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May 29, 2014

Implied Volatility is a Big Factor for Bull Put Spreads

Even though implied volatility has been relatively low in the market, there will be a day when it does rise again. Implied volatility (IV) by definition is the estimated future volatility of a stock’s price. More often than not, IV increases during a bearish market and decreases during a bullish market. The reasoning behind this comes from the belief that a bearish market is more risky than a bullish market. The jury is still out on whether this current bullish market can continue through the summer but regardless, now may be a good time to review a strategy that can take advantage of higher implied volatility even if it doesn’t happen this week. Option traders need to be prepared for all types of trading environments.

Reasoning and Dimensions

Selling bull put spreads during a period of high implied volatility can be a wise strategy, as options are more “expensive” and an option trader will receive a higher premium than if he or she sold the bull put spread during a time of low or average implied volatility. In addition, if the implied volatility decreases over the life of the spread, the spread’s premium will also decrease based on the option vega of the spread. Option vega measures the option’s sensitivity to changes in the volatility of the underlying asset. The implied volatility may decrease if the market or the underlying moves higher.

Outlook and the VIX

Let’s take a look at an example of selling a bull put spread during a time of high implied volatility. In this make-believe environment, the CBOE Market Volatility Index (VIX) has recently moved from 12 percent to about 18 percent in about two weeks which was accompanied by a decline in the market over that same time period. The VIX measures the implied volatility of S&P 500 index options and it typically represents the market’s expectation of stock market volatility. Usually when the VIX rises, so does the implied volatility of options. Despite the drop, let’s say a trader is fairly bullish on XYZ stock. With the option premiums increased because of the implied volatility increasing, a trader decides to sell a bull put spread on XYZ, which is trading around $53 in this example.

Selling the Spread

To sell a bull put spread, the trader might sell one put option contract at the 52.5 strike and buy one at the 50 strike. The short 52.5 put has a price of 1.90, in this example, and the 50 strike is at 0.90. The net premium received is 1.00 (1.90 – 0.90) which is the maximum profit potential. Maximum profit would be achieved if XYZ closed above $52.50 at expiration. The most the trader can lose is 1.50 (2.50 – 1.00) which is the difference between the strike prices minus the credit received. The bull put spread would break even if the stock is at $51.50 ($52.50 – $1.00) at expiration. In other words, XYZ can fall $0.50 and the spread would still be at its maximum profit potential at expiration. If the VIX was still at 12 percent like it had been previously, the implied volatility of these options could be lower and the trader might only be able to sell the spread for 0.90 versus 1.00 when it was at 18%. Subsequently the max loss would be 0.10 higher too. In addition, if the IV decreases before expiration, the spread will also decrease based on the option vega which could decrease the spread’s premium faster than if the IV stayed the same or if it rose.

Final Thoughts

When examining possible option plays and implied volatility is at a level higher than normal, traders may be drawn to credit spreads like the bull put spread. The advantage of a correctly implemented bull put spread is that it can profit from either a neutral or bullish move in the stock and selling premium that is higher than normal.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

November 21, 2013

Long Calls and Bull Call Spreads in AAPL

Purchasing a Call vs. Bull Call Spread

With the Dow and S&P 500 at all-time highs recently, it probably made sense to have at least a moderately bullish bias towards many stocks. The market is due for some type of pullback but whose to say it won’t continue on its bullish pace. Even if it does pullback sooner than later, there will be another bullish opportunity at some point. Is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a couple. One that may be a better option compared to the rest is the bull call spread. To learn to trade this strategy and more in detail please visit our website for details.

Definition

When implementing a bull call, a trader purchases call options at one strike and sells the same number of calls on the same company at a higher strike with the same expiration date. Let’s use Apple Inc. (AAPL) which is currently trading around $515 as an example. In this case you would purchase December calls at the 515 at-the-money strike at the ask price of $13. You would then sell the same number of December calls with a higher strike price, in this case 535 at the bid, $4.

The Math

The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that he purchased one December 515 call and sold one December 535 call resulting in a net debit of $9 (that’s $13 – $4). The difference in the strike prices is $20 (535 – 515). He would subtract 9 from 20 to end up with a maximum profit of $11 per contract. So if he traded 10 contracts, you could make $11,000.

Although he limited his upside, the trader also limited the downside to the net debit of $9 per contract. To simply breakeven, the stock would have to trade at $524 (the strike price of the purchased call (515) plus net debit ($9)) at expiration.

Advantage versus Purchasing a Call

When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the at-the-money December 515 call he would have paid $14. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.

Conclusion

By implementing a bull call spread, traders can hedge their bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.

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

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

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: `WhenIuse 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.