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August 27, 2015

A Directional Option Spread

With the huge selloff in the market last week, it might take some time for stocks to get back to levels they had been trading at just a few sessions ago. In fact, they might not ever make it back to those levels truth be told. Wouldn’t it be nice if there was an option strategy with low risk and a high reward that rewards a big move close to a certain time frame?

For the most part,  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.

Recent Example

Amazon Inc. (AMZN) was trading in the $540 area less than two weeks ago. At the time of this writing, the stock was hovering just below $490. What if you believed the stock would make it back somewhere close to that area by September expiration? A trader could buy a September 530/540/550 (long the 530 – short 2 540 – long the 550) call butterfly for around 0.60. That is the most that can be lost is what was paid. Maximum profit would be earned if the stock closed right at $540 at expiration. The profit would be $9.40 (10 – 0.60) which is derived from the difference between the bought and sold strikes minus the cost of the spread. That is over 1 to 15 risk/reward ratio.

The breakevens on the butterfly are fairly sizable. The spread will profit anywhere between $530.60 and $549.40 at expiration. This was derived from adding the cost of the butterfly to the lowest strike (530 + 0.60) and subtracting the cost from the highest strike (550 – 0.60). In other words, if the trader is not spot on with the $540 prediction, the trade can still profit with some wiggle room.

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

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

August 6, 2015

ITM Put Options

There is always potential for the market or individual stocks to move lower. In fact many traders never even think about bearish strategies because they are always looking for bullish options. Option traders know that stocks and markets do not always go up, but many will wait until they think the decline is over to once again look for a bullish strategy instead of taking advantage of bearish opportunity at hand. Understanding put options is a must for option traders but I am often asked how to choose strike prices. There are several different options to consider and here are a few things to consider specifically based on an expected small move in the underlying. But first let us take break down the anatomy of a put option.

A buyer of a put option has the right, but not the obligation to sell shares of underlying stock at a certain price on or before an expiration day. The price at which the buyer can sell the shares is called the strike price. There are many strike prices and expirations to choose from which can be overwhelming for a trader. When expecting a stock to make a small move especially if the stock is lower in price, it may be advantageous for the trader to select an in-the-money (ITM) put option. An ITM put option is a put with a strike price that is higher than the stock’s current price. Before going further, here’s a look at a possible scenario where buying an ITM put might be warranted.

An ITM put option can be used to capture a relatively small move lower. Suppose an option trader is watching a $10 stock in a downtrend. The stock then rallies higher and now he thinks it is a good time to enter a bearish position with a put option. He surmises the stock might be able to drop about $0.50.

A critical point about capturing this potential $0.50 move down revolves around option delta. Option delta is the rate of change in the option’s value relative to the change in the stock price. Puts have a negative option delta because if the stock rises, puts will lose some of their value. Since puts give the owner the right to sell stock, puts gain value as the stock falls. In this example, the trader is expecting only a $0.50 move lower. Buying an ITM put that has a higher option delta will profit more than a put with a smaller option delta if the anticipated move comes to fruition.

With the stock trading just under $10, the option trader looks at the 10 and 12 strike puts. The 10 strike puts have an option delta of about -0.55 and the 12 strike puts have an option delta of about -0.90. This means that for every $1.00 the stock moves down, the 10 strike put’s premium should increase by $0.55 and the 12 strike put’s premium should increase by $0.90 all other factors held constant. The reverse is also true. If the stock moves higher by $1.00, each put would lose value in the amount of their deltas. Since the expected move is only $0.50, half the deltas would be gained or loss depending on the direction of the stock.

Final Thoughts…

Buying an ITM put option is not always the best way to capture a stock’s move lower, but when it comes to profiting on a perceived small move, an option trader should consider a put option position with a higher option delta and do so with the satisfaction of knowing their loss potential is limited to the cost of the put option.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 8, 2015

It Could be a Double Play

With Alcoa announcing its earnings this past week and a plethora more of them to soon follow, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education; 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 other words, 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 the placement of the long strikes being 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 has a negative impact on double calendars more strongly than it does on double diagonals.

If you have only traded a single-legged calendar or diagonal through earnings season even not during earnings season, it might just be time to give them a look. Maybe you have never traded a calendar or a diagonal. This might be the time to find out about these time spreads.  Once a single position spread makes sense, a double might make even more sense and be more profitable too.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 2, 2015

Short-Term Put Options

A couple of weeks ago we talked about short-term call options and this week I thought it would be appropriate to discuss short-term put options especially with this recent move lower in the market. 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

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

June 17, 2015

Short-Term 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 June 260 calls for 2.80 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 July 260 calls for TSLA, it would have cost him 10.00 and it would have made the at-expiration breakeven point of the trade $270 (260 + 10) versus only $262.80 (260 + 2.80) with the June call options. But the major benefit to buying further out is option theta. The July 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 July options (1.5%) versus the June options (25%) especially if the stock trades sideways or moves very little.

Fast forward to June expiration and let’s pretend TSLA closed basically at $262. The June 260 call would have expired with an intrinsic value of $2 (262 – 260). If the option trader did nothing up until expiration, the long June 260 call would have lost $0.80 (2.80 – 2) because there would be no time value (option theta) left and only the intrinsic value. The July 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 July 260 calls would now be worth $12.55 (12 + 0.55) and profited $2.55 (12.55 – 10).

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 9, 2015

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

May 28, 2015

Option Gamma and AAPL

Many option traders will refer to option delta as the most important option greek. It is debatable but in my opinion the next most important greek for me is option gamma. Option gamma is a one of the so-called second-order option greeks. It is, in theory, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Using option gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using option gamma:

When you buy options you get positive option gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL June 131 long call that has an option delta of 0.56 and option gamma of 0.0588 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive option gamma is a good thing.

When you sell options you get negative option gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative option gamma is a bad thing.

Start by understanding option gamma from this simple perspective. Then, later, worry about figuring out the math, even if a calculator is still needed!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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