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June 6, 2013

A Naked AAPL Call

Filed under: Options Education — Tags: , , , , , , , , — Dan Passarelli @ 11:46 am

A naked call strategy is defined as an option strategy where a trader sells (writes) call options without owning the underlying stock. Some option traders may refer to this strategy as an “uncovered call” or “short call.”

The goal of the naked call is for the trader to collect premiums if the option expires worthless. A trader could sell an out-of-the-money (OTM) naked call each month and pocket premiums, provided the stock price either stays flat or drops. This process could continue as long as the stock remains below the strike price. For those interested in learning all the ins and outs of naked calls and possibly safer alternatives, please visit the Learn To Trade section of our website.

The Specifics
The maximum gain for selling a naked call is limited to the premium received for the call option. With that being said, the loss potential is unlimited – as the stock can rise indefinitely in theory. If the underlying stock’s price is above the strike price at expiration, it will result in the trader having to sell the stock at the strike price (which will be lower than the market price or current price).

A loss on the trade can occur if the stock price rises. If the price of the underlying stock is greater than the short call’s strike price plus the premium received at expiration, the option should probably be bought back to close the trade. If not, when the option is assigned and a short-stock position is acquired, further losses are possible. On the flip side, the maximum profit is achieved when the underlying stock is less than or equal to the strike price of the sold call at its expiration.

An Example
For this specific example, we will take a look at Apple (AAPL) – which is trading right around $440 at the time of this writing. A June 445 call carries a bid price of 7.50. If the stock remains below the strike price (445) by expiration, the call expires worthless and the call seller keeps the $7.50 in premium (less any commissions). The problem is if the stock rallies through the strike price at expiration, the call will be assigned, resulting in a short sale of 100 shares at $445. With the stock at $470, that would represent a loss of $25 a share, or $2,500. Subtract the $750 received in premium and the total loss comes to $1,750.

With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A, perhaps, safer way to structure a trade with a similar risk profile is to sell a call credit spread. Selling a call spread will be discussed in future posts.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 23, 2013

Risk/Reward is Ever Changing

Filed under: Options Education — Tags: , , , , , , , , , — Dan Passarelli @ 1:35 pm

There are quite a few option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or lack of movement in price of the stock.  Examples of such strategies include the sale of naked options  and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three main forces, the initial risk:reward calculation often changes and sometimes even dramatically.  The successful trader with a proper options education is aware of these changes, because the risk to gain the last bit of potential profit is often dramatically out of whack to the magnitude of the profit he or she seeks to obtain.

Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller.  This trader has chosen to sell out-of-the-money (OTM) puts, the June $385 strike, on AAPL which currently trades at $440 in this example.  His risk in the trade is that he is obligated to buy AAPL at the strike price at any time between opening the trade and June expiration.  For taking the risk of writing these puts, his account receives a credit of $1.10 and margin is encumbered based on SEC rules.  The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.

As June expiration approaches, the stock remains at the $440 level and the market price of the puts he has sold decreases as a result of time (theta) decay.  As the price of the puts decreases and the profits increase, the risk:reward increases.  As the price declines below the often used 20% re-evaluation benchmark of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial and may no longer be appropriate given the reward.

The experienced options trader will many times take profits and find opportunities to invest his or her money in other trades that appear to be much more attractive from a risk/reward standpoint than to remain in the existing position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 16, 2013

Reviewing Strangles with AAPL

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 11:49 am

There is no doubt we have discussed straddles in the past in this blog. A straddle is an option 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 trader 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 (which makes up a straddle), the trader 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 (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

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

March 14, 2013

Six-Year Low in the VIX? What’s It Mean to YOUR Options Trading?

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

The VIX, or CBOE’s Implied Volatility Index, hit a six-year low this week. What’s that mean to options trading? Lots!

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

February 7, 2013

Stop AAPL in Time

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 11:28 am

Learning to trade options offers 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  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 moderate risk by the astute 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 obviously apparent the time course that the decay curve will follow.  An option trader has to take into account that the 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 March 470 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -595 for approximately $22,000 as I write this.

At the time of this writing, the stock is trading around $459; these puts are therefore $11 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 $462 at expiration. The options expiration risk is $14,000 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 $462 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 totally eroded away.

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

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 24, 2013

Naked Puts on AAPL Stock

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 11:30 am

The Strategy
If you want to learn to trade here’s a really useful option strategy that all traders should know. Let’s take a look at an option strategy that involves the selling of a put, often referred to as an uncovered put write or a naked put write. A naked put write is when a trader sells a put that is not part of a spread. This strategy is generally considered to be a bullish-to-neutral strategy.

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). Apple just recently announced earnings and the stock dropped over $50. For this example we will assume the stock is trading around $460 a share. A trader sells the March 435 put, which carries a bid price of $10.00 (rounded to make the math a bit easier). Should AAPL stock be trading above $435 a share at expiration, the March 435 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 even more after earnings?

If  AAPL falls another $50 to $410 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 420 put expired with $25 in intrinsic value. The trader loses the $25, less the $10 premium collected results in a loss of $15, or $1,500 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

January 10, 2013

Moneyness and AAPL

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 1:49 pm

Moneyness isn’t a word, is it? Dan uses it often and he even has a section about it in his books. It won’t be found on spell-check, but moneyness is a very important term when it comes to learning to trade options. There are three degrees, if you will, of moneyness for an option, at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let’s take a look at each of these terms, using tech behemoth Apple (AAPL) as an example. At the time of writing, Apple was hovering around the $520 level, so let’s define the moneyness of Apple options using $520 as the price.

At-the-Money
An at-the-money AAPL option is a call or a put option that has a strike price about equal to $520. The ATM options (in Apple’s case the 520-strike put or call) have only time value (a factor that decreases as the option’s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time.

In-the-Money
An option that is in-the-money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of AAPL, ITM options include the 515 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.

A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, an ITM AAPL put carries a strike price of 525 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a January AAPL 530 put has a premium of $14.20 compared to a price of $11.10 for a January 525 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 515 call and AAPL closed at $520 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $515 a share.

Out-of-the-Money
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher than the market price of the underlying, and puts are OTM when their strike price is lower than the stock’s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.

If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 6, 2012

Selling AAPL Puts: Naked or as a Spread

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

One of the bullish strategies in the arsenal of an options trader is that of selling puts. Many traders have have heard of this strategy but are unfamiliar with the nuances and need more options education before possibly implementing them.  The sale can be accomplished either as naked sales (aka selling “cash secured” puts when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or simply selling a put spread).

The requirement 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 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 whose recent sell-off has sparked interest in puts. A trader who sells a December 555 strike put to another trader holding an underlying currently trading at $550 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 (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 and more conservative strategy is to sell a put spread.  When a trader sells a put spread, the fundamental profit is still short sale of the put at the selected strike price.  However, as contrasted to the naked put sale, an additional position is taken to lower the risk and to reduce the margin.  The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration.  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.  However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in stock 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 21, 2012

Going Vertical in AAPL

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 11:04 am

One of the basic directional spreads when learning to trade 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 December expiration, a put credit spread can be established by selling the December 540 put and buying the December 530 put.  As this is written with 31 days to expiration, the maximum potential return is 30% and is achieved as long as AAPL remains above the short put strike of 540.  Maximum risk is defined by the long 530 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 16, 2012

There’s a Time for Everything: Thoughts on AAPL Option Strategies

Filed under: Options Education — Tags: , , , , , , , , , , , , , — Dan Passarelli @ 3:28 pm

Do you know how many different types of options strategies there are? A lot: That’s how many! But that’s not really the important question. More importantly: Do you know why there are so many different types of options strategies? Now we have something to discuss and getting a proper options education can help a trader better understand all of those strategies and when and how to use them.

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish AAPL traders. Now that the stock has severely declined in price, there are traders who are extremely bullish on AAPL and want to get more bang for their buck and buy short-term out-of-the-money calls. Less bullish traders might 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. With the holidays approaching, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the New Year!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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