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May 29, 2014

Implied Volatility is a Big Factor for Bull Put Spreads

Even though implied volatility has been relatively low in the market, there will be a day when it does rise again. Implied volatility (IV) by definition is the estimated future volatility of a stock’s price. More often than not, IV increases during a bearish market and decreases during a bullish market. The reasoning behind this comes from the belief that a bearish market is more risky than a bullish market. The jury is still out on whether this current bullish market can continue through the summer but regardless, now may be a good time to review a strategy that can take advantage of higher implied volatility even if it doesn’t happen this week. Option traders need to be prepared for all types of trading environments.

Reasoning and Dimensions

Selling bull put spreads during a period of high implied volatility can be a wise strategy, as options are more “expensive” and an option trader will receive a higher premium than if he or she sold the bull put spread during a time of low or average implied volatility. In addition, if the implied volatility decreases over the life of the spread, the spread’s premium will also decrease based on the option vega of the spread. Option vega measures the option’s sensitivity to changes in the volatility of the underlying asset. The implied volatility may decrease if the market or the underlying moves higher.

Outlook and the VIX

Let’s take a look at an example of selling a bull put spread during a time of high implied volatility. In this make-believe environment, the CBOE Market Volatility Index (VIX) has recently moved from 12 percent to about 18 percent in about two weeks which was accompanied by a decline in the market over that same time period. The VIX measures the implied volatility of S&P 500 index options and it typically represents the market’s expectation of stock market volatility. Usually when the VIX rises, so does the implied volatility of options. Despite the drop, let’s say a trader is fairly bullish on XYZ stock. With the option premiums increased because of the implied volatility increasing, a trader decides to sell a bull put spread on XYZ, which is trading around $53 in this example.

Selling the Spread

To sell a bull put spread, the trader might sell one put option contract at the 52.5 strike and buy one at the 50 strike. The short 52.5 put has a price of 1.90, in this example, and the 50 strike is at 0.90. The net premium received is 1.00 (1.90 – 0.90) which is the maximum profit potential. Maximum profit would be achieved if XYZ closed above $52.50 at expiration. The most the trader can lose is 1.50 (2.50 – 1.00) which is the difference between the strike prices minus the credit received. The bull put spread would break even if the stock is at $51.50 ($52.50 – $1.00) at expiration. In other words, XYZ can fall $0.50 and the spread would still be at its maximum profit potential at expiration. If the VIX was still at 12 percent like it had been previously, the implied volatility of these options could be lower and the trader might only be able to sell the spread for 0.90 versus 1.00 when it was at 18%. Subsequently the max loss would be 0.10 higher too. In addition, if the IV decreases before expiration, the spread will also decrease based on the option vega which could decrease the spread’s premium faster than if the IV stayed the same or if it rose.

Final Thoughts

When examining possible option plays and implied volatility is at a level higher than normal, traders may be drawn to credit spreads like the bull put spread. The advantage of a correctly implemented bull put spread is that it can profit from either a neutral or bullish move in the stock and selling premium that is higher than normal.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 16, 2014

A Short Iron Condor

A short condor occurs when a trader combines a bear call spread and a bull put spread. It is essentially combining two credit spreads as one trade. The trade is executed by buying a lower-strike out-of-the-money put and selling an out-of-the-money put with a higher strike. Then the trader sells an out-of-the-money call with a higher strike and buys another out-of-the-money call with an even higher strike. Learning to trade more advanced option strategies like an iron condor is not essential for option traders but it can give you more means in which to possibly extract money from the market.

One of the rationales behind selling an iron condor is implied

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volatility (implied volatility is – simply defined – the volatility component of an option price). When IV is inflated (meaning the implied volatility has pushed the option price higher) it lifts the premium values for option sellers. In addition, the profitable range on the short iron condor is can be rather large depending on how it is implemented.

A short iron condor consists of four legs and results in a net credit received. As for profit potential, the maximum potential profit is the initial credit received upon entering the trade. This profit will occur if the underlying stock price, on expiration date, is between the two middle (short) strikes.

One of the benefits of a short iron condor

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(and potentially options in general) is limited risk. For short condors, the maximum loss comes when the underlying stock price drops below the lowest strike or above the highest strike. If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or

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the two higher-strike options) less the initial credit for entering the trade.

Being that we are in the mist of earnings season, it may be best to construct the iron condor to expire before the actual announcement. If not, then it may be best to exit the trade before the announcement especially if the trade is profitable up to that point.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 15, 2013

Determining Option Strategies on AAPL

Compared to trading equities, there are so many more option 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 root 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. Now that the stock has recently broken through several resistance areas, there are traders who continue to be extremely bullish on AAPL 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

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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 summer ending soon and supposedly the slow markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the fall season!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 27, 2013

Getting Vertical With AAPL

One of the basic directional spreads when learning to trade options is that of the vertical spread.  It can be extremely versatile and represents a major building block of more complex spreads. With a vertical spread, the various strike prices for an option are arranged vertically and the expirations 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.  It can be constructed with 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 depending on the outlook and the risk/reward that is desired.

As an example, let us consider a vertical spread in  Apple (AAPL). The stock has dropped considerably over the last several weeks just like the prospect of Aaron Hernandez’s NFL career, and at the time of this writing is hovering around $400. With AAPL being heavily traded, the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.

For the trader who has a bullish diagnosis  for the price action in AAPL into July expiration, a put credit spread can be established by selling the July 380 put ($4 credit) where it has a pivot low and buying the July 375 put ($3 debit). The total premium received is $1. At the time of this writing there are 23 days to expiration, the maximum potential return is 20% and is achieved as long as AAPL remains above the short put strike of 380.  Maximum risk is defined by the long 375 put. The maximum risk is defined by taking the difference in the strikes $5 (380 – 375) minus the premium received ($1) or $4 if AAPL finished below $375 at expiration.

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 zero, and 2. Margin requirements for the position and hence yield are dramatically improved. Understanding the potential risk of each strategy and implementing the one that matches your trading personality can go a long way at making you feel comfortable and successful as a trader.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 6, 2012

Selling AAPL Puts: Naked or as a Spread

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

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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

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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

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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

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

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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

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dramatically improved.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 3, 2012

Selling AAPL Puts: Naked or as a Spread

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 for “those in the know” simply selling a put spread).

The sine qua non 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 variable degree 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

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AAPL. A trader who sells a $590 strike put to another trader holding an underlying currently trading at $585 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 (in option lingo 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 similar strategy is to sell a put spread. In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price. However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a

corollary, to reduce the margin encumbrance. The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options. 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 encumbrance. However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings 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; if you know the road map it is much easier to arrive where you want to be.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 8, 2011

Selling Puts: Naked or as a Spread

One of the bullish strategies in the arsenal of an options trader is that of selling puts. The sales can be accomplished either as naked sales (aka selling “cash secured” puts

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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 for “those in the know” simply selling a put spread).

The sine qua non 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 variable degree in the price of the underlying. The magnitude

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of the “deductible” for the policy is determined by the strike price the trader has sold.

For example, the trader who sells a $55 strike put to another trader holding an underlying currently trading at $60 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 (in option lingo 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 similar strategy is to sell a put spread. In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price. However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance. The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options. 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

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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 encumbrance. However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings 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; if you know the road map it is much easier to arrive where you want to be.

August 18, 2011

If I’d Meant That, I’d Have Said That

To the new option trader, it often seems as if he has entered into the terra incognita of the derivatives world through Alice’s looking glass. Engaging

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the natives in conversation quickly results in encountering colorful characters who appear not to recognize the same reality from which the traveler has arrived. For those who have chosen to enter this new world, Alice’s conversation with Humpty Dumpty seems particularly familiar wherein he declares: `When I use a word,’ Humpty Dumpty said, in rather a scornful tone, `it means just what I choose it to mean — neither more nor less.’

The nomenclature of options is boundlessly confusing. While the casual visitor may only notice the broad categories of puts and calls, the serious student soon will come to realize that the detailed nomenclature is confusing and results from the inescapable fact that options have more moving parts than do stocks. When initiating a stock position, the choices are two: buy or sell the issue. When initiating an options position, the choices are numerous and not mutually exclusive. The selection of the particular series to trade and the anatomic structure in which to place it is often nuanced.

An individual option’s value is a function of three main factors: price of the underlying, time to expiration, and implied volatility. Furthermore the individual options can be combined into complex spreads composed of multiple positions in an almost limitless variety. It is from this abundance of choice that the word salad of option terminology arises.

I find the terminology paradoxically to find its maximum point of obfuscation when used to describe one of the basic building blocks of options, the vertical spread. Verticals represent a two-legged category of spreads in which one option is bought and an option of a different strike is sold; both positions are taken in the same series month and in the same type, either puts or calls. Strike selection determines the directional bias of the trade as well as the credit or debit status. Bullish and bearish trades are easily constructed in both puts and calls.

This simple spread results in a chaotic and confusing panoply of names including: bull call spread, call debit spread, bear call spread, call credit spread, bear put spread, put credit spread, bull put spread, bull call vertical, bear call vertical, bull put vertical, and bear put vertical. As if this collection of a dozen names describing four basic trades were not sufficiently opaque, many traders use an implied shorthand description. For example, they may refer to opening a call credit spread as “selling a call vertical”; conversely opening a call debit spread is often referenced as “buying a call vertical”. The directional bias of the trade is apparent to those having been shown the “secret handshake” by the spread type, call or put, used and the credit or debit status of the opening cash flow.

Unfortunately there is no easy resolution to this nomenclature nightmare. Various traders use the terms inconsistently and variably for no apparent logical reason. Such is everyday life in the world of options.