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June 6, 2013

A Naked AAPL Call

Filed under: Options Education — Tags: , , , , , , , , — Dan Passarelli @ 11:46 am

A naked call strategy is defined as an option strategy where a trader sells (writes) call options without owning the underlying stock. Some option traders 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 price. For those interested in learning all the ins and outs of naked calls and possibly safer alternatives, please visit the Learn To Trade section of our website.

The Specifics
The maximum gain for selling a naked call is limited to the premium received for the call option. With that being said, the loss potential is unlimited – as the stock can rise indefinitely in theory. 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 or current price).

A loss on the trade 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 probably be bought back to close the trade. If not, 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 Apple (AAPL) – which is trading right around $440 at the time of this writing. A June 445 call carries a bid price of 7.50. If the stock remains below the strike price (445) by expiration, the call expires worthless and the call seller keeps the $7.50 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 $445. With the stock at $470, that would represent a loss of $25 a share, or $2,500. Subtract the $750 received in premium and the total loss comes to $1,750.

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. Selling a call spread will be discussed in future posts.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 16, 2013

Reviewing Strangles with AAPL

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 11:49 am

There is no doubt we have discussed straddles in the past in this blog. A straddle is an option strategy that traders  can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the trader is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (which makes up a straddle), the trader purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven).  If at expiration, the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss a trader can take on a strangle is the net premium paid.

Example Trade
To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing  is trading at around $432 after a volatile couple if weeks. The trader would buy both a June 435 call and a June 430 put. For simplicity, we will assign a price of $13 for both – resulting in an initial investment of $26 for our trader (which again is the maximum potential loss).

Should the stock rally past $435 at expiration, the 430 put expires worthless and the $435 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $29, the profit is $3 (intrinsic value less the premium paid).  The same holds true if the stock falls below $430 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial $26, or $2,600 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 10, 2013

Moneyness and AAPL

Filed under: Options Education — Tags: , , , , , , , , , , — Dan Passarelli @ 1:49 pm

Moneyness isn’t a word, is it? Dan uses it often and he even has a section about it in his books. It won’t be found on spell-check, but moneyness is a very important term when it comes to learning to trade 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 $520 level, so let’s define the moneyness of Apple options using $520 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 $520. The ATM options (in Apple’s case the 520-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 515 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 525 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a January AAPL 530 put has a premium of $14.20 compared to a price of $11.10 for a January 525 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 515 call and AAPL closed at $520 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $515 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 16, 2012

There’s a Time for Everything: Thoughts on AAPL Option Strategies

Filed under: Options Education — Tags: , , , , , , , , , , , , , — Dan Passarelli @ 3:28 pm

Do you know how many different types of options strategies there are? A lot: That’s how many! But that’s not really the important question. More importantly: Do you know why there are so many different types of options strategies? Now we have something to discuss and 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 AAPL traders. Now that the stock has severely declined in price, there are traders who are extremely bullish on AAPL and want to get more bang for their buck and buy short-term out-of-the-money calls. 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 and the trader is bullish just to a point, the trader might sell a bull put spread, and so on.

The differences in options strategies, no matter how apparently subtle, 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 nuance. Traders need to consider the following criteria:

  • Directional bias
  • Degree of bullishness or bearishness
  • Conviction
  • Time horizon
  • Risk/reward
  • Implied volatility
  • Bid-ask spreads
  • Commissions
  • And more

Carefully selecting 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 the holidays approaching, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit heading into the New Year!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 1, 2012

The Naked AAPL Call

Filed under: Options Education — Tags: , , , , , , , , — Dan Passarelli @ 11:21 am

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. For those interested in learning all the ins and outs of naked calls and possibly safer alternatives, please visit the Learn To Trade section of our website.

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 Apple (AAPL) – which is trading right around $600 at the time of this writing. A December 650 call carries a bid price of 7.00. If the stock remains below the strike price by expiration, the call expires worthless and the call seller keeps the 7.00 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 $650. With the stock at $670, that would represent a loss of $20 a share, or $2,000. Subtract the $700 received in premium and the total loss comes to $1,300.

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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 18, 2012

Weekly Options Impact and AAPL

Filed under: Uncategorized — Tags: , , , , , , , , — Dan Passarelli @ 1:54 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.

If you are just learning to trade options, 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.  The new week’s options are offered on the Thursday of the week prior to expiration rather than the Friday.

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 635 and 640 call strikes in AAPL that were offered this morning and will expire next Friday, October 26, each have a volume of around 3,000 contracts today alone.

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

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 31, 2012

Back to Basics: Part 1

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 11:20 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, 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 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.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 9, 2012

Moneyness and AAPL

Filed under: Options Education — Tags: , , , , , , , , — Dan Passarelli @ 10:47 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 $490 level, so let’s define the moneyness of Apple options using $490 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 $490. The ATM options (in Apple’s case the 490-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 485 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 495 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, an AAPL 500 put has a premium of $12.20 compared to a price of $4.80 for a 485 put.

If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 485 call and AAPL closed at $490 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $485 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.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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.