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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

February 6, 2014

Option Prices and Earnings

With earnings season in full gear and major players like Priceline.com and Tesla 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

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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

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earnings announcement.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 24, 2013

Implied Volatility and the Debt Ceiling Crisis

In the last couple of months, the market has shown some good movement. The S&P 500 and Dow set their all-time highs and then promptly moved lower. Washington struggled to find common ground which in turned partially shutdown the government and moved stocks all around. Now we are in the middle of earnings season and the roller-coaster ride may continue. It is important for option traders to understand one of the most important steps when learning to trade options;  analyzing implied volatility and historical volatility. This is the way option traders can gain edge in their trades. But analyzing implied volatility and historical volatility is often an overlooked process making some trades losers from the start. An option trader needs to look back at the last couple of months of option trading to see how volatility played a crucial part in option pricing and how it will help them going forward.

Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of a stock with another stock or to the stock itself over a period of time. For example, a stock that has a 30 historical volatility is less volatile than a stock with a 35 historical volatility. Additionally, a stock with a historical volatility of 45 now is more volatile than it was when its historical volatility was, say, 30.

In contrast to historical volatility, which looks at actual stock prices in the past, implied volatility (IV) looks forward. Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock’s options. For example, the market (collectively) expects a stock that has a 20 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile. A recent example of the implied volatility increasing was the debt ceiling crisis. There was some concern that the government would not hammer out a compromise and thus default which put fear into the market and increased implied volatility.

Analyzing Volatility
Implied volatility and historical volatility is analyzed by using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are  misinterpreted by new or less experienced option traders.

Regular users of volatility charts need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” price. In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.

But that is not where the story ends. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sell; if it is below its normal level it may still be a good buy.

Finally, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was typically in the past, the stock is now more volatile than normal.

If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can capitalize on the disparity known as the skew by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.

The Art and Science of Implied Volatility and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are shown here. But there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is different like an expected earnings announcement or a general fear of the economy. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade and that is precisely what every trader needs.

Just a heads up…there is another government deadline coming early next year that might provide for another implied volatility skew. Get ready!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 15, 2013

Determining Option Strategies on AAPL

Compared to trading equities, there are so many more option 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 root 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. Now that the stock has recently broken through several resistance areas, there are traders who continue to be extremely bullish on AAPL 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 summer ending soon and supposedly the slow markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the fall season!

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 23, 2013

Risk/Reward is Ever Changing

There are quite a few option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or lack of movement in price of the stock.  Examples of such strategies include the sale of naked options  and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three main forces, the initial risk:reward calculation often changes and sometimes even dramatically.  The successful trader with a proper options education is aware of these changes, because the risk to gain the last bit of potential profit is often dramatically out of whack to the magnitude of the profit he or she seeks to obtain.

Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller.  This trader has chosen to sell out-of-the-money (OTM) puts, the June $385 strike, on AAPL which currently trades at $440 in this example.  His risk in the trade is that he is obligated to buy AAPL at the strike price at any time between opening the trade and June expiration.  For taking the risk of writing these puts, his account receives a credit of $1.10 and margin is encumbered based on SEC rules.  The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.

As June expiration approaches, the stock remains at the $440 level and the market price of the puts he has sold decreases as a result of time (theta) decay.  As the price of the puts decreases and the profits increase, the risk:reward increases.  As the price declines below the often used 20% re-evaluation benchmark of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial and may no longer be appropriate given the reward.

The experienced options trader will many times take profits and find opportunities to invest his or her money in other trades that appear to be much more attractive from a risk/reward standpoint than to remain in the existing position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 25, 2011

Interesting and Volatile Times

“May you live in interesting times” is an ancient Chinese curse.  The fact that the last few weeks have seen neck snapping and wild changes in volatility, I think we qualify for living in what these philosophers would consider to be interesting times.

For those who are unfamiliar with the impact of volatility on option trades, suffice it to say that the current market contains unique challenges. As I write, the volatility environment has experienced remarkable volatility. While the concept of the volatility of the volatility may seem arcane, it has huge impact on the behavior of option positions.

Remember that option premium, while quoted as a single bid/ask spread, in reality consists of the sum of the extrinsic and intrinsic premiums.  While the intrinsic premium may vary wildly in such markets as we currently are experiencing, it is a straightforward and transparent calculation depending solely on the current market price of the underlying and the strike price under consideration.

The extrinsic premium is not so straightforward and is impacted by several factors, the most important of which are the time to expiration and the IV.  The time to expiration is clearly defined by anyone with a calendar, or perhaps a stopwatch currently, and represents another transparent variable.

The situation is much more interesting in the world of IV.  This is where current unprecedented directional movements impact option prices most dramatically.  The situation is rendered even more complex by the fact that the IV changes are occurring in both directions; it is not simply a trending volatility environment.  The volatility of the volatility has increased dramatically.

Traders must be cautious when establishing new positions and monitor the vega of the position assiduously. In many cases, structured positions such as vertical spreads are indicated in order to reduce vega exposure.

November 2, 2010

Reading Tea Leaves

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

May 17, 2010

A Tale Of Two Options

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.