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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

January 9, 2014

Butterflies, Expiration, the Importance of Time and Christie Brinkley

One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Christie Brinkley is still considered to be still quite attractive by many, her look is not the same as it was decades ago when she was a top model and cover-girl. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and undeniable in the world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading strategy known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the same strike price constructed together in the same underlying in the same expiration. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week. Beauty is in the eye of the beholder!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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 31, 2013

Controlled Stops and AAPL

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

Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely in many instances. Much of this advantage comes from the ability to control positions that are equivalent to stock with far less capital outlay.

However, a less frequently discussed aspect of risk control is the ability to moderate risk by the careful and precise use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear by any means.

As a direct result, it may not be obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software that most brokers have is essential to plan the trade and decide the appropriate time at which to place a time stop.

As a simple example, consider the case of a short position in AAPL established by buying in-the-money December 530 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -540 for approximately $25,000 as I write this.

At the time of this writing, the stock is trading around $522; these puts are therefore $8 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $525 at expiration. The options expiration risk is $20,000 or more. However, if the trader takes the position that the expected or feared move will occur quickly—long before expiration—he could implement a time stop as well.

Using a stop to close the position if the stock gets to $525 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t totally eroded away.

Options offer a variety of ways to control risk. An option trader needs to learn several that match his or her risk/reward criteria.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 1, 2013

Butterflies, Expiration, Raquel Welch and the Importance of Time

One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Raquel Welch is still considered to be still quite attractive by many, her look is not the same as it was decades ago when she was known as a “bombshell”. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and undeniable in the world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading strategy known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the same strike price constructed together in the same underlying in the same expiration. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week. Beauty is in the eye of the beholder!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 18, 2013

Earnings and Other Influences of Option Prices

With earnings season in full gear and major players like Apple and Netflix ready to announce soon, it is probably a good time to review how option prices are influenced.

Perhaps the most easily understood of the options 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 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 price influence 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 options pricing influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over an earnings announcement.

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

February 21, 2013

Expiration Week: Butterflies

One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade vehicles. Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in the same month. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the beast becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 7, 2013

Stop AAPL in Time

Learning to trade options offers a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely and to do so with precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.

However, a less frequently discussed aspect of risk control is the ability to moderate risk by the astute use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.

As a direct result, it is not obviously apparent the time course that the decay curve will follow. An option trader has to take into account that the option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.

As a simple example, consider the case of a short position in AAPL established by buying in-the-money March 470 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -595 for approximately $22,000 as I write this.

At the time of this writing, the stock is trading around $459; these puts are therefore $11 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $462 at expiration. The options expiration risk is $14,000 or more. However, if the trader takes the position that the expected/feared move will occur quickly—long before expiration—he could implement a time stop as well.

Using a stop to close the position if the stock gets to $462 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t totally eroded away.

Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 3, 2013

The Influence of Option Prices

Perhaps the most easily understood of the options 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 price influence, 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 price influence is perhaps the most important. It is without question the most neglected and overlooked component: implied volatility. 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 options pricing influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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