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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

June 18, 2014

AAPL Butterfly After the Split

There has been more talk than usual about Apple Inc. (AAPL) before and now just after the split. Several traders have asked me about what type of AAPL option trade they can use if they think AAPL will rise to around $100 in a few short weeks. Truth be told, there is more than one option strategy that can profit. But an option trader should consider a directional butterfly spread particularly if he or she has a particular time frame in mind as well. Depending on how the butterfly spread is structured, the option trader can structure a high risk/reward ratio for the spread. Let’s take a look at this option strategy.

The long butterfly spread involves selling two options at one strike and then purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered to be the wings and the short options are the body of the butterfly. The option strategy objective is for the stock to be trading at the sold strikes at expiration. The option strategy benefits from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value and the lower strike call on a long call butterfly spread or higher strike put for a long put butterfly spread have intrinsic value.

As mentioned above, if an option trader thinks that AAPL will be trading around $100 in about three weeks, he can implement a long call butterfly spread with the sold strikes (body) right at $100. Put options could also be used but since the spread is being structured out-of-the-money (OTM), the bid/ask spreads of the options tend to be tighter versus in-the-money (ITM) options which would be the case with put options. The narrower the option trader makes the wings (long calls) the less the trade will cost but there will be less room to profit due to the breakevens. If the butterfly spread is designed with larger wings, the more it will cost but there will be a wider area between the breakevens.

At the time of this writing, AAPL is trading around $92. An option trader decides to buy a Jul-03 97/100/103 call butterfly for 0.15. The most the trader can lose is $0.15 if AAPL closes at or below $97 and at or above $103 at expiration. The breakevens on the trade are between $97.15 (97 + 0.15) and $102.85 (103 – 0.15). The maximum profit on the trade in the unlikely event AAPL closes exactly at $100 on expiration would be $2.85 (3 – 0.15). This gives this option strategy a 1 to 19 risk/reward ratio. Granted AAPL needs to move higher and be around $100 in three weeks but one could hardly argue about the risk/reward of the option strategy or the generous breakeven points of the spread.

This AAPL option trade may be a bit overwhelming for a new option trader to understand and there is more than one way to take a bite out of AAPL with a bullish bias. A directional call butterfly spread in this instance is just one way. A big advantage that the directional butterfly strategy may have over another option strategy is the high risk/reward ratio. The biggest disadvantage is the trader needs to be right about the time frame in which the stock will trading between the wings since maximum profit is earned as close to expiration as possible.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 15, 2014

Delta and Your Overall Position

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

An important thing to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock is trading at $590 and purchases 3 June 590 call options. Each call contract has a delta of +0.50. The total delta of the position would then be +1.50 (3 X 0.50) and not 0.50. For every dollar AAPL rises all factors being held constant again, the position should profit $150 (100 X 1 X 1.50). If AAPL falls $2, the position should lose $300 (100 X -2 X 1.50).

Using AAPL once again as the example, lets say a trader decides to purchase a 590/600 bull call spread instead of the long calls. The delta of the long $590 call is once again 0.50 and the delta of the short $600 call is -0.40. The overall delta of the position is 0.10 (0.50 – 0.40). If AAPL moves higher by $5, the position will now gain $50 (100 X 5 X 0.10). If AAPL falls a dollar, the position will suffer a $10 (100 X -1 X 0.10) loss.

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

 

 

April 3, 2014

Different Option Strategies on AAPL

Compared to trading stocks, there are so many more strategies available to an option trader. But more importantly: Do you know why there are so many different types of options strategies? This is the real reason of our discussion and why 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. The stock has recently moved higher after declines in January and February. There are traders who continue to be extremely bullish on AAPL as it heads closer to its earnings announcement and want to get more bang for their buck and buy short-term out-of-the-money calls. This might not be the most prudent way to capture profits but that is a discussion for another time. 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 (which it currently is not but it has been rising) and the trader is bullish just to a point, the trader might sell a bull put spread (credit spread), and so on.

The differences in options strategies, no matter how apparently minor, 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 difference. 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 defining your outlook and intentions and selecting the best 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 spring hopefully ending soon (cold and snowy winter here in Chicago)and supposedly the volatile markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the summer season!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 13, 2014

AAPL Options and Moneyness

Dan Passarelli often uses the word “moneyness” and he even has a section about it in his books. Moneyness isn’t a word, is it? 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 $535 level, so let’s define the moneyness of Apple options using $535 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 $535. The ATM options (in Apple’s case the 535-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 530 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 540 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a March AAPL 545 put has a premium of $11.50 compared to a price of $7.95 for a March 540 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.

Have a great week of trading!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring