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 NFLX traders. Now that the stock has recently gapped up big after earnings and has broken through several resistance areas and is now trading around its all-time high, there are traders who continue to be extremely bullish on the stock. Some option traders 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:
Degree of bullishness or bearishness
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 coming 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!
Implied volatility (IV) has been relatively low in the market until recently. With recent downturn in the market, some implied volatility levels have increased of of their recent lows. Implied volatility by definition is the estimated future volatility of a stock’s price. More often than not, IV increases during a bearish market (or a sell off like we have been seeing) and decreases during a bullish market. The reasoning behind this comes from the belief that a bearish market is more risky than a bullish market. The jury is still out on whether this current bullish market can continue through the summer but regardless, now may be a good time to review a strategy that can take advantage of higher implied volatility even if it doesn’t happen this week. Option traders need to be prepared for all types of trading environments.
Reasoning and Dimensions
Selling bull put spreads during a period of high implied volatility can be a wise strategy, as options are more “expensive” and an option trader will receive a higher premium than if he or she sold the bull put spread during a time of low or average implied volatility. In addition, if the implied volatility decreases over the life of the spread, the spread’s premium will also decrease based on the option vega of the spread. Option vega measures the option’s sensitivity to changes in the volatility of the underlying asset. The implied volatility may decrease if the market or the underlying moves higher.
Outlook and the VIX
Let’s take a look at an example of selling a bull put spread during a time of high implied volatility. In this recent environment, the CBOE Market Volatility Index (VIX) has recently moved from just below 14 percent to about 17 percent in about two weeks which was accompanied by a decline in the market over that same time period. The VIX measures the implied volatility of S&P 500 index options and it typically represents the market’s expectation of stock market volatility. Usually when the VIX rises, so does the implied volatility of options. Despite the drop, let’s say a trader is fairly bullish on XYZ stock. With the option premiums increased because of the implied volatility increasing, a trader decides to sell a bull put spread on XYZ, which is trading around $53 in this example.
Selling the Spread
To sell a bull put spread, the trader might sell one put option contract at the 52.5 strike and buy one at the 50 strike. The short 52.5 put has a price of 1.90, in this example, and the 50 strike is at 0.90. The net premium received is 1.00 (1.90 – 0.90) which is the maximum profit potential. Maximum profit would be achieved if XYZ closed above $52.50 at expiration. The most the trader can lose is 1.50 (2.50 – 1.00) which is the difference between the strike prices minus the credit received. The bull put spread would break even if the stock is at $51.50 ($52.50 – $1.00) at expiration. In other words, XYZ can fall $0.50 and the spread would still be at its maximum profit potential at expiration. If the VIX was still at 12 percent like it had been previously, the implied volatility of these options could be lower and the trader might only be able to sell the spread for 0.90 versus 1.00 when it was at 18%. Subsequently the max loss would be 0.10 higher too. In addition, if the IV decreases before expiration (like it has been known to do if the underlying rises), the spread will also decrease based on the option vega which could decrease the spread’s premium faster than if the IV stayed the same or if it rose.
When examining possible option plays and implied volatility is at a level higher than normal, traders may be drawn to credit spreads like the bull put spread. The advantage of a correctly implemented bull put spread is that it can profit from either a neutral or bullish move in the stock and selling premium that is higher than normal.
Several days ago, there was a rumor that Samsung was planning on acquiring smartphone maker BlackBerry Limited (BBRY) and the stock shot up over 25%. The rumors so far have failed to materialize. That being said, let’s look at an made-up example of a take-over and a way to use options to capture the possible move. A $50 stock is rumored to be taken out at $55. Looks like a nice spec trade right? You go to the option chain to look for some calls to buy and you notice that the options have gotten pretty expensive. Implied volatility has skyrocketed. Sometimes implied volatility can make options so expensive that even if the trade goes your way the profit is just not there–but the risk is. So, what’s an options trader to do?
One solution can be to buy a bull call spread instead of the outright call. The rationale? It’s called hedging–hedging volatility premium. Whenever you buy options, you’re getting long implied volatility. If implied volatility is expensive, the options are expensive too. And if implied volatility subsequently falls after you make the trade, those options drop in value too. So, what if you both buy and sell an option to create a spread? Let’s look at the two legs of a bull call spread
Bull Call Spread – Long Leg
A bull call spread is when a trader buys one call and sells another that has a higher strike price. Look at it as two trades. The long call would be the one you might buy if you were to spec on the take-over stock. In the case of a take over, this call likely has high implied volatility as the market scrambles to buy up calls, making it pricey.
Bull Call Spread – Short Leg
Because there is a target price in which the take-over target is expected to be bought, you only need exposure up to a certain point–the take-over price. Why not sell a call at or above the expected take-over price? You’re not giving up upside. But you are taking in (expensive) premium to hedge the (expensive) premium you’re buying with the long call leg. It’s a perfect spread.
Let’s look at this in terms of absolute risk. A stock currently trading for $50 is rumored for take over at $55. News is expected within a couple of weeks.
Buy 1 February 50 call at $4
Sell 1 February 55 call at $2
Net debit $2
Max loss = $2 (That’s better than just buying the 50 calls outright)
Max gain = $3 (That’s the $5 spread minus the $2 premium)
Break even = $52 (That’s $50 strike plus $2 spread premium)
Here the max loss/max gain ratio of the spread is 2:3. The max loss/max gain ratio of the outright call would be 4:1 (Remember, you expect the stock only to rise to $55). The spread looks better so far. Let’s look at the break evens. The spread break-even is $52. The outright call’s break even is $54. Better still.
With all option strategies, there are opportune times when they offer an advantage over an alternative strategy. Bull call spreads and take-over candidates are a natural fit. Traders always need to look for ways to construct the smartest position in terms of risk-reward.
The last several months, the market has shown some good movement with some wild swings. The S&P 500 and Dow set their all-time highs once again, and then promptly moved lower. Now we are about to start the next 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.
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. High is giid for selling and low is good for buying option premium.
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.
Now you know a little more about how implied volatility can affect options, it is time to put that knowledge to use and get the edge in your trades!
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 (option theta) 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 continued and expanding 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 even more weeklys that go for consecutive weeks (1 week options, 2 week options, 3 week options, 4 week options and 5 week options).
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. In addition, it gives premium-selling option traders even more choices to take advantage of option theta. 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.
Option 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. enjoy the Holidays!
The World Series playoffs are about to begin and it is the most exciting time of the year if you are a fan of baseball. But did you ever stop and think for a minute how these fantastic athletes got to be where they are? It took a lot of dedication, courage and a well thought out plan to make it to their elite level. If that sounds familiar it should because those same attributes are what it takes to learn to trade and become a successful options trader.
Need a Plan
You might be dedicated and have the courage to be an options trader, but do you have a trading plan that you follow? I talk to a lot of option traders and sadly it is true. Option traders spend a lot of time looking for solid trades that they often neglect probably the most important part: the management of the trade. If that is you take a little solace because you are not alone.
A simple way to combat this problem is by having a plan in place before even entering the trade. This is the psychological part of trading. Having a plan in place will remove emotions from getting in the way of decision making and possibly producing unwanted results. Should I stay in the trade or should I exit? Decisions like that should not be made after the trade is executed because many option traders can become too emotional when the trade is in progress especially when they are losing money on the trade. Here are a few things to consider about trade management.
Plan Should Include Determining Exits
Option traders should think about how they are determining their exits for profit and loss. Don’t forget to consider how the greeks and the implied volatility may be affected if the outlook or environment changes. In a volatile market like this, an options trader may need to make some adjustments especially about taking early profits or exiting for a loss.
I generally determine my exits two ways; a certain percentage or based on the chart. When using a certain percentage, I determine how much percentage-wise I am winning to risk on the trade and what percentage I am looking to take profits. When using the chart, I determine at what levels I will exit my position for a loss if that area is violated and I always look to take some profit off if the stock comes into an area I deem a target area (maybe a support or resistance level).
Option traders should also think about how they will exit if their targets are not met. How will the exit or stop be determined? Once again, don’t forget to use the greeks and implied volatility in your methods because it could make the difference between profiting or losing.
All trading including option trading can be very difficult at times just like training to be a professional athlete and appear in the World Series. Not having plan in place can make it exponentially more difficult and determining exits is just one part of that plan. It helps to have courage and be dedicated to reaching your goals but a solid trading plan can go a long way towards potential success. Athletes that train without a plan are similar to option traders letting their emotions make decisions for them. Once there is well thought out plan in place and most importantly the plan is followed, an option trader removes unwanted emotions which can hinder his or her chances of being successful.
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.
Many option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.
The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.
The trader’s objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.
What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.
To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.
One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!
At first, options can be a very complex entity to understand. But if a trader looks at things from a fundamental perspective, it may become clearer. The options world is ruled by three basic forces consisting of: price of the underlying, time to options expiration, and implied volatility (IV). Trades are most profitably constructed when the trader considers the impact each of these three forces has when designing the architecture of the options trade under consideration.
For the new options traders, learning about options and the impact of these three fundamental forces may be confusing and the magnitude of the influence of each on the profitability of trades is easily under-appreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders start out as being stock traders where “only price pays” the initial reluctance and hesitation to consider additional factors impacting a trade is easily understood.
In order to help understand the initially confusing manner in which options respond to their outside and inside forces, it is helpful to breakdown an option’s price into its two components: extrinsic value and intrinsic value. Remember that the quoted price of an option reflects the sum of the intrinsic (if any) and extrinsic values. Intrinsic value of an option is that portion of the premium which is in-the-money and is impacted solely by the price of the underlying. Extrinsic value is also known as time premium and is impacted by both time to expiration and IV.
OK. I want to hire Ben Bernanke to run my PR (not that I have a PR guy, but if I did…). He’s a gosh-darn brilliant spin-doctor. What am I talking about? OK. Here’s the trading world we’re living in these days:
There is good economic news… The market goes up. It’s good news, after all!
There is bad economic news… The market goes up. The Fed won’t taper and will keep propping the market up!
How can you lose?!
These, of course, are famous last words. If I had a nickel for every time an over-confident novice trader told me how he just can’t lose… Well, let’s just say I’d have a lot of nickels.
The fact is you can lose. This market-news paradigm cannot last forever (and, yes. I know that right now I’m alienating those cocky, over confident novice traders. But I’m only trying to help you keep that money you’ve made with your “can’t lose system”!)
The market simply can’t keep going up forever with disregard to economic news. Sorry. It just can’t. At some point, it is time to pay the piper.
Be the piper.
It’s all timing. Early in my career, I worked (as a clerk, before I became a floor trader) for a trading firm run by a brilliant man. In the 90s, his model said the market was over priced. There were internet companies that flat out told investors they would not make money in the foreseeable future that doubled, then tripled, then quadrupled in share price. Were they overpriced? Yes. But that didn’t stop the stocks from rising violently. But one day (as we market historians know) that bubble burst. After fighting the market for a few years, the boss was finally right. By that point, he’d lost millions and had to abandon his strategy and never recouped what he lost. Once his ship finally came in, he missed the boat.
So the question of the day is, when will this market pull back? We’re starting to see signs now. I was just chatting with a CME Group floor-trader friend of mine today. He told me about how the Fed Funds contract was pricing in higher interest rates in the near future. Translation: The fix is in! The Fed Funds contract is an excellent predictor of future interest rates. Higher interest rates means the market will end its climb to the nose-bleed seats and sit and rest.
Don’t get me wrong. I’m not necessarily predicting a bursting bubble like we saw with the internet stocks. I’m just saying the sweet ride long-term stock investors have enjoyed is coming to a close soon.
But, we’re option traders. What do we care?! Option traders can make money either way. Once the market starts pulling back, there are going to be call credit spread opportunities galore. The implied volatility will likely return some—probably to the mid-teens. And the market will probably drift somewhat lower—or at least not rise.
And so, we start to wait with a watchful eye. We start looking for some of these call credit spread opportunities now (like the WYNN trade John talked about in Group Coaching this week). And we wait as more set ups transpire.
Bernanke might not be long for being able to continue enjoying his cake, but we option traders can always get a piece of the pie.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.