that has about an option delta of 23 percent.

What does the 23 percent mean? Let’s convert the option delta into dollars to see. This percentage means that this particular Apple option will gain or lose value just like 23 percent of 100 shares of Apple as the price changes. Look at the definition this way if it is easier, for every $1 Apple advances; the call option will increase 23 cents attributable to delta. So, Apple is currently trading at around $405 (rounded for simplicity) and we have purchased the 425 call. We need the call to advance past $425 in order (which is not out of the) for the option to be in-the-money, but can we benefit from a rally that falls short of $425?

The Benefit of Option Delta
Apple is a major momentum stock, just look at what happens after good news – more often than not the stock rallies. In fact, I don’t think it is a stretch to say that the stock often moves quite a bit. Look at 2009 when Apple dropped as low as the 78 region in late January then rallied to finish the year above $210. That is a major gain.

Playing the November 425 call affords a trader the chance to make money in the case that the stock rallies. If the stock hits $425, that means it has moved 20 points. Take the 20 points and multiply that by 23 cents (option delta of .23) and you have a move of $4.60 in the call (20 X 0.23).

Conclusion
By looking at the option delta, we were able to have clear expectations for option profit based on stock movement. Does this mean that playing the delta is a fool-proof to analyze an option? No. There are other important pricing factors that affect the value of an option, too. Time (theta), volatility (vega) and more also play an important role. Delta is just one of the greeks that can be taken into account when looking for the right option to purchase. Make sure to do your homework so you can enter the option game prepared to succeed.

July 6, 2010

Up And Down With Volatility: AAPL For The Teacher

Filed under: Options Education — Tags: , — Dan Passarelli @ 9:00 pm

Implied volatility is a major determinate of the magnitude of the extrinsic option premium.  Considered together with time, these two factors act in concert to define the pricing of the time value (extrinsic value) of options.

Two characteristics of implied volatility are reproducibly reflected in option pricing: 1.The inverse relationship of price of the underlying security, and 2.The correlation of implied volatility with the rapidity of the price movement. The largest movements in implied volatility are therefore to be expected in a rapid downward price move of the underlying security.

Because vertical volatility skew results in an array of implied volatility values it is helpful to consider the generally accepted reference point. This benchmark value of implied volatility is the average of the implied volatility values for the at-the-money front month strikes in all but the last week of the options cycle.

It is always helpful to return to these basic concepts when significant movement occurs in order to be certain the conceptual relationships are maintained.  Departure from the expected behavior is often an important clue to something nefarious afoot, as it was in the famous Sherlock Holmes investigation of the disappearance of the race horse, Silver Blaze, wherein the critical clue was that of the dog who didn’t bark.

Last Tuesday sell off in AAPL proves to be instructional when considered in light of the effects on implied volatility.  AAPL closed Monday at $268.30 and the IV was 35%.  AAPL gapped down Tuesday morning and by 1:00 PM was trading at $256.91 with option implied volatility of 40%. On the basis of Monday’s closing price and implied volatility values, this price represented a move of greater than 2 standard deviations.

IV responded as predicted by the usual relationship. The dog barked.

Bill Burton

Writer, Market Taker Mentoring LLC

April 26, 2010

A Penny Here, A Penny There

Filed under: Options Education — Tags: , , — Dan Passarelli @ 2:12 pm

One of the more difficult problems with which to deal for an options trader has historically been the broad bid-ask spreads quoted for options. Experienced traders have routinely negotiated the bid-ask spreads downward with varying success when trading individual positions, but the non-economic price has been the significant effort and time required to achieve these negotiated results.

Beginning in January2007, CBOE initiated a Pilot Program to reduce bid-ask spreads to as low as 1¢. From its inception in the options of Whole Foods, symbol WFMI. There are currently 216 in the series (including such big names as Apple, AAPL and more) quoted in these penny increments with another 75 slated to join the penny program on May third of this year. CBOE maintains an Excel file of option series currently included within this “Penny Pilot” program at: http://www.cboe.org/hybrid/pennypilot.aspx

Because option positions are frequently constructed with several individual legs, the impact of the ability to trade with tighter bid-ask spreads can have significant impact on the aggregate slippage of positions. Combined with the falling commission rates resulting from the increasingly intense completion amongst brokers specializing in options, significant trading efficiencies have resulted.

January 27, 2010

Can Apple ( AAPL ) Stock Fall After the Tablet Computer’s Release?

Filed under: Uncategorized — Tags: , , , — Dan Passarelli @ 5:00 pm

You Tablet, iTablet, We All Tablet for the Apple iPad Tablet Tech heads and computer geeks the world around will focus their attention toward San Francisco, California on January 27, 2010 with breathless anticipation toward Apple’s ( NASDAQ: AAPL ) unveiling of its new tablet-style computer.  With Steve Jobs making a run for world-wide domination of media (online music, online videos, books, movies, and games) – is there even the slightest chance that the stock could fall?

Technically Speaking
When looking at the potential for a stock as it heads into a news event (like the release of the Apple tablet computer), it is often best to take a look at technical performance. One can not deny how solid Apple performed in 2009, does this past performance indicate that the coming 11 months will be the same? Well, let’s take a look.

Since hitting a 2009 nadir in the 78 region, the stock has gained more than 150% – pretty good performance. However, could this performance be setting up a bear run? Well, the stock is in uncharted territory, trading in rarified air in a historical perspective. The closest potential historic support for Apple is its 50-day moving average. This trendline has done a decent job helping usher the stock higher, and the announcement of the Apple tablet computer should help strengthen this trendline’s resolve. With the equity in the process of rebounding off this trendline, one could expect technical history to repeat itself.

Raging Bulls
That said, is there any reason to believe the stock could drop? Any reason for Apple to fall after releasing its new tablet computer? Perhaps, stick with me here. Researching the stock a bit we find that a massive 40 analysts follow the equity. What is even more massive is the amount of “strong buy” rankings Apple receives – 30. Moreover, nine of the remaining analysts rate Apple a “hold” or better. With analyst coverage this bullish, there is little room for the stock to benefit from upgrades. In fact, an upgrade from the lone bull would be like dumping a tablespoon of salt in the ocean … in other words, the impact would be minimal.

With very little chance for upgrades, the downgrade potential is massive. What if the Apple tablet computer fails miserably? What if analysts hate the Apple tablet computer? What if the public doesn’t want to pay the money for the Apple tablet (perhaps not likely, but…)? Could any of these actions lead to downgrades? Yes. Could these downgrades act like an anchor to the stock? Yes. Of course, it is nice to see various levels of technical support residing under Apple shares. Not only is there the stock’s 50-day moving average, but it also could rely on the 200 level, its 10-week moving average (which is slightly below the shares), or its 10-month moving average (much lower than the current position) if need be.   

Conclusion
At one point in time, people referred to Apple as a recession-proof stock. Is this the case? Perhaps. It certainly seems that analysts and investors feel the stock is bulletproof. I guess we will find out for sure.