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December 18, 2013

Strangles and AAPL

Today we are going to discuss an option strategy that you may not have thought about in quite some time. 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 $540 after a volatile couple if weeks. The trader would buy both a January 545 call and a January 535 put. For simplicity, we will assign a price of $17 for both – resulting in an initial investment of $34 for our trader (which again is the maximum potential loss).

Should the stock rally past $545 at expiration, the 535 put expires worthless and the $545 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 $38, the profit is $4 (intrinsic value less the premium paid). The same holds true if the stock falls below $535 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 $34, or $3,400 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.

I hope you have a safe and very Happy Holiday!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 16, 2013

Reviewing Strangles with AAPL

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

January 10, 2013

Moneyness and AAPL

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

November 16, 2012

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

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

September 20, 2012

Bull Call Spread vs. Purchasing a Call on AAPL

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. To learn to trade more option strategies, please visit our website.

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 $700 as an example. In this case you would purchase October calls at the 700 at-the-money strike at the ask price of $20. You would then sell the same number of October calls with a higher strike price, in this case 720 at the bid, $11.

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 October 700 call and sold one October 720 call resulting in a net debit of $9 (that’s $20 – $11). The difference in the strike prices is $20 (720 – 700). You, therefore, subtract 9 from 20 to end up with a maximum profit of $11 per contract. So, if you traded 10 contracts, you could make $11,000.

Although you limited your upside, you also limited the downside to the net debit of $9 per contract. To simply breakeven, the stock would have to trade at $709 (the strike price of the purchased call (700) plus net debit ($9)).

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 October 700 call you would have paid 20. 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring