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November 6, 2014

AAPL and Risk Control

Now that Apple’s earnings announcement is behind us, it may be a good time to take another look at the technology giant. With the volatility event over, you might be looking to implement an option position. Even though the company announced its earnings, there may still be some volatile action ahead as the market heads towards the holidays.  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 an option trader, but perhaps the single most attractive characteristic is the ability to control risk rather precisely in many instances. Much of this advantage comes from the ability to control positions that are similar to stock with far less capital outlay.

One particular form of risk control that is often dismissed among option traders is the time stop. Time stops take advantage of the time decay (theta) and can help control risk. It is important to understand that this time decay is not linear by any means.

As a direct result, it may not be apparent the course the time decay curve will follow. An option trader has to take into account that the option modeling software that most online brokers have is essential to plan the trade and decide the appropriate time at which to place a time stop. This of course is dependent on how much risk the option trader is willing to take concede due to time decay as part of the whole risk element of the trade. Other risk factors include delta, gamma and theta just to name a few.

As an example, consider the case of a bullish position in AAPL implemented by buying in-the-money December 105 calls. A trader could establish a position consisting of 10 long contracts with a position delta of +700 for approximately $5,000 as I write this.

At the time of this writing, the stock is trading around $109; these call options are therefore $4 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade if AAPL is at or abelow $106 (where potential support is at) at expiration. The options expiration risk is $4,000 or more. However, if the option 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 $106 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 and the option having a higher price. In this scenario, closing the position prior to expiration helps the trader lose less when the stop triggers. This is especially true if there is a fair amount of time until expiration and time decay hasn’t totally eroded away the option premium.

As one can see, options offer a variety of ways to control risk. An option trader needs to learn several that match his or her risk/reward criteria and personality.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 14, 2014

AAPL and Option Gamma

Many option traders will refer to option delta as the most important option greek. It is debatable but in my opinion the next most important greek is option gamma. Option gamma is a one of the so-called second-order option greeks. It is, in theory, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Using option gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using option gamma:

When you buy options you get positive option gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL September 95 long call that has an option delta of 0.55 and option gamma of 0.0478 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive option gamma is a good thing.

When you sell options you get negative option gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative option gamma is a bad thing.

Start by understanding option gamma from this simple perspective. Then, later, worry about figuring out the math.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 10, 2014

Option Delta and Option Gamma

The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.

ATM, ITM and OTM

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

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 26, 2013

Gamma and AAPL

Many option traders will refer to the trifecta of option greeks as delta, theta and vega. But the next most important greek is gamma. Options gamma is a one of the so-called second-order options greeks. It is, if you will, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Using options gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using gamma:

When you buy options you get positive gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL January 565 long call that has a delta of 0.51 and gamma of 0.0115 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive gamma is a good thing.

When you sell options you get negative gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative gamma is a bad thing.

Start by understanding options gamma from this simple perspective. Then, later, worry about working in the math.

Happy New Year!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 22, 2013

Learning to Adjust Option Positions

Dan’s online Options Education series this month (August series) has all been all about helping traders learn to adjust options positions. Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into breakeven trades and winners. Given that, it’s easy to see why it’s important to learn to adjust options positions.

Adjusting 101

Adjusting options positions is a technique in which an option trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market outlook or physiology changes and the original trade no longer reflects the trader’s thoughts. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.

This seems like a very obvious rule. And at the onset of any trade, it is. If I’m bullish, I’m going to take a positive delta position. If I think a stock will be range-bound, I’d take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.

Gamma

Gamma—particularly negative gamma—is the cause of the need for adjusting.

Gamma definition: Gamma is the rate of change of an option’s (or option position’s) delta relative to a change in the underling.

Oh, yeah. And, just in case you forgot…

Delta definition: Delta is the rate of change on an option’s (or option position’s) price relative to a change in the underlying.

In the case of negative gamma, trader’s deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).

Finally

Therefore, traders must learn to adjust options positions, especially income trades, in order to stave off adverse deltas created by the negative gamma that accompanies income trades. But remember, just because you can adjust a position doesn’t mean you should!

To find out more about next month’s topic and have access to the archived previous seminars including “Option Trade Adjustments” please visit Options Education.

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

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

October 25, 2012

Learn to Adjust Options Positions

Dan’s online Options Education series this month has all been all about helping traders learn to adjust options positions. Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into winners. Given that, it’s easy to see why it’s important to learn to adjust options positions.

Adjusting 101

Adjusting options positions is a technique in which a trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market physiology changes and the original trade no longer reflects the trader’s thesis. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.

This seems like a very obvious rule. And at the onset of any trade, it is. If I’m bullish, I’m going to take a positive delta position. If I think a stock will be range-bound, I’d take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.

Gamma

Gamma—particularly negative gamma—is the cause of the need for adjusting.

Gamma definition: Gamma is the rate of change of an option’s (or option position’s) delta relative to a change in the underling.

Oh, yeah. And, just in case you forgot…

Delta definition: Delta is the rate of change on an option’s (or option position’s) price relative to a change in the underlying.

In the case of negative gamma, trader’s deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).

Wrap Up

Therefore, traders must learn to adjust options positions, especially income trades, in order to stave off adverse deltas created by the negative gamma that accompanies income trades.

To find out more about next month’s topic and have access to the archived previous seminars including “Option Trade Adjustments” please visit Options Education.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 6, 2012

Butterflies and Weekly Options

The weekly options have been the topic of our blog many times before. Despite this topic being the trendy subject and in the forefront of many discussions, it is helpful to recognize the functional flexibility this dramatically shortened lifespan brings to a variety of option strategies. If you need to find out more about weekly options or other option strategies, feel free to visit the options education section on our website.

As an example, consider the case of a frequently traded spread vehicle, the butterfly. For those first encountering this strategy, it is helpful to consider briefly its components. It is constructed by establishing both a credit and a debit spread sharing a central strike price. It can be constructed in either all puts or all calls.

Butterflies can be designed to be either a non-directional or directional trade strategy. Functional characteristics include: negative vega, variable delta and accelerating gamma and theta during its life span. In the case of the long standing monthly duration option cycles which had heretofore been available, these characteristics developed over weeks to months and reached their final expression during the week of option expiration.

These functional characteristics have limited the utility of butterflies over brief duration moves occurring early in the options cycle. Many butterfly traders have had the experience of correctly predicting price action early in the cycle only to have the butterfly deliver little, if any, profit.

The short nine day duration of the weekly options has dramatically accelerated the pace of butterfly trading as the changes begin to occur literally over the extent of a few hours. As such, it is possible to gain the advantage of this trade structure over brief directional moves or in the case of non-directional traders to have market exposure for briefer periods of time.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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