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December 18, 2013

Strangles and AAPL

Today we are going to discuss an option strategy that you may not have thought about in quite some time. A straddle is an option strategy that traders can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the trader is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (which makes up a straddle), the trader purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars

Like a straddle, a strangle has two breakeven points. 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 (yes, unlimited). 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 a strangle is the net premium paid.

Example Trade

To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing is trading at around $540 after a volatile couple if weeks. The trader would buy both a January 545 call and a January 535 put. For simplicity, we will assign a price of $17 for both – resulting in an initial investment of $34 for our trader (which again is the maximum potential loss).

Should the stock rally past $545 at expiration, the 535 put expires worthless and the $545 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $38, the profit is $4 (intrinsic value less the premium paid). The same holds true if the stock falls below $535 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial $34, or $3,400 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. 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.

I hope you have a safe and very Happy Holiday!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 3, 2013

Keeping Options Simple

At first, options can be a very complex entity to understand. But if a trader looks at things from a fundamental perspective, it may become clearer. The options world is ruled by three basic forces consisting of: price of the underlying, time to options expiration, and implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces has when designing the architecture of the options trade under consideration.

For the new options traders, learning about options and the impact of these three fundamental forces may be confusing and the magnitude of the influence of each on the profitability of trades is easily under-appreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders start out as being stock traders where “only price pays” the initial reluctance and hesitation to consider additional factors impacting a trade is easily understood.

In order to help understand the initially confusing manner in which options respond to their outside and inside forces, it is helpful to breakdown an option’s price into its two components: extrinsic value and intrinsic value. Remember that the quoted price of an option reflects the sum of the intrinsic (if any) and extrinsic values. Intrinsic value of an option is that portion of the premium which is in-the-money and is impacted solely by the price of the underlying. Extrinsic value is also known as time premium and is impacted by both time to expiration and IV.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 16, 2013

Reviewing Strangles with AAPL

There is no doubt we have discussed straddles in the past in this blog. A straddle is an option strategy that traders can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the trader is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (which makes up a straddle), the trader purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars

Like a straddle, a strangle has two breakeven points. 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 (yes, unlimited). 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 a strangle is the net premium paid.

Example Trade

To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing is trading at around $432 after a volatile couple if weeks. The trader would buy both a June 435 call and a June 430 put. For simplicity, we will assign a price of $13 for both – resulting in an initial investment of $26 for our trader (which again is the maximum potential loss).

Should the stock rally past $435 at expiration, the 430 put expires worthless and the $435 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $29, the profit is $3 (intrinsic value less the premium paid). The same holds true if the stock falls below $430 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial $26, or $2,600 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. 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

January 10, 2013

Moneyness and AAPL

Moneyness isn’t a word, is it? Dan uses it often and he even has a section about it in his books. It won’t be found on spell-check, but moneyness is a very important term when it comes to learning to trade options. There are three degrees, if you will, of moneyness for an option, at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let’s take a look at each of these terms, using tech behemoth Apple (AAPL) as an example. At the time of writing, Apple was hovering around the $520 level, so let’s define the moneyness of Apple options using $520 as the price.

At-the-Money
An at-the-money AAPL option is a call or a put option that has a strike price about equal to $520. The ATM options (in Apple’s case the 520-strike put or call) have only time value (a factor that decreases as the option’s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time.

In-the-Money
An option that is in-the-money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of AAPL, ITM options include the 515 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.

A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, an ITM AAPL put carries a strike price of 525 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a January AAPL 530 put has a premium of $14.20 compared to a price of $11.10 for a January 525 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 515 call and AAPL closed at $520 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $515 a share.

Out-of-the-Money
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher than the market price of the underlying, and puts are OTM when their strike price is lower than the stock’s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.

If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 16, 2012

There’s a Time for Everything: Thoughts on AAPL Option Strategies

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 and getting a proper options education can help a trader better understand all of those strategies and when and how to use them.

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish AAPL traders. Now that the stock has severely declined in price, there are traders who are extremely bullish on AAPL and want to get more bang for their buck and buy short-term out-of-the-money calls. Less bullish traders might buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high 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. With the holidays approaching, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the New Year!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 8, 2012

Thoughts on AAPL Risk

Hurricane Sandy and the recent decline in Apple Inc. (AAPL) stock is a reminder of how “black swan” events can impact our lives in unforeseen and unforeseeable ways. Yogi Berra summed it up succinctly in his aphorism that “the future isn’t what it used to be.” It never is.

One helpful organizational concept of financial risk is to consider that risk comes in two categories. The usual type of risk is analyzed by the bell shaped curve of a Gaussian (log normal) distribution that most traders are familiar with. The other general category of risk is characterized by the unforeseen events that result in major alterations of the financial landscape. It is this category of risk to which Nassim Taleb has drawn attention in his books regarding the lack of predictability of consequential rare events.

How does this impact the world of the trader and the usefulness of options? The fact is that all funds invested in the market are totally at risk at all times and the comfort that stop losses may give can give a trader can be a false sense of security. From this concept, the ability to control stock with far less invested capital becomes inescapably attractive.

Such is one core function of options; control of stock with commitment of far less capital than outright purchase. To take a straightforward example, shares of AAPL which has taken center-stage on many traders and investors radars, currently trades around $560 after a major decline. The stock may now look attractive to buyers after its fall from around $700. To control 100 shares by outright stock purchase would require $56,000. A substantially delta equivalent position using deep in-the-money calls, the December 400 strike, could be purchased for approximately $16,200. As is characteristic of a deep in-the-money option, there is very little eroding time premium for which the trader is paying. In this example, there is substantially less risk buying the call option than purchasing the stock outright.

Should Armageddon arrive unannounced again and it might, which position is better: the total loss of the value of the stock position or the vaporization of the money paid for the option?

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.