Testimonials

November 21, 2012

Going Vertical in AAPL

Filed under: Options Education — Tags: , , , , , , , — Dan Passarelli @ 11:04 am

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

Filed under: Options Education — Tags: , , , , , , — Dan Passarelli @ 11:26 am

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.