Testimonials

March 25, 2011

There’s a Time for Everything: Thoughts on Options Strategies

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 4:56 pm

Do you know how many different types of options strategies there are? A lot: That’s how many! But that’s not really the important question. More importantly: Do you know why there are so many different types of options strategies? Now we have something to discuss.

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish traders. Traders who are extremely bullish get more bang for their buck buying short-term out-of-the-money calls. Less bullish traders my buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high and the trader is bullish just to a point, the trader might sell a bull put spread, and so on.

The differences in options strategies, no matter how apparently subtle, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position and, in turn, structure a position that addresses each nuance. Traders need to consider the following criteria:

  • Directional bias
  • Degree of bullishness or bearishness
  • Conviction
  • Time horizon
  • Risk/reward
  • Implied volatility
  • Bid-ask spreads
  • Commissions
  • And more

Carefully selecting options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners, or taking losses bigger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. Be sure to spend time optimizing your options strategies over the next few weeks to build the habit.

March 12, 2011

Maximizing Fade Plays

Filed under: Uncategorized — Tags: , , , , , , , , , , , , — Dan Passarelli @ 9:50 am

Do you feel like you’ve seen this movie before? Trouble in the Middle East. People in the streets; panic in the market. Is this recent wave of trouble going to last forever? Not likely. Perhaps there is an opportunity to fade this fall. But how should an option trader play the fade to maximize chances of success and maximize option-trading returns?

The obvious starting point for a trader to fade this fall is to take a positive-delta position. This is fancy options speak for a bullish trade. There are lots of different ways to take a bullish stance given all the various types of option-trading strategies out there. So, the question really is: Which is best?

There are a few major considerations here. First, traders must strive to maximize reward by minimizing risk. In order to do so, option traders must define their expectations. Am I looking for an extreme turn around? A mild retracement? A dead-cat bounce? The more a strategy can be tailored to expectations, the more risk can be controlled and reward can be maximized.

Next traders need to consider implied volatility. This is where option traders can get an edge in their options positions. If implied volatility is high (overpriced), option traders should consider option-selling strategies. If implied volatility is low (underpriced), option traders should consider option-buying strategies.

In the current market scenario we have a situation where if the turmoil in the Middle East subsides, the market should rally somewhat, but it’s not likely to go to the moon. Further, with the VIX at its current nose-bleed levels and implied volatility of individual stocks following suit, it’s easy to find overpriced options. Any clever fader trader should be looking for put credit spreads to sell. Put credit spreads have positive delta and take a short position on implied volatility. Great candidates for this sort of play are indexes and ETFs like SPX, SPY, DJX, DIA, et. al. Traders are best off staying away from oil stocks and precious metals that might be adversely affected by Middle East stability.

November 2, 2010

Reading Tea Leaves

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 8:24 am

It is often a daunting task deciphering the tremendous amount of information contained within an option chain for the trader beginning his study of the world of options.  One of the most nuanced variables embedded within the prices quoted for the chains is that of the relative values of implied volatility (IV) amongst the various strike prices and the various months of expiration.

The IV of each of the various available options for a given underlying is not usually constant for each individual strike price and expiration cycle.  The IV can and often does vary between individual strike prices within the same cycle; this variation is termed vertical skew.  In addition, IV often varies at the same exact strike price when considered between various expiration cycles; this variation is termed a horizontal skew.

To review briefly, remember that option prices depend largely on the three primal forces of time to expiration, price of the underlying, and IV.  The only one of these factors not immediately accessible to anyone with a quote screen and a calendar is IV.  It is by changes in the magnitude of IV that future events of potential major import to the price of the underlying are expressed.

As an example of the information that can be gained by considering apparent anomalous values for IV, consider the case of ITMN.  This biotech stock is represented in upcoming expiration cycles of: November, December, January, and April.  Considering the example of the 14 strike call, the IV for these various months are:  54, 65, 78, and 136 respectively.

I have no idea what is up in the first quarter of 2011 for this stock, but the options markets are pricing a substantial probability of a significant price move between January and April expirations.  These types of IV spikes are typically seen in biotech stocks ahead of significant FDA decisions.

Bill Burton, Market Taker Mentoring LLC

October 25, 2010

It Happens Every Quarter

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 2:16 pm

Classic parables of warning are often offered to traders considering exploring the world of option trading by those who do not understand the physiology of the various option “beasts”.  These “instructive” stories have various iterations, but one frequently repeated story has a core point of “wisdom” that can be illustrated by the following frequently encountered sequence of events:  A trader buys call options shortly ahead of correctly predicting better than expected earnings and the expected price rise of the underlying.  When the options open following this increase in price of the underlying, he has gained little if any profit from his long call.  The “obvious” conclusion?  The market makers are thieves, the options game is rigged, and I need to look elsewhere for trading opportunities.

Perhaps we should not throw the baby out with the bath water quite yet.  Is there some rational explanation for this behavior?  In a word, yes, there is.  In order to understand the phenomenon, we need to consider the physiology of an option.

One of the major determinants of the magnitude of the option time premium (aka extrinsic premium) is the implied volatility (IV).  There are various available databases available to track the history of this value, and a reproducibly observed phenomenon is that IV almost always stereotypically correlated with earnings releases. It typically spikes in anticipation of the release and the uncertainty surrounding this information and collapses very quickly following the release and the resultant price reaction of the underlying to this information.

It is this rapid, predictable decline in IV that results in the commonly observed sequence of events related in our parable.  If the purchased option contained significant time premium, it will have been devastated by the collapse of IV and the trader’s anticipated profits will have been erased or significantly reduced.

Armed with this knowledge, is there any way to immunize the trade against this sequence of events?  As you may have guessed, the answer is yes.  While description of the various strategies is beyond the scope of this brief post, suffice it to say that the category of vega negative or vega neutral trades holds the key to dealing successfully with this situation.

Bill Burton, Market Taker Mentoring LLC

July 23, 2010

Where’s the Pony?

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 12:20 pm

Time to expiration, price of the underlying, implied volatility, historical volatility, puts, calls, delta, gamma, theta, vega, in the money, at the money, out of the money, intrinsic value, extrinsic value, higher commissions, egregious bid ask spreads, no options traded on a stock with a beautiful technical set up, multiple potential beasts and physiologies, LEAPS; why would one even bother with options?  If I retain a shred of rationality, an open question to be sure, there must be some reason to complicate my life with these additional variables.

Ronald Reagan was fond of making a point with the story of the 8 year old boy who while visiting his grandfather’s farm fell into a pile of horse manure.  When his father found him a short while later, the boy was smiling ear-to-ear and happily shoveling away the muck.  When asked why, the son replied: “With this much poop, there must be a pony in here somewhere.”  Option trading is gaining popularity because the pony hidden beneath the pile of muck is (drum roll please): risk control.

Traders new to options often incorrectly focus on the ability to leverage positions, but in his classic summarization of this approach Jared Woodard opines:

But leverage, as anyone who’s followed the fate of the investment banks knows, is just a means for magnifying outcomes.  A leveraged risk-taker will experience more glorious wins and more disastrous losses, like a deranged person who shouts both poetry and obscenities (instead of whispering them quietly to himself, like the rest of us).

There are other logical and valid reasons for using options as one’s investment vehicle of choice to be sure, but the singular advantage of options is risk control.

Bill Burton,

Writer, Market Taker Mentoring LLC

July 6, 2010

Up And Down With Volatility: AAPL For The Teacher

Filed under: Options Education — Tags: , — Dan Passarelli @ 9:00 pm

Implied volatility is a major determinate of the magnitude of the extrinsic option premium.  Considered together with time, these two factors act in concert to define the pricing of the time value (extrinsic value) of options.

Two characteristics of implied volatility are reproducibly reflected in option pricing: 1.The inverse relationship of price of the underlying security, and 2.The correlation of implied volatility with the rapidity of the price movement. The largest movements in implied volatility are therefore to be expected in a rapid downward price move of the underlying security.

Because vertical volatility skew results in an array of implied volatility values it is helpful to consider the generally accepted reference point. This benchmark value of implied volatility is the average of the implied volatility values for the at-the-money front month strikes in all but the last week of the options cycle.

It is always helpful to return to these basic concepts when significant movement occurs in order to be certain the conceptual relationships are maintained.  Departure from the expected behavior is often an important clue to something nefarious afoot, as it was in the famous Sherlock Holmes investigation of the disappearance of the race horse, Silver Blaze, wherein the critical clue was that of the dog who didn’t bark.

Last Tuesday sell off in AAPL proves to be instructional when considered in light of the effects on implied volatility.  AAPL closed Monday at $268.30 and the IV was 35%.  AAPL gapped down Tuesday morning and by 1:00 PM was trading at $256.91 with option implied volatility of 40%. On the basis of Monday’s closing price and implied volatility values, this price represented a move of greater than 2 standard deviations.

IV responded as predicted by the usual relationship. The dog barked.

Bill Burton

Writer, Market Taker Mentoring LLC

May 17, 2010

A Tale Of Two Options

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 1:04 pm

For contrarian traders looking to short Thursday’s explosive price move in NFLX, two bearish trades had dramatically different success as the price of the underlying declined into the afternoon. As is often the case, you can learn a lot just by watching and analyzing the sequence of events in autopsies of the trades.

In order to set the stage, NFLX closed on Wednesday at $107 and the implied volatility (IV) of the front month at-the-money puts and calls averaged 57%.  Options of NFLX are very liquid and were trading with reasonable BA spreads.

By 10:30 AM, NFLX price had risen dramatically to $117.46. For the trader who wished to take a contrarian view, he could have purchased the out-of-the-money May 115 puts, the then at-the-money strike for $4.95. Importantly, the IV was 84%. Another trader who prefers to sell premium, could have sold the slightly out-of-the-money calls, the May 120 strike, for $5 at an IV of 84%.

At 2:00 PM the stock had sold off to $113.96.  How did our two traders fare? The put buyer could have sold his position for $5.60 for a net profit of 65¢ on the initial position.  The premium seller would have been able to close his call position for $2.70 for a gain of $2.30. Both positions were closed at an IV of around 71%.

What is the explanation for the disparity in the results?  The reason is volatility crush.  Both positions were initiated at an IV of 84% and closed at an IV of 71%.  However the call sale represented a vega negative trade while the put buy was a vega positive trade.  Volatility had exploded upwards with the dramatic and sudden price rise.

Although IV is generally considered to be inversely related to price, it is important to realize that it can also spike with dramatic and rapid price rises. The outcomes of these two different trades emphasize the importance of considering IV as well as price when designing option trades.

February 15, 2010

WMT Put Spread

Filed under: Uncategorized — Tags: , , , — Dan Passarelli @ 1:38 pm

Implied volatility (IV) – simply put, it is the estimated future volatility of a security’s price. More often than not, IV increases during a bearish market and it decreases during a bullish market. This reasoning stems, in part, from the belief that a bearish market is more risky than a bullish market. It is a general trading principle that high IV is a signal to sell credit spreads and low IV is a signal to buy debit spreads. Let’s focus on selling a bear put spread during a time of high IV.

Selling put spreads during a period of high IV is a can be a wise strategy, as options are more expensive and you will receive a higher premium than if you sold the put spread during a time of high or average IV. Let’s look at the basic transaction first. Selling a put spread occurs when a trader sells a put option on an underlying, then at the same time buys a put on the same underlying at a lower strike price with the same expiration. Both sides of this contract are opening transactions and they always involve the same number of contracts.  The maximum loss for a put spread is limited to the difference between the strikes less the premium received for selling the put spread. What about the part we all want to know about, the maximum profit? The max profit is limited to the premium received for selling the spread. The break-even-point is the higher strike price less the premium received.

Let’s take a look at this example with a particular stock. In the current current environment, IV is high across the board. Let’s say a trader is farily bullish on Wal-Mart Stores (WMT). The trader decides to sell a put spread on WMT, which is trading around $53 in this example. To sell a put spread our trader might sell one put option contract at the 55 strike and buy one at the 52.50 strike. The short 55 put holds a price of $1.90, in this example, and the 52.50 is at 40 cents. The net premium received, therefore, is $1.50 ($1.90 less $.40). Using these price points, the trade would break even if the stock is below $53.50 ($55 – $1.50) at expiration. Therefore, the stock must rise, but only slightly to produce a winner.

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