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April 15, 2014

Ever Consider a Bear Put Spread?

The market has been on quite a run lower lately since the S&P 500 hit its all-time high earlier this month. Maybe the market will reverse and move higher at some point but traders need to be prepared like Boy Scouts just in case there is another move lower not only now, but for in the future as well. Options give traders a plethora of options so to speak for a trader with a bearish bias. Bearish directional option strategies are certainly an option but sometimes buying a put option can be a little bit more risky than maybe a trader wants because of potential price swings. A bearish option trader may want to be a little more cautious especially in this current volatile atmosphere.

An Alternative

A better alternative than the long put may be to buy a debit spread (bear put). A bear put spread involves buying a put option and selling a lower strike put option against it with the same expiration. The cost of buying the higher strike put option is somewhat offset by the premium received from the lower strike that was sold. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The options trader will realize this maximum gain if the price of the stock is lower than the short put’s strike expiration. The most the options trader can lose is the cost of the spread. This maximum loss will occur if the stock is trading above the long put’s strike at expiration.

An Advantage

An advantage of a bear put spread is that if the stock pulls back, the spread will lose less than just being long puts

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because of the spread typically has smaller delta and initial costs due to being long and short options. The trade’s delta is smaller because the positive larger delta of the long put option is somewhat offset by the smaller negative delta of the short put option. For example, what if XYZ stock is trading at $40 a share and an option trader purchases an ATM put option ($40 strike) with a delta of 0.50. For every dollar XYZ goes up or down, the put option should increase or decrease by $0.50. If a bear put debit spread was created by adding a short put with a lower strike price of 35 and delta of 0.20, the delta for the spread would now be 0.30 (.50 – .20). Now the spread would gain or lose $0.30 for every dollar the stock went up or down.

Trade-Off

It is probably obvious to a great many of you how a smaller delta might be a disadvantage for the trade. If the trader is correct on the movement and the stock decreases in value, potentially a larger profit could be realized with just being long the put option because of the potential higher delta. But once again a trader needs to determine if a lower overall cost using the bear put and possibly a lower overall risk is worth the trade-off versus the long put.

Finally

Understanding current market conditions (especially now) and applying and managing the proper options strategy is crucial for success at all times. Deciding when to implement a bear put spread instead of buying puts for a bearish bias is just one example of this.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 3, 2014

Different Option Strategies on AAPL

Compared to trading stocks, there are so many more strategies available to an option trader. But more importantly: Do you know why there are so many different types of options strategies? This is the real reason of our discussion and why getting a proper options education can help a trader better understand all of those strategies and when and how

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Different options strategies exist because each one serves

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a unique purpose for a unique market condition. For example, take bullish AAPL traders. The stock has recently moved higher after declines in January and February. There are traders who continue to be extremely bullish on AAPL as it heads closer to its earnings announcement and want to get more bang for their buck and buy short-term out-of-the-money calls. This might not be the most prudent way to capture profits but that is a discussion for another time. 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 (which it currently is not but it has been rising) and the trader is bullish just to a point, the trader might sell a bull put spread (credit spread), and so on.

The differences in options strategies, no matter how apparently minor, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the

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profitability (or potential loss) of an option position and, in turn, structure a position that addresses each difference. 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 defining your outlook and intentions and selecting the best 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 spring hopefully ending soon (cold and snowy winter here in Chicago)and supposedly the volatile markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the summer season!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 13, 2014

AAPL Options and Moneyness

Dan Passarelli often uses the word “moneyness” and he even has a section about it in his books. Moneyness isn’t a word, is it? 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 $535 level, so let’s define the moneyness of Apple options using $535 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 $535. The ATM options (in Apple’s case the 535-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 530 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 540 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a March AAPL 545 put has a premium of $11.50 compared to a price of $7.95 for a March 540 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

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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

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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.

Have a great week of trading!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring