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August 28, 2014

Short-Term Put Options

Last week we talked about short-term call options and this week I thought it would be appropriate to discuss short-term put options. The mentality behind short-term put options is probably different than the mentality behind short-term call options. Many times option traders consider short-term put options as a means of protection. With the market extended and the possibility of stocks moving lower in the near future, it might be a good time to talk about put options.

If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.

Some investors who are looking to protect an investment only consider buying short-term puts, or front-month puts for protection. The problem however, is that there is a flaw to the reasoning of purchasing short-term put options as protection. Similar to short-term call options, the contracts have a higher option theta (time decay) and relying on short-term puts to protect a straight stock purchase is not necessarily the best way to protect the stock.

Although short-term puts may be cheaper than longer expiration puts, if an option trader was to continually purchase short-term puts as protection, it could end up being a rather expensive way to insure the stock particularly if the stock never declines to the short-term puts strike price. If a put option with a longer expiration was purchased, it would certainly cost more initially, but time decay (premium eroding) would be less of a factor due to a smaller initial option theta. Here is an example using short-term put options.

Using a hypothetical trade, let’s say a stock is trading slightly above $13 and our hypothetical trader wants to by the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months because the trader is counting on the earning reports to move the stock higher.

Being a smart options trader, our trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money September 13 put, which carries an ask price of 0.50 (rounded for simplicity purposes). That $0.50 premium represents almost 4 percent of the current stock price. In fact, if the option trader rolled the short-term put option month after month, it would create a big dent in the initial outlay of cash. After about seven months (assuming the stock hangs around $13 and each monthly put option costs 0.50) the trader would lose more than 25 percent on the $13 investment.

If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops.

Buying a put option is a hedge and can be considered a decent insurance policy for a stock investment. Buying short-term put options as a hedge can make it an extra expensive hedge due to time decay (option theta). Option traders and investors can usually find better ways to protect a stock. To learn new and different approaches, please visit the Learn to Trade section of our website.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 21, 2014

Short-Term Call Options

With the market once again considering a move higher as earnings wind down, it might be a good time to talk about call options. When an option trader buys a call option, he or she has the right to buy the underlying at a particular price (strike price) before a certain time (expiration). Keep in mind that just because the option trader has the right to buy the stock, doesn’t mean that he or she has to necessarily do so. The call option just like a put option can be sold anytime up until expiration for a profit or loss.

A lot of traders especially those who are just learning to trade options can fall in love with call options and especially short-term call options because they are cheaper than call options with longer expirations. We can classify short-term call options as call options that expire in less than thirty days for the sake of this discussion. But there is a potential problem with purchasing short-term call options. The shorter the amount of time that is purchased, the higher the option theta (time decay) will be. The higher the time decay, the quicker the premium will erode away the call option’s premium. The call option may be cheaper due to a shorter time until expiration, but it may not be worth it overall. Let us take a look.

With Tesla Motors (TSLA) trading around $260 last week, an option trader might have considered call options to profit from an expected move higher. He could have purchased the August 260 calls for 3.30 that expired in 3 days. Yes, the options are cheap and yes they will profit if TSLA moves up vigorously in the next couple of days. But the option theta is 0.70 on the call options meaning they will lose $0.70 for everyday that passes with all other variables being held constant, In fact if the stock trades sideways, the option theta will increase the closer it gets to expiration since there is currently no intrinsic value (the in-the-money portion of the option’s premium) on the call options.

If an option trader purchased the September 260 calls for TSLA, it would have cost him 12.00 and it would have made the at-expiration breakeven point of the trade $272 (260 + 12) versus only $263.30 (263 + 3.30) with the August call options. But the major benefit to buying further out is option theta. The September 260 calls had an option theta of 0.15 meaning for every day that passes, the option premium would decrease $0.15 based on the option theta and all other variables being held constant. This is certainly a smaller percentage of a loss based on option theta for the September options (1.25%) versus the August options (21.21%) especially if the stock trades sideways or moves very little.

Fast forward to August expiration, TSLA closed basically at $262. The August 260 call would have expired with an intrinsic value of $2 (262 – 260). If the option trader did nothing up until expiration, the long August 260 call would have lost $1.30 (3.30 – 2) because there would be no time value (option theta) left and only the intrinsic value. The September 260 call would have lost approximately $0.45 (3 X 0.15) in theta but also gained $1 (2 X 0.50) from delta based on a delta of 0.50 and a $2 (262 – 260) move higher. The September 260 calls would now be worth $12.55 (12 + 0.55) and profited $0.55 (12.55 – 12).

Having enough time until expiration is a critical element when an option trader is considering buying options like the call options we talked about above. Keep in mind that as a general rule, options lose value over time and the option theta starts to accelerate even more with 30 days or less left until expiration. Buying a call option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta, might be worth the more expensive price especially if the underlying fails to move higher.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 26, 2014

Outright Call Options and Put Options

Another topic that is brought up often in my Group Coaching class is buying call options and put options outright. When option traders first get their feet wet trading options, they often just buy call options for a bullish outlook and put options for a bearish outlook. In their defense, they are new so they probably do not know many if not any advanced strategies which means they are limited in the option strategies they can trade. Buying call options and put options are the most basic but many times they may not be the best choice.

If an option trader only buys and for that matter sells options outright, he or she often ignores some of the real benefits of using options to create more flexible positions and offset risk.

Here is a recent example using Twitter Inc. (TWTR). If an option trader believed TWTR stock will continue to rise like it has been doing, he could buy a July 39 call for 1.80 when the stock was trading at $38.50. However the long call’s premium would suffer if TWTR stock fell or implied volatility (measured by vega) decreased. Long options can lose value and short options can gain value when implied volatility decreases keeping other variables constant.

Instead of buying a call on TWTR stock, an option trader can implement an option spread (in this case a bull call spread) by also selling a July 42 call for 0.75. This reduces the option trade’s maximum loss to 1.05 (1.80 – 0.75) and also lowers the option trade’s exposure to implied volatility changes because of being long and short options as part of the option spread. This option spread lowers the potential risk however it limits potential gains because of the short option.

In addition, simply buying call options and put options without comparing and contrasting implied volatility (vega), time decay (theta) and how changes in the stock price will affect the option’s premium (delta) can lead to common mistakes. Option traders will sometimes buy options when option premiums are inflated or choose expirations with too little time left. Understanding the pros and cons of an option spread can significantly improve your option trading.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 12, 2014

Homeruns and OTM Call Options

This past week in Group Coaching, a student asked me about buying deep out-of-the money (OTM) options. Many option traders especially those that are new initially buy deep out-of-the-money options because they are cheap and can offer a huge reward. Unfortunately many times, these “cheap” options are rarely a bargain. Don’t get me wrong, at first glance an OTM call that costs $0.25 may seem like a steal. If it works out, it could turn into a real homerun as they say in baseball; maybe even a grand slam. But if the call’s strike price is say $20 or $30 (depending on the stock price) above the market and the stock has never rallied that much before in the amount of time until expiration, the option will likely expire worthless or close to it.

Negative Factors

Many factors work against the success of a deep OTM call from profiting. The call’s delta (rate of change of an option relative to a change in the underlying) will typically be so small that even if the stock starts to rise, the call’s premium will not increase much. In addition, option traders will still have to overcome the bid-ask spread (the difference between the buy and sell price) which might be anywhere from $0.05 to $0.15 or even more for illiquid options.

Option traders that tend to buy the cheapest calls available are probably calls that have the shortest time left until expiration. If an OTM call option expires in less than thirty days, its time decay measured by theta (rate of change of an option given a unit change in time) will be often larger than the delta especially for higher priced and more volatile stocks. Any potential gains from the stock rising in price can be negated by the time decay. Plus each day the OTM call option premium will decrease if the stock drops, trades sideways or rallies just a tad.

Final Thoughts

A deep OTM call option can become profitable only if the stock unexpectedly jumps much higher. If the stock does rise sharply, an OTM call option can hit the proverbial homerun and post impressive gains. The question option traders need to ask themselves is how much are they willing to lose waiting for the stock to rise knowing that the odds are unlikely for it to happen in the first place? Trades like these have very low odds and may be better suited for the casino then the trading floor.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 10, 2014

Double Your Pleasure

With earnings season just kicking off once again, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options. The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future writings, the selection of strike prices and position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 27, 2014

Directional Butterfly

Many option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.

A Butterfly

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.

The trader’s objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.

Directional Butterfly

What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.

To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.

Final Thoughts

One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 26, 2013

The Fundamentals of Iron Condors

Have you ever noticed a professional athlete warming up before a game or match? What are they doing? They are stretching, running, throwing and catching just to name a few for example. What they are really doing is working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career no matter what your career is.

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique similar to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives. Doing this on every potential trade can only improve your odds.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 21, 2013

Long Calls and Bull Call Spreads in AAPL

Purchasing a Call vs. Bull Call Spread

With the Dow and S&P 500 at all-time highs recently, it probably made sense to have at least a moderately bullish bias towards many stocks. The market is due for some type of pullback but whose to say it won’t continue on its bullish pace. Even if it does pullback sooner than later, there will be another bullish opportunity at some point. Is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a couple. One that may be a better option compared to the rest is the bull call spread. To learn to trade this strategy and more in detail please visit our website for details.

Definition

When implementing a bull call, a trader purchases call options at one strike and sells 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 $515 as an example. In this case you would purchase December calls at the 515 at-the-money strike at the ask price of $13. You would then sell the same number of December calls with a higher strike price, in this case 535 at the bid, $4.

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 he purchased one December 515 call and sold one December 535 call resulting in a net debit of $9 (that’s $13 – $4). The difference in the strike prices is $20 (535 – 515). He would subtract 9 from 20 to end up with a maximum profit of $11 per contract. So if he traded 10 contracts, you could make $11,000.

Although he limited his upside, the trader also limited the downside to the net debit of $9 per contract. To simply breakeven, the stock would have to trade at $524 (the strike price of the purchased call (515) plus net debit ($9)) 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 at-the-money December 515 call he would have paid $14. 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

October 31, 2013

Controlled Stops and AAPL

If you are like a lot of other option traders, you probably avoided trading Apple Inc. (AAPL) during its recent earnings announcement. Now that the volatility event is over, you might be looking to take an option position. Even though the company announced its earnings, there may still be some volatile action ahead. Here are a few thoughts that should be considered on AAPL or any other position you may enter.

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 in many instances. Much of this advantage comes from the ability to control positions that are equivalent to stock with far less capital outlay.

However, a less frequently discussed aspect of risk control is the ability to moderate risk by the careful and precise 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 by any means.

As a direct result, it may not be obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software that most brokers have is essential to plan the trade and decide the appropriate time 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 December 530 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -540 for approximately $25,000 as I write this.

At the time of this writing, the stock is trading around $522; these puts are therefore $8 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 $525 at expiration. The options expiration risk is $20,000 or more. However, if the trader takes the position that the expected or 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 $525 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. An option trader needs to learn several that match his or her risk/reward criteria.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 25, 2013

Seeing Double

Today we will talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals

Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options.

The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future writings, the selection of strike prices and position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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