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August 20, 2015

Choosing Between Different Risk/Reward Scenarios

As an option trader, you have so many different strategies and risk/reward scenarios to think about before initializing a trade. Many of my students in my Group Coaching class as well as my one-on-one students ask me all the time how do you decide between buying a debit spread and selling a credit spread as one example. Let’s take a look at a scenario below and some things for an option trader to think about.

Risk and Reward

A debit spread such as a bull call spread or a bear put spread is considered to have a better risk/reward ratio then a credit spread such as a bull put spread or a bear call spread depending on how it is initiated. Usually the reason is because the debit spread is implemented close to where the stock is currently trading with an expected move higher or lower. A credit spread is usually initiated out-of-the-money (OTM) in anticipation the spread will expire worthless or close to worthless with the underlying barely moving. Here is a recent example I talked about with a student less than a week ago. LinkedIn Corp (LNKD) was trading around $187.50 last week. The stock looked like it could drop lower. The trader could consider buying a bear put or selling a bear call spread.

If the option trader expected a move lower into the close of Friday, he or she could have considered buying a 185/187.5 debit spread for August expiration (4 days). If the 187.5 put cost the trader 2.25 and 1.15 was received for selling the 185 put, the bear put (debit) spread would cost the trader $1.10 (also the maximum loss if the stock is at $187.50 or higher at expiration) and have a maximum profit of $1.40 (2.50 (strike difference) – 1.10 (cost)) if the stock was trading at or below $185 at expiration. Thus the risk/reward ratio would be 1/1.27.

If the option trader was unsure if the $187.50 stock was going to move lower but felt the stock would at least stay below a resistance area around $190 by August expiration, the trader could sell a 190/192.5 credit spread with August expiration. If a credit of 1.00 was received for selling the 190 call and it cost the trader 0.50 to buy the 192.5, a net credit would be received of $0.50 for selling the bear call (credit) spread. The maximum gain for the spread is $0.50 if the stock is trading at $190 or lower at expiration and the maximum loss is $2 (2.50 (strike difference) – 0.50 (premium received)) if the stock is trading at or above $192.50 at expiration. Thus the risk reward ratio would be 4/1.

Probability

The risk/reward ratio on the credit spread (4/1) does not sound like something an option trader would strive for does it? Think of it this way though, the probability of the credit spread profiting are substantially better than the debit spread. The debit spread most certainly needs the stock to move lower at some point to profit. If the stock stays around $187.50 or moves higher, the puts will expire worthless and a loss is incurred from the initial debit ($1.10). With the credit spread, the stock can effectively do three things and it would still be able to profit. The stock can move below $187.50, trade sideways and even rise to just below breakeven at $190.50 (190 (sold call) + 0.50 (initial credit)) at expiration and the credit spread would profit. Of course if it closes at $190 or lower, the maximum profit of $0.50 is achieved because the spread expires worthless. A loss is only realized if the stock closes above the breakeven level of $190.50. I like to say OTM credit spreads have three out of four ways of making money and debit spreads usually have one way of profiting especially if the underlying is basically around the long option when the spread is initialized.

Conclusion

There are several more factors to consider when choosing between a debit spread and a credit spread like time until expiration, implied volatility and bid/ask spreads just to mention a few. We will talk about these other factors in future blogs. The risk/reward of the spread and the probability of the trade profiting are just a few to consider mentioned above. A trader always wants to put the odds on his or her side to increase the chances of extracting money from the market. The credit spread can put the odds substantially on the trader’s side but it comes at a cost of a higher risk/reward ratio.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 13, 2015

Have Your Stocks Taken a Hit?

It has been a tough couple of weeks for bullish traders and investors as several events have moved the market and stocks lower. Some stock buyers are waiting for some of their losers to rally and some are buying more stock at cheaper prices. But as most experienced investors know, the market can always go lower now or in the future. Here is one option strategy that can make sense in some cases; the stock repair strategy.

Introduction to the Stock Repair Strategy

The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits

There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy

Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example

An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next three months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the September options.

The trader buys 1 November 60 call at 6 and sells 2 November 70 calls at 3. The spread is established cash-neutral.

Bought 1 Nov 60 call at 6
Sold 2 Nov 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. The P&L diagram below shows how the position functions if held until expiration.

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy

The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Some stocks that have experienced recent declines may be excellent candidates for the stock repair. For others, the stock repair strategy might not be appropriate. For stocks that look like they are finished or may even head lower, the Stock Repair Strategy can’t help – just take your lumps! But for those that might slowly climb back, just partially, this can be a powerful option strategy to recoup all or some of the losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 25, 2015

Long Calls and Bull Call Spreads

With Nasdaq trading around all-time closing highs and the S&P 500 currently threatening its all-time highs recently, it probably makes sense to keep at least a moderately bullish bias towards many stocks. The market is due for some type of pullback, but who knows when that will happen. Even if it does pullback sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.

Definition

When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching just a couple of weeks ago. Tesla Motors (TSLA) moved up to a resistance area right around $250, formed a bullish base and then closed above resistance at around $253. With implied volatility (IV) generally being low, which is advantageous for purchasing options as with a bull call spread, and a directional bias, a bull call spread can be considered.

The Math

The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that at the time one June 255 call was purchased for 8.00 and one June 260 call was sold for 6.00 resulting in a net debit of $2 (8 – 6). The difference in the strike prices is $5 (260 – 255). He would subtract $2 from $5 to end up with a maximum profit of $3 per contract. So if he traded 10 contracts, you could make $3,000 (10 X 300).

Although he limited his upside, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to trade at $257 (the strike price of the purchased call (255) plus the net debit ($2)) at expiration.

Advantage Versus Purchasing a Call

When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the out-of-the-money June 255 call, he would have paid $8. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.

Conclusion

By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 19, 2015

Your Overall Option Delta

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context, one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

What many traders fail to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock is trading at $128 and purchases 3 March 130 call options. Each call contract has a delta of +0.40. The total delta of the position would then be +1.20 (3 X 0.40) and not just 0.40. For every dollar AAPL rises all factors being held constant again, the position should profit $120 (100 X 1 X 1.20). If AAPL falls $2, the position should lose $240 (100 X -2 X 1.20) based on the delta alone.

Using AAPL once again as the example, lets say a trader decides to purchase a March 130/135 bull call spread instead of the long calls. The delta of the long $130 call is once again 0.40 and the delta of the short $135 call is -0.22. The overall delta of the position is 0.18 (0.40 – 0.22). If AAPL moves higher by $3, the position will now gain $54 (100 X 3 X 0.18) with all factors being held constant again. If AAPL falls a dollar, the position will suffer a $18 (100 X -1 X 0.18) loss based on the delta alone.

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 22, 2015

Hedging Risk in Potential Take-Over Stocks

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.

Example

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.

Wrap Up

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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 15, 2014

Debit Spread Versus Credit Spread

Students in my Group Coaching class as well as my one-on-one students ask me all the time how do you decide between buying a debit spread and selling a credit spread? This is inherently a discussion that could fill a thick book so I will just try to give you a few thoughts to consider.

Risk and Reward

A debit spread such as a bull call spread or a bear put spread is considered to have a better risk/reward ratio then a credit spread such as a bull put spread or a bear call spread. Usually the reason is because the debit spread is implemented close to where the stock is currently trading with an expected move higher or lower. A credit spread is many times initiated out-of-the-money (OTM) in anticipation the spread will expire worthless or close to worthless. For example, if a stock is trading at $50 and an option trader expects the stock to move about $5 higher the trader could buy a 50 call and sell a 55 call. If the 50 call cost the trader $5 and $3 was received for selling the 55 call, the bull call (debit) spread would cost the trader $2 (also the maximum loss) and have a maximum profit of $3 (5 (strike difference) – 2 (cost)) if the stock was trading at or above $55 at expiration. Thus the risk/reward ratio would be 1/1.5.

If the option trader was unsure if the $50 stock was going to move higher but felt the stock would at least stay above a support area around $45 the trader could sell a 45 put and buy a 40 put. If a credit of $1 was received for selling the 45 put and it cost the trader $0.50 to buy the 40 put, a net credit would be received of $0.50 for selling the bull put (credit) spread. The maximum gain for the spread is $0.50 if the stock is trading at $45 or higher at expiration and the maximum loss is $4.50 (5 (strike difference) – 0.50 (premium received)) if the stock is trading at or below $40 at expiration. Thus the risk reward ratio would be 9/1.

Probability

The risk/reward ratio on the credit spread does not sound like something an option trader would strive for does it? Think of it this way though, the probability of the credit spread profiting are substantially better than the debit spread. The debit spread most certainly needs the stock to move higher at some point to profit. If the stock stays at $50 or moves lower, the calls will expire worthless and a loss is incurred from the initial debit ($2). With the credit spread, the stock can effectively do three things and it would still be able to profit. The stock can move above $50, trade sideways and even drop to $45 at expiration and the credit spread would expire worthless and the trader would keep the initial premium received ($0.50). I like to say OTM credit spreads have three out of four ways of making money and debit spreads usually have one way depending on how the spread is initiated.

Implied Volatility

Another thing to consider when considering either a debit or credit spread is the implied volatility of the options. In general, when implied volatility is low, options are “cheap” which may be advantageous for buying options including debit spreads. When options are “expensive”, it may be advantageous to sell options including credit spreads. Option traders that are considering selling a credit spread should also take into account if the implied volatility is perceived as being high. Just the opposite, option traders that are considering buying a debit spread prefer the implied volatility to be low. As a general rule of thumb, I look at the 30-day IV over the last year and make note of the 52-week high and 52-week low. If the current 30-day IV is below 50% (closer to the 52-week low), I look at it is more of an advantage to do a debit spread over a credit spread. If the current 30-day IV is above 50% and closer to the 52-week high, I look at it as an advantage to implement a credit spread over a debit spread. I will not change my outlook like switching to a debit spread from a credit spread because the IV is relatively low. If this is the case, an option trader should maybe consider looking somewhere else for profit.

There are several factors to consider when choosing between a debit spread and a credit spread. The risk/reward of the spread, the probability of the trade profiting, the implied volatility of the options and the outlook for the underlying are just a few to consider. A trader always wants to put the odds on his or her side to increase the chances if extracting money from the market.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 1, 2014

Long Calls and Bull Call Spreads

With the Dow and S&P 500 falling just off their all-time highs recently and yet refusing to move much lower at this point, it probably makes sense to keep at least a few bullish trade ideas in your trading stable. The market is due for some type of bigger correction, but who knows when that will happen. Even if it does pullback sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.

Definition

When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching just about a month ago. In late August, Tesla Motors (TSLA) moved up to a resistance area right around $260, formed a bullish base and then closed above resistance at around $263. With implied volatility (IV) generally being low at the time, which is advantageous for purchasing options as with a bull call spread, and a directional bias, a bull call spread was considered.

The Math

The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that at the time one September 265 call was purchased for 8.00 and one September 270 call was sold for 6.00 resulting in a net debit of $2 (8 – 6). The difference in the strike prices is $5 (270 – 265). He would subtract $2 from $5 to end up with a maximum profit of $3 per contract. So if he traded 10 contracts, he could make $3,000 (10 X 300).

Although he limited his upside, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to trade at $267 (the strike price of the purchased call (265) plus the net debit ($2)) at expiration.

Advantage Versus Purchasing a Call

When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the out-of-the-money September 265 call, he would have paid $8. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.

Conclusion

By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 17, 2014

Long Calls and Bull Call Spreads

With the Dow and S&P 500 falling just off their all-time highs recently and yet refusing to move much lower at this point, it probably makes sense to keep at least a moderately bullish bias towards many stocks. The market is due for some type of pullback, but who knows when that will happen. Even if it does pullback sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.

Definition

When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching just a couple of weeks ago. Tesla Motors (TSLA) moved up to a resistance area right around $260, formed a bullish base and then closed above resistance at around $263. With implied volatility (IV) generally being low, which is advantageous for purchasing options as with a bull call spread, and a directional bias, a bull call spread can be considered.

The Math

The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that at the time one September 265 call was purchased for 8.00 and one September 270 call was sold for 6.00 resulting in a net debit of $2 (8 – 6). The difference in the strike prices is $5 (270 – 265). He would subtract $2 from $5 to end up with a maximum profit of $3 per contract. So if he traded 10 contracts, you could make $3,000 (10 X 300).

Although he limited his upside, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to trade at $267 (the strike price of the purchased call (265) plus the net debit ($2)) at expiration.

Advantage Versus Purchasing a Call

When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the out-of-the-money September 265 call, he would have paid $8. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.

Conclusion

By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 15, 2014

Delta and Your Overall Position

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

An important thing to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock is trading at $590 and purchases 3 June 590 call options. Each call contract has a delta of +0.50. The total delta of the position would then be +1.50 (3 X 0.50) and not 0.50. For every dollar AAPL rises all factors being held constant again, the position should profit $150 (100 X 1 X 1.50). If AAPL falls $2, the position should lose $300 (100 X -2 X 1.50).

Using AAPL once again as the example, lets say a trader decides to purchase a 590/600 bull call spread instead of the long calls. The delta of the long $590 call is once again 0.50 and the delta of the short $600 call is -0.40. The overall delta of the position is 0.10 (0.50 – 0.40). If AAPL moves higher by $5, the position will now gain $50 (100 X 5 X 0.10). If AAPL falls a dollar, the position will suffer a $10 (100 X -1 X 0.10) loss.

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

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 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. 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 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

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