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December 11, 2013

Options and Math

One of the greatest advantages of options trading is its extreme flexibility in both the initial construction of positions and in the ability to adjust a position to match the new outlook of the underlying. The trader who limits his or her world to that of simply trading equities and ETF’s can only deal in terms of short or long. A change in an outlook often requires starting a new position or exiting the old one. The

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options trader can usually accommodate the newly developed outlook with much more fluidly, often with minor adjustments on the position in order to achieve the right fit with the new outlook.

One concept with which the trader needs to be familiar in order to construct the necessary adjustments is that of the synthetic relationships. Most options traders neglect to familiarize themselves with the concept when learning to trade options. This concept arises from the fact that appropriately structured option positions are virtually indistinguishable in function from the corresponding long or short equity/ETF position. One approach to remembering the relationships is to memorize all of the relationships. It may be easier to do this by remembering the mathematical formula and modifying as needed.

For those who remember high school algebra, the fundamental equation expressing this relationship is S=C-P. The variables are defined as S=stock, C=call, and P=put. This equation states that stock is equivalent to a long call and a short put.

Using high school algebra to formulate this equation, the various equivalency relationships can easily be determined. Remember that we can maintain the validity of the equation by performing the same action to each of the two sides. This fundamental algebraic adjustment allows us, for example, to derive the structure of a short stock position by multiplying each side by -1 and maintain the equality relationship. In this case (S)*-1 =(C-P)*-1 or –S=P-C; short stock equals long put and short call.

Such synthetic positions are frequently used to establish positions or to modify existing positions either in whole or part. You might have not liked algebra when you were in school, but applying some of the formulas can help an options trader exponentially!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 25, 2013

Seeing Double

Today we will talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options

The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future writings, the selection of strike prices and position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 4, 2013

Historical and Implied Volatility

Dan mentioned recently in a blog that VIX (CBOE Implied Volatility Index) was hovering around a six year low. With the market seemingly on the edge lately due to global events like North Korea and Cyprus, 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.

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 20 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 now is more volatile than it was when its historical volatility was, say, 20.

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 20implied 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.

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

Volatility chart practitioners need to perform three separate analyses. First, they need to compare current implied volatility with

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

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

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 28, 2013

Double Calendars vs. Double Diagonals

Today we will talk about a subject that is brought up quite often in MTM Group Coaching and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby months and long option contracts in farther out months in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options

The structural difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason of existence of the double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future blogs, nuances of strike selection and dynamic position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 31, 2013

Options and Algebra

One of the greatest advantages of options trading is its extreme flexibility in both the initial construction of positions and in the ability to adjust a position to match the new outlook of the underlying.  The trader who limits his or her world to that of simply trading equities and ETF’s can only deal in terms of short or long. A change in an outlook often requires starting a new position or exiting the old one.  The options trader can usually accommodate the newly developed thesis much more fluidly, often with minor adjustments on the position in order to achieve the right fit with the new outlook.

One concept with which the trader needs to be familiar in order to construct the necessary adjustments is that of the synthetic relationships.  Most options traders neglect to familiarize themselves with the concept when learning to trade options. This concept arises from the fact that appropriately structured option positions are virtually indistinguishable in function from the corresponding long or short equity/ETF position.  One approach to remembering the relationships is to memorize all of the relationships.  I find remembering the mathematical formula and modifying as needed to be much more useful and easier.

For those who remember high school algebra, the fundamental equation expressing this relationship is S=C-P.  The variables are defined as S=stock, C=call, and P=put.  This equation states that stock is equivalent to a long call and a short put.

Using high school algebra to formulate this equation, the various equivalency relationships can easily be determined. Remember that we can maintain the validity of the equation by performing the same action to each of the two sides.  This fundamental algebraic adjustment allows us, for example, to derive the structure of a short stock position by multiplying each side by -1 and maintain the equality relationship.  In this case (S)*-1 =(C-P)*-1 or –S=P-C; short stock equals long put and short call.

Such synthetic positions are frequently used to establish positions or to modify existing positions either in whole or part.  You might have hated algebra when you were in school, but applying some of the formulas can help an options trader exponentially!

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 17, 2013

Great Trader Part II

About a month ago we talked about an options trader having a commitment to excellence. This time we’ll go over why an options trader needs a trading plan and how to go about writing one. If you really want to improve your trading in 2013 you should absolutely to do this but be forewarned; this is the part nobody wants to do. Most options traders think that their trading plan is in their head and all I need is a proper options education. “I know what I need to do when I need to do it” most beginning and some veteran options traders will exclaim. If it was just that easy, everyone would be a great options trader. Unfortunately it’s not. That is specifically why you need a written options trading plan. Just because you know what to do doesn’t mean you will do it.

Before you even begin to write your options trading plan, you must take an inventory of yourself. What are your strengths and weaknesses? You must take the time to truly examine yourself and be honest about whom you are. Your options trading plan must match your personality.

The first thing you need to do to start your options trading plan is to write down your goals like we talked about last time. Once you do this, it brings everything into perspective. The same reason you need to write down your goals is the same reason you need to write down your options trading plan-so your thoughts are transformed from the subconscious to the conscious. It doesn’t matter if you write the plan on a nice piece of paper or a cocktail napkin. It just needs to be written down in your own words.

The next section of your options trading plan will be money management. This is one of the most crucial and often overlooked components of successful options trading. How much are you going to risk per trade? What are your weekly or monthly profit targets? What are the maximum losses you are comfortable with on a daily, weekly or monthly basis? All of these questions need to be answered right in this section.

Strategies will be the next component of your options trading plan. This will be the meat and potatoes of the plan so to speak. A thing to consider is to start with relatively a few simple strategies (long calls and puts) and master them before you write in more complex option strategies into your plan. You need to describe in as much detail as possible the strategy you intend to use. You will probably be making constant changes to this part until you get exactly what you want.

The last section will be the follow up and review. This is when an option trader needs to print out the charts and the option chains and review them. Did I follow my written options trading plan like I said I would? This needs to be done when the market is closed so all your attention can be on the review. You must keep a trading journal and must always acknowledge your winners and more importantly learn from your losing trades.

This is just a general outline of an options trading plan to get you started. If you need more help or more direction, feel free to contact me.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 8, 2012

What’s the Delta of that Happening to AAPL?

Filed under: Uncategorized — Tags: , , , , — Dan Passarelli @ 1:11 pm

It is standard trader lingo on the trading floor. “What’s your delta of making it to the party tonight?” “What’s the delta the broker comes back and buys more of these?” “I’m about 90 delta I’m going to dump Sheila tonight”. Option traders have probably used the word delta in this context every single day of their life and if you learn to trade options like a professional, you may too.

It’s the “traders’ definition” of delta—that is, delta is the likelihood of an option expiring in-the-money. Though this definition actually has a few mathematical shortcomings, making it not entirely technically correct, every professional option trader I know thinks about delta this way. And, in turn most traders borrow the concept of delta being the likelihood of success to adopt into their every-day speech.

The idea is every option has an associated delta figure attached to it. Like, at the time of this writing, the Apple (AAPL) September 655 calls have a 0.25 delta. Yes. That means that they change in value 25 percent like the underlying stock. But it also is interpreted by traders to mean that the AAPL September 655 calls have a 25-percent chance of expiring in-the-money.

This practical use of delta helps guide traders’ expectations and helps them make better trading decisions by factoring probability into their decision-making process. I encourage traders to think about option delta this way. You should start today. I’m 100 delta that you’ll be glad you did.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 28, 2012

Great Trader Part II

About two months ago, we talked about an options trader having a commitment to excellence. This time we’ll go over why an options trader needs a trading plan and how to go about writing one. This is the part nobody wants to do. Most options traders think that their trading plan is in their head and all I need is a proper options education. “I know what I need to do when I need to do it” most beginning and some veteran options traders will exclaim. If it was just that easy, everyone would be a great options trader. Unfortunately it’s not. That is specifically why you need a written options trading plan. Just because you know what to do doesn’t mean you will do it.

Before you even begin to write your options trading plan, you must take an inventory of yourself. What are your strengths and weaknesses? You must take the

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time to truly examine yourself and be honest about whom you are. Your options trading plan must match your personality.

The first thing you need to do to start your options trading plan is to write down your goals like we talked about last time. Once you do this, it brings everything into perspective. The same reason you need to write down your goals is the same reason you need to write down your options trading plan-so your thoughts are transformed from the subconscious to the conscious. It doesn’t matter if you write the plan on a nice piece of paper or a cocktail napkin. It just needs to be written down in your own words.

The next section of your options trading plan will be money management. This is one of the most crucial and often overlooked components of successful options trading. How much are you going to risk per trade? What are your weekly or monthly profit targets? What are the maximum losses you are comfortable with on a daily, weekly or monthly basis? All of these questions need to be answered right in this section.

Strategies will be the next component of your options trading plan. This will be the meat and potatoes of the plan so to speak. A thing to consider is to start with relatively a few simple strategies (long calls and puts) and master them before you write in more complex option strategies into your plan. You need to describe in as much detail as possible the strategy you intend to use. You will probably be making constant changes to this part until you get exactly what you want.

The last section will be the follow up and review. This is when an option trader needs to print out the charts and the option chains and review them. Did I follow my written options trading plan like I said I would? This needs to be done when the market is closed so all your attention can be on the review. You must keep a trading journal and must always acknowledge your winners and more importantly learn from your losing trades.

This is just a general outline of an options trading plan to get you started. We will go into more detail in each area in upcoming features.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 3, 2011

Juicing Volatility in Apple (AAPL)

Over half of 2011 has been characterized by a low implied volatility (IV) environment in virtually all underlying securities.  This milieu ended suddenly and abruptly on the recent sell-off that started towards the end of July and IV generally remains significantly elevated above its recent nadir due mostly to the European debt and banking crisis.

An example of the recent rise in IV can be seen in Apple ( AAPL ).  This underlying spent most of 2011 with options trading at IV’s of 30 percent or below.  Since August, the options have begun trading in the range of an IV of 30 percent and higher–even as high as 52 percent. Since its peak in October, IV has steadily declined to its current level of 32 percent at the time of this writing.

In October at the height of IV, traders need to be on guard and conscious of the fact that volatility could decline and possibly their long option premiums.  It is important to recognize that positions characterized by being long volatility (positive vega trades), especially long calls, will likely be negatively impacted by increasing prices since IV is generally inversely related to price.

Option strategists wanting to take a bullish position in AAPL may want to consider trade structures which offset much, if not all of the impact of decreasing IV.  In optionspeak, this can be described as reducing the vega of the position. Such strategies could include buying a debit call spread as opposed to a single-legged long call position. This technique is referred to as volatility hedging. More on this in future blog posts.

October 6, 2011

Analyzing Options With Volume and Open Interest

Volume and open interest are two very important options data that can help traders understand what is going on in the options market. it is an important part of any trader’s options education. Volume and open interest helps traders make better decisions, and can make them more profitable traders. But to be able to use volume and open interest data, traders must understand exactly what each represents. Let’s take a close look at volume and open interest.

Volume and Open Interest

Volume and open interest are two distinctly different things. Volume is the number of contracts traded in a day. Each day volume starts over at zero. Open interest is the number of contracts that have been created—that are open. Open interest is an on-going, running total.

Volume and Open interest Example

Imagine it is the day after expiration and a new contract month, the November expiration cycle, is listed for option class XYZ. A trader, Retail Joe, logs into his online retail trading account from home. Retail Joe enters a buy order to buy 10 November 65 calls. The order is routed to the exchange and executes with Mark Etmaker, a market maker on one of the U.S. options exchanges.

Because this is the first day these contracts were made available to trade, open interest was zero at the start of the day. Volume is always zero at the start of the day. After the trade is made, both open interest and volume increased: Retail Joe is long 10, and on the other side of the trade, Mark Etmaker is short 10. Therefore:

Volume: 10

Open interest: 10

Now imagine that later that day, a third party trades

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in the November 65 call series. Tina Trader decides to sell 10 calls (maybe as part of a covered call). It just so happens that Mark Etmaker is the market maker who buys the calls from Tina. Notice what happens with volume and open interest.

Volume: 20

Open interest: 10

Because the trade happened the same day, the trade increases volume by the number of contracts traded. But a new contract wasn’t created; it just changed hands. Now, the two parties to the call are Joe and Tina; Mark Etmaker is flat. Therefore, open interest remains the same.

The next morning, volume and open interest is:

Volume: 0

Open interest: 10

Volume starts anew and open interest continues on.

Now, imagine that (coincidentally) Joe decides to sell the 10-lot to close and Tina just so happens to buy hers back at the same time; they trade with each other. Now, both Joe and Tina have no calls—they are flat. Now volume and open interest is:

Volume: 10

Open interest: 0

Ten contracts changed hands; so volume is 10. And the existing contract was closed; so open interest is zero.