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October 30, 2014

The Stock Repair Strategy

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 10:43 am

It has been a tough couple of weeks for traders and investors as the first part of October was unpleasant for bullish stock positions. Some stock buyers are waiting for some of their losers to rally and some are buying more stock at chepaer prices. But as most expereinced investors know, the market can always go lower now or in the future. Here is one option strategy that can make sense in some cases; the stock repair strategy.

Introduction to the Stock Repair Strategy

The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits

There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy

Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example

An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next two months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the September options.

The trader buys 1 November 60 call at 6 and sells 2 November 70 calls at 3. The spread is established cash-neutral.

Bought 1 Nov 60 call at 6
Sold 2 Nov 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. The P&L diagram below shows how the position functions if held until expiration.

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy

The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Some stocks that have experienced recent declines may be excellent candidates for the stock repair. For others, the stock repair strategy might not be appropriate. For stocks that look like they are finished or may even head lower, the Stock Repair Strategy can’t help – just take your lumps! But for those that might slowly climb back, just partially, this can be a powerful option strategy to recoup all or some of the losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 23, 2014

Math is Beneficial for Option Trading

One of the greatest advantages for an option trader is the initial flexibility of the position and the ability to adjust a position to match the new outlook of the underlying. The option trader who limits his or her world to that of simply trading equities also limits the position and outlook to either long (bullish) or short (bearish) positions. A change in an outlook regardless of the reason often requires starting a new position or closing out the old one. The options trader can usually change with  the newly developed outlook with much more ease, often with a minor option adjustment on the position in order to achieve the right fit for the new outlook.

Option Adjustments

One concept with which the option trader needs to be familiar in order to construct a necessary option adjustment is that of the synthetic relationship. Most options traders neglect to familiarize themselves with this 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 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 below and modifying as needed.

Synthetic Formula

For those who remember algebra probably that was taught back in high school, 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 option positions or to make an option adjustment either in whole or part. You might have not liked or did well with algebra when you were in school, but applying some of the formulas can help an option trader exponentially!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 2, 2014

A Butterfly Spread to Lock in Profits

There are several ways to make adjustments or lock in profits on a profitable long call or long put position. One of my favorites has to be converting the option position to a long butterfly spread. It may sound funny, but probably the hardest part about an option trader converting his position to lock in profits with a butterfly spread is getting to a profitable position in the first place; the rest is relatively easy! Let’s take a look at a scenario and an outlook in which this butterfly spread can be considered.

Butterfly Spread on BIDU

Let’s assume an option trader has been watching Baidu Inc. (BIDU) stock and noticed the stock pulled back slightly from the uptrend in which it has been trading. When Baidu stock was trading around $175 in the middle of June, he decides to buy the July 175 call options for 7. Lo and behold about a week later the stock moves higher and it’s trading around $185. The $185 level is potential resistance for the stock because is has previously traded to that area twice before and the trader is concerned it might happen once again. The trader thinks there may be a chance that Baidu stock may trade sideways at that level. Converting a long call position to a butterfly spread is advantageous if a neutral outlook is forecast (as in this case). A long butterfly spread has its maximum profit attained if the stock is trading at the short strikes (body of the butterfly) at expiration.

The option trader is already long the July 175 call which constitutes one wing of the butterfly so he needs to sell two July 185 calls which is the body of the butterfly and where the option trader thinks the stock may trade until expiration. $185 represents where the maximum profit can be earned at expiration. A July 195 call (other wing) would need to be purchased to complete the long call butterfly spread.

The original cost of the July 175 call was 7. The two short July 185 calls sell for 5.25 a piece and the long July 195 call costs 2. The converted 175/185/195 long call butterfly spread produces a credit of 1.50 (-7 + 10.50 – 2). Now here’s a look at the possible scenarios that could happen and some possibilities that can be considered.

 Take Profit

With Baidu stock trading around $185, the July 175 call option has increased in value to 11.25. That means the trader can sell the call and make a profit of $4.25 (11.25 – 7). Certainly this is a viable option and should be considered on some of the contracts before adjusting the position.

Maximum Loss

Maximum loss for a long butterfly spread is realized if the stock is trading at or below the lowest strike (lower wing) or at or above the highest strike (higher wing). In this case the maximum loss is not a loss at all but a credit of $1.50. In essence, the original $7 potential risk from buying the July 175 call is now erased and has turned into a guaranteed profit even if Baidu stock completely collapses. If the stock continues to move higher and past the 195 strike at expiration, the maximum loss is still achieved; albeit a $1.50 profit. But more could have been made by simply keeping the original position intact. That is why it may be prudent if there is more than one contract (long call) to maybe not convert all the positions to a butterfly spread, particularity if the trader thinks that the stock can still climb higher. Keeping the long call would have more profitable if this scenario played out.

Maximum Profit

Maximum profit is achieved if the trader is right and stock closes right at $185 at expiration. The current profit on the trade is $4.25 as discussed above. If Baidu stock continues to trade sideways or ends up at $185 at expiration, that $4.25 profit has now grown to an $11.50 profit. The maximum profit for a butterfly spread is derived from taking the difference between the bought and sold strikes which in this case is $10, and adding premium received from converting the position to a butterfly spread ($1.50). Not too bad of a result if Baidu stock trades sideways or ends up at $185 at expiration. It seems pretty clear that the long butterfly spread is very beneficial when a sideways outlook is forecast after the long option has profited.

As long as the strike prices align with the trader’s outlook, converting a long call or a long put to a butterfly spread can be very effective after gains are realized. If there are multiple contracts, it allows an option trader to take profits now and also potentially earn more if the stock essentially goes nowhere and ends up close to the short strikes at expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 18, 2014

AAPL Butterfly After the Split

There has been more talk than usual about Apple Inc. (AAPL) before and now just after the split. Several traders have asked me about what type of AAPL option trade they can use if they think AAPL will rise to around $100 in a few short weeks. Truth be told, there is more than one option strategy that can profit. But an option trader should consider a directional butterfly spread particularly if he or she has a particular time frame in mind as well. Depending on how the butterfly spread is structured, the option trader can structure a high risk/reward ratio for the spread. Let’s take a look at this option strategy.

The long butterfly spread involves selling two options at one strike and then purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered to be the wings and the short options are the body of the butterfly. The option strategy objective is for the stock to be trading at the sold strikes at expiration. The option strategy benefits from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value and the lower strike call on a long call butterfly spread or higher strike put for a long put butterfly spread have intrinsic value.

As mentioned above, if an option trader thinks that AAPL will be trading around $100 in about three weeks, he can implement a long call butterfly spread with the sold strikes (body) right at $100. Put options could also be used but since the spread is being structured out-of-the-money (OTM), the bid/ask spreads of the options tend to be tighter versus in-the-money (ITM) options which would be the case with put options. The narrower the option trader makes the wings (long calls) the less the trade will cost but there will be less room to profit due to the breakevens. If the butterfly spread is designed with larger wings, the more it will cost but there will be a wider area between the breakevens.

At the time of this writing, AAPL is trading around $92. An option trader decides to buy a Jul-03 97/100/103 call butterfly for 0.15. The most the trader can lose is $0.15 if AAPL closes at or below $97 and at or above $103 at expiration. The breakevens on the trade are between $97.15 (97 + 0.15) and $102.85 (103 – 0.15). The maximum profit on the trade in the unlikely event AAPL closes exactly at $100 on expiration would be $2.85 (3 – 0.15). This gives this option strategy a 1 to 19 risk/reward ratio. Granted AAPL needs to move higher and be around $100 in three weeks but one could hardly argue about the risk/reward of the option strategy or the generous breakeven points of the spread.

This AAPL option trade may be a bit overwhelming for a new option trader to understand and there is more than one way to take a bite out of AAPL with a bullish bias. A directional call butterfly spread in this instance is just one way. A big advantage that the directional butterfly strategy may have over another option strategy is the high risk/reward ratio. The biggest disadvantage is the trader needs to be right about the time frame in which the stock will trading between the wings since maximum profit is earned as close to expiration as possible.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 15, 2014

Delta and Your Overall Position

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

An important thing to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock is trading at $590 and purchases 3 June 590 call options. Each call contract has a delta of +0.50. The total delta of the position would then be +1.50 (3 X 0.50) and not 0.50. For every dollar AAPL rises all factors being held constant again, the position should profit $150 (100 X 1 X 1.50). If AAPL falls $2, the position should lose $300 (100 X -2 X 1.50).

Using AAPL once again as the example, lets say a trader decides to purchase a 590/600 bull call spread instead of the long calls. The delta of the long $590 call is once again 0.50 and the delta of the short $600 call is -0.40. The overall delta of the position is 0.10 (0.50 – 0.40). If AAPL moves higher by $5, the position will now gain $50 (100 X 5 X 0.10). If AAPL falls a dollar, the position will suffer a $10 (100 X -1 X 0.10) loss.

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

 

 

June 6, 2013

A Naked AAPL Call

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 premium 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