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December 22, 2011

Weekly Options Impact

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 12:55 pm

Options have traditionally traded in 12 cycles per year.  Since there are 52 weeks per year, most monthly cycles have had a life span of 4 weeks with the occasional 5 week cycle in order to make the math work out. In these multi-week cycles, each week tends to have its own personality and the tempo of price change would often accelerate as expiration approached.  This effect was at least in part the result of the non linear nature of the decay curve of extrinsic premium.  It is as if the option cycle began with a decay curve akin to an easy green ski trail and ends on a double black diamond slope.

For strategies that include a component of being short premium, the maximum potential total profit or loss is only achieved at expiration.  This effect is easily seen in the case of vertical spreads which only reach their maximum potential gain or loss at expiration or when the spread goes deep in-the-money or out-of-the-money.

CBOE introduced weekly options in 2005 on several broad indices and the launch was met with a tepid reception.  However, trading volume in weekly options contracts has recently exploded, additional indices and ETF underlyings have been added, and a number of actively traded equities have joined the family of weekly options.  An updated list of the rapidly increasing available weeklies can be found at this CBOE site: http://www.cboe.com/micro/weeklys/introduction.aspx

Weekly options are a rapidly evolving and changing part of the options world.  As an example of this rapid evolution, the new week’s options have begun to be offered on the Thursday of the week prior to expiration rather than the Friday as had been the case previously effective July 1, 2010.

The availability of weekly options has undoubtedly had a significant impact on a variety of strategies.  Their acceptance and increase in trading volume has been nothing short of stunning.  For example, the 390 and 395 call strikes in AAPL that will expire tomorrow, December 23, each have an open interest of around 10,000 contracts.

Are weekly options something that you can incorporate into your trading plan? You will have to decide for yourself.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 27, 2011

Option Delta and Apple (AAPL)

Filed under: Options Education — Tags: , , — Dan Passarelli @ 9:22 am

Option Delta and Apple ( AAPL )
Apple (NASDAQ: AAPL) sure is making a lot of news lately, what with the company’s earnings report and the introduction of the new Apple iPhone 4S. One may expect the Apple iPhone 4S to push the stock higher (after this dip), but some may believe the rebound will be still short-lived. Perhaps a smart move is to purchase a short-term, out-of-the-money option on the equity – let’s look for an option with a delta greater than 20 on Apple and see how the option could play out.

Option Delta and the Trade
First, let’s define option delta before we go into the option play. Option delta is a ratio that compares a stock’s change in price to the corresponding price change in said stock’s option. For this example, we are going to use the Apple November 425 call that has about an option delta of 23 percent.

What does the 23 percent mean? Let’s convert the option delta into dollars to see. This percentage means that this particular Apple option will gain or lose value just like 23 percent of 100 shares of Apple as the price changes. Look at the definition this way if it is easier, for every $1 Apple advances; the call option will increase 23 cents attributable to delta. So, Apple is currently trading at around $405 (rounded for simplicity) and we have purchased the 425 call. We need the call to advance past $425 in order (which is not out of the) for the option to be in-the-money, but can we benefit from a rally that falls short of $425?

The Benefit of Option Delta
Apple is a major momentum stock, just look at what happens after good news – more often than not the stock rallies. In fact, I don’t think it is a stretch to say that the stock often moves quite a bit. Look at 2009 when Apple dropped as low as the 78 region in late January then rallied to finish the year above $210. That is a major gain.

Playing the November 425 call affords a trader the chance to make money in the case that the stock rallies. If the stock hits $425, that means it has moved 20 points. Take the 20 points and multiply that by 23 cents (option delta of .23) and you have a move of $4.60 in the call (20 X 0.23).

Conclusion
By looking at the option delta, we were able to have clear expectations for option profit based on stock movement. Does this mean that playing the delta is a fool-proof to analyze an option? No. There are other important pricing factors that affect the value of an option, too. Time (theta), volatility (vega) and more also play an important role. Delta is just one of the greeks that can be taken into account when looking for the right option to purchase. Make sure to do your homework so you can enter the option game prepared to succeed.

July 21, 2011

Back To Basics: Part 1

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 9:36 am

In an attempt to understand the complexities of the world they observed in daily life, ancient Babylonian philosophers considered all things to be constituted of one or more of the four classical elements of: earth, air, water, and fire. In this world view, the natural environment was considered to consist of various objects composed of varying portions of each of these fundamental elements or forces. While modern atomic theory has supplanted this early concept, these historic constructs can provide a helpful organizational structure within which to consider the importance of fundamental primal forces impacting various option trade structures.

Similar to the early view of the Babylonians, the options world is ruled by three primal 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 anatomy of the options trade under consideration.

For the new options trader, 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 underappreciated. Failure to consider each of these forces and its individual effect will reduce the probability of a successful trade. Since most option traders come from the universe of stock traders where “only price pays” the initial reluctance 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 milieu, it is helpful to dissect 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 (or less generously “sizzle” as opposed to “steak” of the intrinsic value) and is impacted by both time to expiration and IV.

July 7, 2011

The Naked Call

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

We recently took a look at the naked put; let’s take a look at the same strategy on the call side of the equation, the naked call. The naked call is defined as an option strategy where an option player sells (writes) call options without owning the underlying security. Some may refer to this strategy as an “uncovered call” or “short call.”

The goal of the naked call is for the trader to collect premiums if the option expires worthless. A trader could sell an out-of-the-money (OTM) naked call each month and pocket premiums, provided the stock price either stays flat or drops. This process could continue as long as the stock remains below the strike.

The Specifics
The maximum gain for selling a naked call is limited to the premium received for the call option. That said, the loss potential is unlimited – as the stock can rise indefinitely. If the underlying stock’s price is above the strike price at expiration, it will result in the trader having to sell the stock at the strike price (which will be lower than the market price).

A loss can occur if the stock price rises. If the price of the underlying stock is greater than the short call’s strike price plus the premium received at expiration the option should be bought in to close the trade. Otherwise, when the option is assigned and a short-stock position is acquired, further losses are possible. On the flip side, the maximum profit is achieved when the underlying stock is less than or equal to the strike price of the sold call at its expiration.

An Example
For this specific example, we will take a look at General Electric (GE) – which is trading slightly above $19 at the time of writing. An August 20 call carries a bid price of 27 cents. If the stock remains below the strike price by expiration, the call expires worthless and the call seller keeps the $0.27 in premium (less any commissions). The problem is if the stock rallies through the strike price at expiration, the call will be assigned, resulting in a short sale of 100 shares at $20. With the stock at $23, that would represent a loss of $3 a share, or $300. Subtract the $27 received in premium and the total loss comes to $273.

With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A, perhaps, safer way to structure a trade with a similar risk profile is to sell a call credit spread. We’ll have a short blog posting on this in the future. For those interested in learning all the ins and outs of credit spreads, contact us about our online content in the Students section of the Market Taker webite. http://markettaker.com/contact_us/

June 23, 2011

Moneyness

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 9:51 am

Moneyness isn’t a word, is it? It won’t be found on spell-check, but moneyness is a very important term when it comes to options. There are three degrees, if you will, of moneyness for an option, at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let’s take a look at each of these terms, using tech behemoth Apple (AAPL) as an example. At the time of writing, Apple was hovering around the $320 level, so let’s define the moneyness of Apple options using $320 as the price.

At-the-Money
An at-the-money AAPL option is a call or a put option that has a strike price about equal to $320. The ATM options (in Apple’s case the 320-strike put or call) have only time value (a factor that decreases as the option’s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time.

In-the-Money
An option that is in-the-money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of AAPL, ITM options include the 315 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.

A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, an ITM AAPL put carries a strike price of 325 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, an AAPL 330 put has a premium of $12.30 compared to a price of $3.80 for a 310 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 315 call and AAPL closed at $320 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $315 a share.

Out-of-the-Money
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher than the market price of the underlying, and puts are OTM when their strike price is lower than the stock’s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.

If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.