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December 11, 2014

The Iron Condor

An iron 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.

A short iron condor consists of four legs as described above 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 rationales behind selling an iron condor is implied 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 can be rather large depending on how it is implemented. Certainly the larger the profitable range, the smaller the maximum profit and the greater the risk. The smaller the profitable range,  the larger the maximum profit will be and there will be less overall risk but there is less of a chance the underlying will remain in that range. Like many spreads in option trading, there is a trade-off.

One of the benefits of a short iron condor (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 (long put) or above the highest strike (long call). If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or the two higher-strike options) less the initial credit for entering the trade.

Being that earnings season is mostly behind us, it is not a major concern at this time. But when the season does return (and it will),  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

November 17, 2014

Delta and Another Famous Greek

We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work such as implied volatility, time decay and the constant changing of prices, it may be difficult to gauge how much option prices will change. Certainly these are all important factors to consider when pricing options.  But have you ever wondered how much an option is going to change with respect to say the underlying? Very simple – check out its delta.

Delta is arguably the most heavily identifiable Greek (unless you count Socrates or Aristotle) especially by individuals learning to trade options. It offers a quick and relatively easy way to tell us what to expect from our option positions as we watch the price action of the underlying. Calls have positive deltas, as they typically move higher on a rise in the stock, and puts have negative deltas, as they typically move lower when the stock rises.

While some investors view delta as the percentage chance an option has of expiring in-the-money, it is really more of a way to project expected appreciation or depreciation. A delta of 0.50 for an AAPL call option suggests the option should move 50 cents higher when the AAPL moves up by a dollar, and lose 50 cents for every dollar AAPL moves lower.

But delta is only foolproof when all other factors are held constant, which is rarely the case (and certainly never the case for time decay). As option traders know, time decay is inevitable for all options particularly hurting long positions due to option premiums shrinking due to the passing of time. If an option is moving more (or less) than its delta would suggest, it is likely because other variables are shifting. For example, buying demand might be pushing implied volatility higher, raising the price of the options.

Still, this king of all Greeks is a good starting point for gauging how your options are likely to move. Option traders should consider mastering this option greek before moving on to the other greeks. Here at Market Taker Mentoring, we have many programs to teach you about option delta and much much more about all things options by experienced professionals. As Socrates once said, “Employ your time in improving yourself by other men’s writings, so that you shall gain easily what others have labored hard for.”

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 15, 2014

Debit Spread Versus Credit Spread

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

Risk and Reward

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

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

Probability

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

Implied Volatility

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

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

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 25, 2014

The World Series and Exits for an Options Trader

The World Series playoffs are about to begin and it is the most exciting time of the year if you are a fan of baseball. But did you ever stop and think for a minute how these fantastic athletes got to be where they are? It took a lot of dedication, courage and a well thought out plan to make it to their elite level. If that sounds familiar it should because those same attributes are what it takes to learn to trade and become a successful options trader.

Need a Plan

You might be dedicated and have the courage to be an options trader, but do you have a trading plan that you follow? I talk to a lot of option traders and sadly it is true. Option traders spend a lot of time looking for solid trades that they often neglect probably the most important part: the management of the trade. If that is you take a little solace because you are not alone.

A simple way to combat this problem is by having a plan in place before even entering the trade. This is the psychological part of trading. Having a plan in place will remove emotions from getting in the way of decision making and possibly producing unwanted results. Should I stay in the trade or should I exit? Decisions like that should not be made after the trade is executed because many option traders can become too emotional when the trade is in progress especially when they are losing money on the trade. Here are a few things to consider about trade management.

Plan Should Include Determining Exits

Option traders should think about how they are determining their exits for profit and loss. Don’t forget to consider how the greeks and the implied volatility may be affected if the outlook or environment changes. In a volatile market like this, an options trader may need to make some adjustments especially about taking early profits or exiting for a loss.

I generally determine my exits two ways; a certain percentage or based on the chart. When using a certain percentage, I determine how much percentage-wise I am winning to risk on the trade and what percentage I am looking to take profits. When using the chart, I determine at what levels I will exit my position for a loss if that area is violated and I always look to take some profit off if the stock comes into an area I deem a target area (maybe a support or resistance level).

Option traders should also think about how they will exit if their targets are not met. How will the exit or stop be determined? Once again, don’t forget to use the greeks and implied volatility in your methods because it could make the difference between profiting or losing.

Finally

All trading including option trading can be very difficult at times just like training to be a professional athlete and appear in the World Series. Not having plan in place can make it exponentially more difficult and determining exits is just one part of that plan. It helps to have courage and be dedicated to reaching your goals but a solid trading plan can go a long way towards potential success. Athletes that train without a plan are similar to option traders letting their emotions make decisions for them. Once there is well thought out plan in place and most importantly the plan is followed, an option trader removes unwanted emotions which can hinder his or her chances of being successful.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 17, 2014

Long Calls and Bull Call Spreads

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

Definition

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

The Math

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

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

Advantage Versus Purchasing a Call

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

Conclusion

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

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 11, 2014

Calendar Spreads

A calendar spread, or what it is sometimes referred to as a time spread or horizontal spread can be a simple and quite useful option strategy. The calendar spread is designed to work somewhat like a covered call but without the potentially huge outlay of cash that can accompany buying shares of stock. The spread profits from time decay (option theta) and can make money in any direction depending on the strikes that are chosen. The spread can be set-up with a bullish, bearish or neutral outlook on the underlying either using call options or put options.

How to Create a Calendar Spread

Creating a calendar spread involves buying and selling options on the same underlying with the same strikes but different expirations. The best case-scenario is for the stock to finish at the strike price allowing the short-term option to expire worthless and still have the long option retain much of its value.

For the sake of this example, close to at-the-money (ATM) options will be used but out-of-the-money (OTM) and in-the-money (ITM) options can also be used depending if there is a bullish or bearish bias. As a general guideline, if I have a bullish outlook on the underlying I use call options and put options for a bearish bias. The reasoning is that OTM options generally have tighter bid/ask spreads than options that are currently trading ITM. Initially being down less money entering any option trade due to a tighter bid/ask spread is always a good thing.

Simple to Follow Example

In late August, Marriot International (MAR) was trading just over $69. The stock has been slowly rising over the last year. The trader forecasts that the stock will still be about the same price or maybe a tad higher by September expiration. This scenario makes it worthwhile to look at a calendar spread. MAR has September and October expiration’s available. The trader can buy the October 70 call for 1.25 and sell the September 70 call for 0.55. The total cost of the calendar spread is 0.70 (1.25 – 0.55) and that also represents the most that can be lost.

If the stock remains relatively flat as September expiration approaches, the calendar spread’s value should increase. Hypothetically, with about a week left until September expiration the October 70 call might be worth 1.00 and the September 70 call might drop to 0.15. The spread now would be 0.85. A profit could now be made of $0.15 (1.25 – 0.55). That doesn’t sound like much but a $0.15 profit on a $0.70 investment in a couple of weeks is not a bad return in my opinion.

The whole key to the success of the calendar spread is the stock must not have huge price swings. If the stock falls more than anticipated, the spread’s value will decline along with the stock. If the stock rises well above $70, the short September 70 call will partially or fully offset the increase in the long October 70 call depending on how much the stock rises.

Conclusion

There are other factors that can affect a calendar spread like implied volatility skews that can both help and hurt the spread. It is advantageous for the implied volatility to be higher for the short option versus the long option. This way the more expensive premium is sold and the cheaper is purchased. This component will be discussed in greater detail at a later time.

The beauty of the calendar spread is that it almost functions like a credit spread without the added risk. The risk with a credit spread is that it may suffer a substantially greater loss than a calendar spread if the stock moves in the opposite direction of the outlook due to high risk and low reward scenario that accompanies most out-of-the-money (OTM) credit spreads.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 7, 2014

An Option Strangle with AAPL Options

An option strangle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With an option strangle, the trader is betting on both sides of a trade by purchasing a put and a call generally just out-of-the-money (OTM), but with the same expiration. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this or any other option strategy sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars

An option strangle has two breakeven points just like the option straddle. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration, the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (for upside moves). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss a trader can take on an option strangle is the net premium paid.

Implied Volatility

The implied volatility (IV) of the options plays a key role in an option strangle as well. With no short options in this spread, the IV exposure is concentrated. When IV is considered low compared to historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant which is certainly a bonus for long option strangle holders.

Example Trade

To create an option strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. An option trader may think Apple Inc. (AAPL) looks good for a potential option strangle. At the time of this writing, Apple stock is trading at around $98. With IV lower than HV and the trader unsure in what direction the Apple stock may move, the option strangle could be the way to go. The trader would buy both an Aug-29 99 call and an Aug-29 97 put. For simplicity, we will assign a price of 1.65 for both – resulting in an initial investment of 3.30 (1.65 + 1.65) for our trader (which again is the maximum potential loss).

Apple Stock Rallies

Should the Apple stock rally past the call’s breakeven point which is $102.30 (99 + 3.30) at expiration, the 97 put expires worthless and the $99 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example at expiration the stock is trading at $104 which means the intrinsic value of the call $5 (104 – 99), the profit is $1.70 (5 – 3.30) which represents the intrinsic value less the premium paid.

Apple Stock Declines

The same holds true if the stock falls below the put’s breakeven point at expiration. The put is in ITM and the call expires worthless. At expiration, if Apple stock is trading below the put’s breakeven point of the trade which is $93.70 (97 – 3.30), a profit will be realized. The danger is that Apple stock finishes between $97 and $99 as expiration occurs. In this case, both legs of the position expire worthless and the initial 3.30, or $330 of actual cash, is lost.

Maximum Loss

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Profits and losses can be realized way before expiration and it is up to the trader to decide how and when to close the position. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 24, 2014

Earnings Season and Option Prices

With earnings season in full gear and major players like LinkedIn and Tesla ready to announce soon, it is probably a good time to review how an option price can be influenced.

Perhaps the most easily understood of the option price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The option price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third option price influence in relation to earnings season is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we are in the midst of earnings season, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these option price influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over earnings season.

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 5, 2014

Reviewing Your Trades Like Roger Ebert

In my opinion, one of the most helpful things to do to improve your option trading is reviewing your trades. You need to pretend that you are the late, great Roger Ebert of option trading and give your trades a thumbs up or down. This is a fantastic way to gauge how you are developing as a trader and incorporate it into your trading plan. A lot of option traders are disheartened when they examine their profit and loss statements, but this can be deceiving. Why? Many good trades lose money and a lot of bad trades make money. Your goal as an option trader is to follow your trading plan and take the best trades that make sense to you and put the odds are your side for a successful trade. Easier said then done you might say but reviewing your trades is a very important step to take in order to become consistently profitable and putting the odds on your side.

Capture Your Trades

The first thing an option trader should consider doing is to capture his trades with some type of screen capture software. Every trader should have this in his or her trading plan. There are a plethora of options out there and many are free. An option trader should have a record of the chart, option chain, implied volatility and any other tangible that may be pertinent to the trade. If the trade is in effect for several days, screens shots can be taken periodically to help a trader understand what is happening on the charts and to the options. Once the trade is exited, screen shots should be taken again to compare the start and end of the trade.

Review

Now that the option trader has the concrete evidence in his hands or on his computer, it’s time to look at the damage or lack there of. When reviewing your trades, it is advantageous to do this part after the close of the market so full attention can be on the reviewing process. Label the chart and option chain with what strategy was used. Where did the trading plan call for entry, stop and target? Then where was the trade actually entered and exited? Were there any discrepancies? If there were, a trader needs to find out why and correct them in the future.

Correct and Make Adjustments

If the trade suffered a loss in particular, and the trading plan was followed, was it just part of the odds or is there something that can be done to improve the odds for next time? It really doesn’t matter what the violation or mistake was, it just needs to be recognized and taken into account for next time. Sometimes the loss is not the fault of the trader but many more times it probably was. Changes and adjustments both mentally and physically need to be made and corrected to improve trading performance. Once a trader has recognized and corrected his errors and adjusted the trading plan, trading can become a whole lot easier.

Last Thoughts

Reviewing your trades like Roger Ebert used to review movies for so many years can be an essential ingredient to becoming the option trader you want to be. The key to becoming successful and growing as an options trader is to learn to acknowledge your winners, but cherish and learn from your losses because that is what will make you profitable in the end. You will absolutely learn more from your losses than from your winners… thumbs up!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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