Testimonials

May 23, 2013

Risk/Reward is Ever Changing

Filed under: Options Education — Tags: , , , , , , , , , — Dan Passarelli @ 1:35 pm

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

December 6, 2012

Selling AAPL Puts: Naked or as a Spread

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 11:10 am

One of the bullish strategies in the arsenal of an options trader is that of selling puts. Many traders have have heard of this strategy but are unfamiliar with the nuances and need more options education before possibly implementing them.  The sale can be accomplished either as naked sales (aka selling “cash secured” puts when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or simply selling a put spread).

The requirement of this position is that of being short puts.  As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of in the price of the underlying.  The magnitude of the “deductible” for the policy is determined by the strike price the trader has sold.

Here is an example using AAPL whose recent sell-off has sparked interest in puts. A trader who sells a December 555 strike put to another trader holding an underlying currently trading at $550 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible.  In return for issuing this insurance policy (known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions.  The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased.  In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used and more conservative strategy is to sell a put spread.  When a trader sells a put spread, the fundamental profit is still short sale of the put at the selected strike price.  However, as contrasted to the naked put sale, an additional position is taken to lower the risk and to reduce the margin.  The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration.  Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread.  In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin.  However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in stock they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure.  This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 26, 2012

Risk: Reward is Not Static on AAPL

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 11:06 am

Several groups of 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 failure of movement in price of the underlying.  Examples of such strategies include naked option sales and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three primal forces, the initial risk:reward calculus often changes dramatically.  The successful trader with a proper options education is aware of these changes, because the risk to extract the last bit of potential profit is often dramatically out of proportion to the magnitude of the profit he seeks to capture.

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 write out-of-the-money puts, the August $510 strike, on AAPL which currently trades at $570 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 August expiration.  For taking the risk of writing these puts, his account receives a credit of $1 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 August expiration approaches, the stock remains at the $570 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 in such trades often finds the opportunities to deploy capital in other trades to be much more attractive than to remain in the existing position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 3, 2012

Selling AAPL Puts: Naked or as a Spread

Filed under: Options Education — Tags: , , , , , , , , — Dan Passarelli @ 12:21 pm

One of the bullish strategies in the arsenal of an options trader is that of selling puts. Many traders have have heard of this strategy but are unfamiliar with the nuances and need more options education before possibly implementing them.  The sale can be accomplished either as naked sales (aka selling “cash secured” puts when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or for “those in the know” simply selling a put spread).

The sine qua non of this position is that of being short puts.  As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of variable degree in the price of the underlying.  The magnitude of the “deductible” for the policy is determined by the strike price the trader has sold.

Here is an example using AAPL. A trader who sells a $590 strike put to another trader holding an underlying currently trading at $585 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible.  In return for issuing this insurance policy (in option lingo known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions.  The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased.  In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used similar strategy is to sell a put spread.  In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price.  However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance.  The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options.  Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread.  In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin encumbrance.  However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure.  This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable; if you know the road map it is much easier to arrive where you want to be.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 4, 2012

Naked Puts on AAPL Stock

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 4:48 pm

The Strategy
If you want to learn to trade here’s a really useful option strategy that all traders should know. Let’s take a look at an option strategy that involves the selling of a put, often referred to as an uncovered put write or a naked put write. A naked put write is when a trader sells a put that is not part of a spread. This strategy is generally considered to be a bullish-to-neutral strategy.

The maximum profit is the premium received for the put. The maximum profit is achieved when the underlying stock is greater than or equal to the strike price of the sold put. Though this allows for a lot of room for error (The stock can be anywhere above the strike at expiration), note that the maximum loss is unlimited and occurs when the price of the underlying stock is less than the strike price of the sold put less the premium received. So, executing this trade in the right situation is essential. To calculate breakeven, subtract the premium received from the sold put’s strike price.

The Example
For our example we will use Apple (AAPL). For this example we will assume the stock is trading around $625 a share. A trader sells the April 615 put, which carries a bid price of $10.00 (rounded to make the math a bit easier). Should AAPL stock be trading above $615 a share at expiration, the April 615 contract will expire worthless and the trader will keep the premium collected. (Do not forget to take any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls?

If AAPL falls to, say, $600 at expiration, the put would expire in-the-money and would have to be purchased back to avoid assignment. This could cost the trader a rather hefty sum. Assigning values, our investor collected $10 in premium. The 615 put expired with $15 in intrinsic value. The trader loses the $15, less the $10 premium collected results in a loss of $5, or $500 of actual cash.

Why Sell Naked Puts?
We have already discussed the profit potential of selling naked puts, but there is another reason to do so – owning the stock. Selling naked puts is a good way to purchase at a specific price by choosing a strike near said target price. Should the stock price drop below the put strike and the puts are assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the premium is pocketed at expiration.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 29, 2011

Risk:Reward Is Not Static

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 10:47 am

Several groups of 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 failure of movement in price of the underlying.  Examples of such strategies include naked option sales and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three primal forces, the initial risk:reward calculus often changes dramatically.  The successful option trader needs to be aware of these changes, because the risk to extract the last bit of potential profit is often dramatically out of proportion to the magnitude of the profit he seeks to capture.

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 write out-of-the-money puts, the October $90 strike, on XYZ which currently trades at $100.  His risk in the trade is that he is obligated to buy XYZ at the strike price at any time between opening the trade and October expiration.  For taking the risk of writing these puts, his account receives a credit of $1 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 October expiration approaches, the stock remains at the $100 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 option trader in such trades often finds the opportunities to deploy capital in other trades to be much more attractive than to remain in the existing position.