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January 16, 2014

A Short Iron Condor

A short condor occurs when a trader combines a bear call spread and a bull put spread. It is essentially combining two credit spreads as one trade. The trade is executed by buying a lower-strike out-of-the-money put and selling an out-of-the-money put with a higher strike. Then the trader sells an out-of-the-money call with a higher strike and buys another out-of-the-money call with an even higher strike. Learning to trade more advanced option strategies like an iron condor is not essential for option traders but it can give you more means in which to possibly extract money from the market.

One of the rationales behind selling an iron condor is implied

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volatility (implied volatility is – simply defined – the volatility component of an option price). When IV is inflated (meaning the implied volatility has pushed the option price higher) it lifts the premium values for option sellers. In addition, the profitable range on the short iron condor is can be rather large depending on how it is implemented.

A short iron condor consists of four legs and results in a net credit received. As for profit potential, the maximum potential profit is the initial credit received upon entering the trade. This profit will occur if the underlying stock price, on expiration date, is between the two middle (short) strikes.

One of the benefits of a short iron condor (and potentially options in general) is limited risk. For short condors, the maximum loss comes when the underlying stock price drops below the lowest strike or above the highest strike. If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or

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the two higher-strike options) less the initial credit for entering the trade.

Being that we are in the mist of earnings season, it may be best to construct the iron condor to expire before the actual announcement. If not, then it may be best to exit the trade before the announcement especially if the trade is profitable up to that point.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 26, 2013

The Fundamentals of Iron Condors

Have you ever noticed a professional athlete warming up before a game or match? What are they doing? They are stretching, running, throwing and catching just to name a few for example. What they are really doing is working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career no matter what your career is.

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading

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iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they

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should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It

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is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique similar to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives. Doing this on every potential trade can only improve your odds.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 27, 2013

Getting Vertical With AAPL

One of the basic directional spreads when learning to trade options is that of the vertical spread.  It can be extremely versatile and represents a major building block of more complex spreads. With a vertical spread, the various strike prices for an option are arranged vertically and the expirations available to trade are displayed horizontally.  This defined risk position consists of both a long and short position at different strike prices within the same expiration.  It can be constructed with either puts or calls and the initial cash flow can be either a credit or debit.  Strike prices can be selected to produce either aggressive or conservative stances depending on the outlook and the risk/reward that is desired.

As an example, let us consider a vertical spread in  Apple (AAPL). The stock has dropped considerably over the last several weeks just like the prospect of Aaron Hernandez’s NFL career, and at the time of this writing is hovering around $400. With AAPL being heavily traded, the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.

For the trader who has a bullish diagnosis  for the price action in AAPL into July expiration, a put credit spread can be established by selling the July 380 put ($4 credit) where it has a pivot low and buying the July 375 put ($3 debit). The total premium received is $1. At the time of this writing there are 23 days to expiration, the maximum potential return is 20% and is achieved as long as AAPL remains above the short put strike of 380.  Maximum risk is defined by the long 375 put. The maximum risk is defined by taking the difference in the strikes $5 (380 – 375) minus the premium received ($1) or $4 if AAPL finished below $375 at expiration.

As contrasted to a naked put sale, this position has the following major differences: 1. Risk is crisply defined as opposed to the naked sale maximum risk of the underlying going to zero, and 2. Margin requirements for the position and hence yield are dramatically improved. Understanding the potential risk of each strategy and implementing the one that matches your trading personality can go a long way at making you feel comfortable and successful as a trader.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 14, 2013

Baseball, Buying a Car and Iron Condors

With spring training right around the corner, traders should ask themselves this question; have you ever noticed a baseball player warming up before a game? Or watched footage of a baseball player at practice? What are they doing? Swinging a bat. Throwing and catching balls. Running bases. Working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career.

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique akin to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

December 6, 2012

Selling AAPL Puts: Naked or as a Spread

One of the bullish strategies in the arsenal of an options trader is that of selling puts. Many traders have have heard of this strategy but are unfamiliar with the nuances and need more options education before possibly implementing them. The sale can be accomplished either as naked sales (aka selling “cash secured” puts when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or simply selling a put spread).

The requirement of this position is that of being short puts. As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of in the price of the underlying. The magnitude of the “deductible” for the policy is determined by the strike price the trader has sold.

Here is an example using AAPL whose recent sell-off has sparked interest in puts. A trader who sells a December 555 strike put to another trader holding an underlying currently trading at $550 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible. In return for issuing this insurance policy (known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions. The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased. In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used and more conservative strategy is to sell a put spread. When a trader sells a put spread, the fundamental profit is

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still short sale of the put at the selected strike price. However, as contrasted to the naked put sale, an additional position is taken to lower the risk and to reduce the margin. The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration. Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread. In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result

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in a higher trade yield than the naked put sale because of the dramatically lower margin. However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in stock they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure. This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 21, 2012

Going Vertical in AAPL

One of the basic directional spreads when learning to trade options is that of the vertical spread.  It is extremely versatile and represents a major building block of more complex spreads. It is so named because of the configuration of the position when overlain on the classic format for displaying option quotes.  In this format, the various strike prices for an option are arrayed vertically and the months available to trade are displayed horizontally.  This defined risk position consists of both a long and short position at different strike prices within the same expiration month.  It can be constructed in either puts or calls and the initial cash flow can be either a credit or debit.  Strike prices can be selected to produce either aggressive or conservative stances.

As an example, let us consider a vertical spread in market leader Apple (AAPL).  Current vital signs of the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.

For the trader who has a bullish thesis for the price action in AAPL into December expiration, a put credit spread can be established by selling the December 540 put and buying the December 530 put.  As this is written with 31 days to expiration, the maximum potential return is 30% and is achieved as long as AAPL remains above the short put strike of 540.  Maximum risk is defined by the long 530 put.

As contrasted to a naked put sale, this position has the following major differences: 1. Risk is crisply defined as opposed to the naked sale maximum risk of the underlying going to 0, and 2. Margin requirements for the position and hence yield are dramatically improved.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 3, 2012

Selling AAPL Puts: Naked or as a Spread

One of the bullish strategies in the arsenal of an options trader is that of selling puts. Many traders have have heard of this strategy but are unfamiliar with the nuances and need more options education before possibly implementing them.  The sale can be accomplished either as naked sales (aka selling “cash secured” puts when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or for “those in the know” simply selling a put spread).

The sine qua non of this position is that of being short puts.  As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of variable degree in the price of the underlying.  The magnitude of the “deductible” for the policy is determined by the strike price the trader has sold.

Here is an example using AAPL. A trader who sells a $590 strike put to another trader holding an underlying currently trading at $585 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible.  In return for issuing this insurance policy (in option lingo known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions.  The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased.  In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used similar strategy is to sell a put spread.  In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price.  However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance.  The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options.  Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread.  In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin encumbrance.  However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure.  This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable; if you know the road map it is much easier to arrive where you want to be.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 19, 2012

Maximizing Fade Plays With AAPL and Others

Do you feel like you’ve seen this movie before? Trouble in the Europe especially Spain. People in the streets; panic in the market. Is this recent wave of trouble going to last forever? Not likely. Perhaps there is an opportunity to fade this fall. But how should an option trader play the fade to maximize chances of success and maximize option-trading returns? Trade ideas like this are discussed weekly in the MTE newsletter.

The obvious starting point for a trader to fade this fall is to take a positive-delta position. This is fancy options speak for a bullish trade. There are lots of different ways to take a bullish stance given all the various types of option-trading strategies out there. So, the question really is: Which is best?

There are a few major considerations here. First, traders must strive to maximize reward by minimizing risk. In order to do so, option traders must define their expectations. Am I looking for an extreme turn around? A mild retracement? A dead-cat bounce? The more a strategy can be tailored to expectations, the more risk can be controlled and reward can be maximized.

Next traders need to consider implied volatility. This is where option traders can get an edge in their options positions. If implied volatility is high (overpriced), option traders should consider option-selling strategies. If implied volatility is low (underpriced), option traders should consider option-buying strategies.

In the current market scenario we have a situation where if the turmoil in the Europe and Spain subsides, the market should rally somewhat, but it’s not likely to go to the moon. Further, with the levels and implied volatility of individual stocks at inflated levels, it’s easy to find overpriced options. Any clever fader trader should be looking for put credit spreads to sell. Put credit spreads have positive delta and take a short position on implied volatility. Great candidates for this sort of play are AAPL, GOOG, PCLN, et. al. Traders are best off staying away from bank stocks and precious metals that might be adversely affected by European instability.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 8, 2011

Selling Puts: Naked or as a Spread

One of the bullish strategies in the arsenal of an options trader is that of selling puts. The sales can be accomplished either as naked sales (aka selling “cash secured” puts

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when cash is set aside for potentially buying the stock in the event of assignment) or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or for “those in the know” simply selling a put spread).

The sine qua non of this position is that of being short puts. As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of variable degree in the price of the underlying. The magnitude

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of the “deductible” for the policy is determined by the strike price the trader has sold.

For example, the trader who sells a $55 strike put to another trader holding an underlying currently trading at $60 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible. In return for issuing this insurance policy (in option lingo known as “writing” the contract), the seller receives a premium which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions. The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased. In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used similar strategy is to sell a put spread. In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price. However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance. The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options. Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread. In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin encumbrance. However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlyings they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure. This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable; if you know the road map it is much easier to arrive where you want to be.

August 18, 2011

If I’d Meant That, I’d Have Said That

To the new option trader, it often seems as if he has entered into the terra incognita of the derivatives world through Alice’s looking glass. Engaging the natives in conversation quickly results in encountering colorful characters who appear not to recognize the same reality from which the traveler has arrived. For those who have chosen to enter this new world, Alice’s conversation with Humpty Dumpty seems particularly familiar wherein he declares: `When I use a word,’ Humpty Dumpty said, in rather a scornful tone, `it means just what I choose it to mean — neither more nor less.’

The nomenclature of options is boundlessly confusing.  While the casual visitor may only notice the broad categories of puts and calls, the serious student soon will come to realize that the detailed nomenclature is confusing and results from the inescapable fact that options have more moving parts than do stocks.   When initiating a stock position, the choices are two:  buy or sell the issue. When initiating an options position, the choices are numerous and not mutually exclusive. The selection of the particular series to trade and the anatomic structure in which to place it is often nuanced.

An individual option’s value is a function of three main factors: price of the underlying, time to expiration, and implied volatility. Furthermore the individual options can be combined into complex spreads composed of multiple positions in an almost limitless variety. It is from this abundance of choice that the word salad of option terminology arises.

I find the terminology paradoxically to find its maximum point of obfuscation when used to describe one of the basic building blocks of options, the vertical spread. Verticals represent a two-legged category of spreads in which one option is bought and an option of a different strike is sold; both positions are taken in the same series month and in the same type, either puts or calls. Strike selection determines the directional bias of the trade as well as the credit or debit status.  Bullish and bearish trades are easily constructed in both puts and calls.

This simple spread results in a chaotic and confusing panoply of names including: bull call spread, call debit spread, bear call spread, call credit spread, bear put spread, put credit spread, bull put spread, bull call vertical, bear call vertical, bull put vertical, and bear put vertical. As if this collection of a dozen names describing four basic trades were not sufficiently opaque, many traders use an implied shorthand description. For example, they may refer to opening a call credit spread as “selling a call vertical”; conversely opening a call debit spread is often referenced as “buying a call vertical”.  The directional bias of the trade is apparent to those having been shown the “secret handshake” by the spread type, call or put, used and the credit or debit status of the opening cash flow.

Unfortunately there is no easy resolution to this nomenclature nightmare.  Various traders use the terms inconsistently and variably for no apparent logical reason.  Such is everyday life in the world of options.

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