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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

August 28, 2014

Short-Term Put Options

Last week we talked about short-term call options and this week I thought it would be appropriate to discuss short-term put options. The mentality behind short-term put options is probably different than the mentality behind short-term call options. Many times option traders consider short-term put options as a means of protection. With the market extended and the possibility of stocks moving lower in the near future, it might be a good time to talk about put options.

If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.

Some investors who are looking to protect an investment only consider buying short-term puts, or front-month puts for protection. The problem however, is that there is a flaw to the reasoning of purchasing short-term put options as protection. Similar to short-term call options, the contracts have a higher option theta (time decay) and relying on short-term puts to protect a straight stock purchase is not necessarily the best way to protect the stock.

Although short-term puts may be cheaper than longer expiration puts, if an option trader was to continually purchase short-term puts as protection, it could end up being a rather expensive way to insure the stock particularly if the stock never declines to the short-term puts strike price. If a put option with a longer expiration was purchased, it would certainly cost more initially, but time decay (premium eroding) would be less of a factor due to a smaller initial option theta. Here is an example using short-term put options.

Using a hypothetical trade, let’s say a stock is trading slightly above $13 and our hypothetical trader wants to by the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months because the trader is counting on the earning reports to move the stock higher.

Being a smart options trader, our trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money September 13 put, which carries an ask price of 0.50 (rounded for simplicity purposes). That $0.50 premium represents almost 4 percent of the current stock price. In fact, if the option trader rolled the short-term put option month after month, it would create a big dent in the initial outlay of cash. After about seven months (assuming the stock hangs around $13 and each monthly put option costs 0.50) the trader would lose more than 25 percent on the $13 investment.

If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops.

Buying a put option is a hedge and can be considered a decent insurance policy for a stock investment. Buying short-term put options as a hedge can make it an extra expensive hedge due to time decay (option theta). Option traders and investors can usually find better ways to protect a stock. To learn new and different approaches, please visit the Learn to Trade section of our website.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 21, 2014

Short-Term Call Options

With the market once again considering a move higher as earnings wind down, it might be a good time to talk about call options. When an option trader buys a call option, he or she has the right to buy the underlying at a particular price (strike price) before a certain time (expiration). Keep in mind that just because the option trader has the right to buy the stock, doesn’t mean that he or she has to necessarily do so. The call option just like a put option can be sold anytime up until expiration for a profit or loss.

A lot of traders especially those who are just learning to trade options can fall in love with call options and especially short-term call options because they are cheaper than call options with longer expirations. We can classify short-term call options as call options that expire in less than thirty days for the sake of this discussion. But there is a potential problem with purchasing short-term call options. The shorter the amount of time that is purchased, the higher the option theta (time decay) will be. The higher the time decay, the quicker the premium will erode away the call option’s premium. The call option may be cheaper due to a shorter time until expiration, but it may not be worth it overall. Let us take a look.

With Tesla Motors (TSLA) trading around $260 last week, an option trader might have considered call options to profit from an expected move higher. He could have purchased the August 260 calls for 3.30 that expired in 3 days. Yes, the options are cheap and yes they will profit if TSLA moves up vigorously in the next couple of days. But the option theta is 0.70 on the call options meaning they will lose $0.70 for everyday that passes with all other variables being held constant, In fact if the stock trades sideways, the option theta will increase the closer it gets to expiration since there is currently no intrinsic value (the in-the-money portion of the option’s premium) on the call options.

If an option trader purchased the September 260 calls for TSLA, it would have cost him 12.00 and it would have made the at-expiration breakeven point of the trade $272 (260 + 12) versus only $263.30 (263 + 3.30) with the August call options. But the major benefit to buying further out is option theta. The September 260 calls had an option theta of 0.15 meaning for every day that passes, the option premium would decrease $0.15 based on the option theta and all other variables being held constant. This is certainly a smaller percentage of a loss based on option theta for the September options (1.25%) versus the August options (21.21%) especially if the stock trades sideways or moves very little.

Fast forward to August expiration, TSLA closed basically at $262. The August 260 call would have expired with an intrinsic value of $2 (262 – 260). If the option trader did nothing up until expiration, the long August 260 call would have lost $1.30 (3.30 – 2) because there would be no time value (option theta) left and only the intrinsic value. The September 260 call would have lost approximately $0.45 (3 X 0.15) in theta but also gained $1 (2 X 0.50) from delta based on a delta of 0.50 and a $2 (262 – 260) move higher. The September 260 calls would now be worth $12.55 (12 + 0.55) and profited $0.55 (12.55 – 12).

Having enough time until expiration is a critical element when an option trader is considering buying options like the call options we talked about above. Keep in mind that as a general rule, options lose value over time and the option theta starts to accelerate even more with 30 days or less left until expiration. Buying a call option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta, might be worth the more expensive price especially if the underlying fails to move higher.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 26, 2014

Outright Call Options and Put Options

Another topic that is brought up often in my Group Coaching class is buying call options and put options outright. When option traders first get their feet wet trading options, they often just buy call options for a bullish outlook and put options for a bearish outlook. In their defense, they are new so they probably do not know many if not any advanced strategies which means they are limited in the option strategies they can trade. Buying call options and put options are the most basic but many times they may not be the best choice.

If an option trader only buys and for that matter sells options outright, he or she often ignores some of the real benefits of using options to create more flexible positions and offset risk.

Here is a recent example using Twitter Inc. (TWTR). If an option trader believed TWTR stock will continue to rise like it has been doing, he could buy a July 39 call for 1.80 when the stock was trading at $38.50. However the long call’s premium would suffer if TWTR stock fell or implied volatility (measured by vega) decreased. Long options can lose value and short options can gain value when implied volatility decreases keeping other variables constant.

Instead of buying a call on TWTR stock, an option trader can implement an option spread (in this case a bull call spread) by also selling a July 42 call for 0.75. This reduces the option trade’s maximum loss to 1.05 (1.80 – 0.75) and also lowers the option trade’s exposure to implied volatility changes because of being long and short options as part of the option spread. This option spread lowers the potential risk however it limits potential gains because of the short option.

In addition, simply buying call options and put options without comparing and contrasting implied volatility (vega), time decay (theta) and how changes in the stock price will affect the option’s premium (delta) can lead to common mistakes. Option traders will sometimes buy options when option premiums are inflated or choose expirations with too little time left. Understanding the pros and cons of an option spread can significantly improve your option trading.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 6, 2014

Weekly Options and Time Decay

There are so many different characteristics of options that I talk a lot about with my options coaching students. But one of the more popular subjects is that premium sellers see the most dramatic erosion of the time value of options they have sold during the last week of the options cycle. Most premium sellers strive to keep the options they have sold short (also known as options they have “written”) out-of-the-money (OTM) in order that the entirety of the premium they have sold represents time (extrinsic) premium and is subject to this rapid time decay.

With 12 monthly cycles, there historically have been only 12 of these final weeks per year in which premium sellers have seen the maximum benefit of their core strategy. The widespread use of weekly options has changed the playing field. Options with one week durations are available on several indices and several hundred different stocks. These options have been in existence since October 2005 but only in the past couple of years have they gained widespread recognition and achieved sufficient trading volume to have good liquidity. Further now, there are weeklys that go for consecutive weeks (1 week options, 2 week options, 3 week options, 4 week options and 5 week options) that were just late last year.

Standard trading strategies employed by premium sellers can be executed in these options. The advantage is to gain the “sweet spot” of the time decay of premium without having to wait through the entirety of the 4 to 5 week option cycle. The party never ends for premium sellers using these innovative methods. Of course there is a trade-off because the shorter the time there is left until expiration, the smaller the option premiums are compared to an option with a longer expiration. As option traders we are used to tradeoffs.

Traders interested in using these weeklys MUST understand settlement procedures and be aware of last days for trading. An excellent discussion of weeklies given by Dan Passarelli is available at Learn to Trade Weeklys.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 23, 2014

Thoughts on Front-Month Puts

With the market threatening to move lower after a bullish run last year and earning’s season upon us,it might be a good time to talk about put options. If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.

A lot of traders especially those who are just learning to trade options can be smitten by put options especially buying the shortest-term, or front month put for protection. The problem, however, is that there is a flaw to the reasoning of purchasing front-month puts as protection. Front-month contracts have a higher theta (time decay) and relying on front-month puts to protect a straight stock purchase is not necessarily the best way to protect the stock. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.

Although front month options are often cheaper, they are not always your best bet. The idea may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his or her position; but sound reasoning does not always lead to good practice. Here’s an example.

We will use a hypothetical trade. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months as the trader wants to allow the news events to move the stock higher.

Being a smart options trader, our stock trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money July 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would create a big dent in the initial outlay of cash. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.

If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops. Buying the put is a hedge and and a solid insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.

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

November 7, 2013

A Discussion About Put Options

There has been significant talk recently about a potential market pullback but so far market participants have remained relatively bullish. Whether it happens tomorrow or well into the future, there is a time when the market and every stock will lose value. If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.

A lot of traders especially those who are just learning to trade options can be enthralled by put options especially buying the shortest-term, or front month put for protection. The problem, however, is that there is a flaw to the reasoning of purchasing front-month puts as protection. Front-month contracts have a higher theta (time decay) and relying on front-month puts to protect a straight stock purchase is not necessarily the best way to protect the stock. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.

Although front month options are often cheaper, they are not always your best bet. The idea may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his or her position; but sound reasoning does not always lead to good practice. Here’s an example.

We will use a hypothetical trade. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he or she thinks the stock will beat its earnings’ estimates in each of the next two quarters. This investment will take at least six months as the trader wants to allow the news events to move the stock higher.

Being a smart options trader, our stock trader wants some insurance against a potential drop in the stock just in case. The trader decides to buy a slightly out-of-the-money April14 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would create a big dent in the initial outlay of cash. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.

If the stock drops in price, then the ultimate rationalization for the strategy is realized; protection. The put provides a hedge. The value of the option will increase as the stock drops, which can offset the loss suffered as the stock drops. Buying the put is a hedge and and a solid insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.

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

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