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Dec
31
If you want to make money as a trader, you need movement and you need it now. The more the merrier. Most people associate volatility with their high school football coach. Others view it as something to be avoided. And a few-mainly option and commodity traders- see volatility as opportunity.
Volatility is the measure of variance around the mean price. If a stock has low volatility, its band of price movement is limited. On the other hand, a stock with a wide band of price movement is considered volatile. Most investors want to have the value of their investments increase over time. But traders want price to move rapidly and with variation. If a trader can predict the proper direction of movement within a certain time frame, they can make many trades with small profits which will compound over time. Traders want movement and they want it now! To do that, they need investment vehicles with volatility and options can certainly fill the bill.
Types of volatility
There are two types of volatility: implied and historical.
Implied volatility is what the market expects for a stock’s price movement. If implied volatility is high, the market expects the stock price movement to be choppy. Of course, low implied volatility suggests smoother stock price movements within a limited price range.
Implied volatility is, indeed, the same as option value. However, implied volatility can be different for different positions on the same stock. Typically, when volatility on a stock is on the rise, the market is focusing on the stock and something out of the ordinary is happening. If a stock is breaking out, and is not accompanied by volatility, the breakout will probably not be sustained. If volatility builds up along with other technical indicators, a break-out can be significant.
Historical volatility measures the stock price changes in the market and translates this into a statistical measure of variance. We won’t concern ourselves with the math but the result is presented as an annualized percentage. This percentage provides an idea of how far the stock price can vary from its average price. For instance, if a stock has an average price of $40 with a volatility of 50% this means that price could vary between $20 and $60.
An option price is affected by several components: the strike price, days to expiration, current stock price, dividends paid (within the option period), interest rates and implied volatility. Each stock has many options and each will be different mainly due to implied volatility. In general, out-of-the- money (OTM) options have a higher implied volatility because of more risk than at or in-the-money options. Moreover, puts and calls for the same period usually doesn’t have the same implied volatility.
A good option trading strategy using volatility
Covered Call writing is when an owner of the underlying stock sells (writes) an out of the money call. This is a popular strategy and is considered a conservative option trade. According to Ravi Kant Jain in his article “Putting volatility to Work”, a trader should start with a mildly bullish stock. If a trader picks a very bullish stock, it could be akin to shooting oneself in the foot as the trader will lose the potential gains of owning the stock unencumbered by having it called away if n option is exercised. Historical volatility is the next thing to consider. If the historical volatility is high, this demonstrates that the stock moves a lot. That’s good. This means that the stock has a good chance of moving below the strike price as well as above it. Jain recommends that the best candidate is a stock with the biggest difference between implied (option premium) and historical volatility.
Dec
30
Anything that still produces excellent investment results after 400 years must have something to it. Four hundred years ago, Japanese rice traders developed a system to track trading sentiment. Call it the first technical trading system in history. The theory is that as sentiment goes, so goes prices. If market feels that demand for a stock, rice, option, etc, is strong, it will be demonstrated in how price moves over a period of time. If price and buying patterns change, sentiment can also be changing. For example, if a stock price opens at one price and closes at a higher price without going below the opening price for the whole day, demand is strong (Fig 1). If price opens and spikes up but ends the day lower than at the opening, demand may be waning (Fig. 2). If the stock opens then spikes up, spikes down and closes at the opening price, it indicates total confusion as bulls and bears are indecisive. This usually signals a trend reversal (Fig.3). Candlestick figures which show opening, high and low and closing are called Japanese Candlesticks. The color makes it easy to see if a stock is moving up or down. Usually, “up” is green (or clear) and “down” is red (or black). Over the centuries, distinctive patterns have demonstrated a high degree of success in predicting a change in sentiment and resulting price direction.
Fig. 1 Increasing value candlestick Fig 2. Decreasing value
There are over fifty candlestick patters but about thirteen are most common to traders. Most option traders use a candlestick as a primary indicator which points out potential opportunities. Further analysis needs to be done to confirm the sentiment indicator of the candlestick. For example, if a Doji is spotted, the trader will then focus on the stock and do further analysis in accordance with the particular trading system.
The example below demonstrates how one trading system can be employed to confirm a Doji candlestick pattern.
Fig. 4
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Once the Doji appears, further analysis depends on the system. In this case, the trader would look at RSI (relative strength indicator) to see if the stock is over sold or over bought. In this case, the RSI shows the stock in an oversold situation. The trader than checks the 20 day simple moving average (green line). It shows the prices moving back up toward the sma. Next, the trader might want to check to see if the current price levels are abnormal for the stock. One does this by using Bollinger Bands, (upper and lower orange bands. |
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TheBlack line is the median. The prices are well outside the boundry lines. Every indicator in this system seems to confirm the reversal that the Doji indicated. Analysis, fundamentals on issues should be checked to make sure there are no company or industry issues. |
Candlesticks make a good preliminary indicator for a possible option trade but it should be backed up with other indicators and at least three out of four indicators should technically confirm the venerable candlestick. The Doji is only one of many useful candlestick patterns and a trader is well advised to learn about them. Four hundred years speaks volumes.
Dec
29
It’s not surprising. It used to be all the talk amongst the financial egghead group. But now, the dawdling masses are catching on. Not many stock or option investors know about the investment theory that won a Nobel Prize in 1991. Nor do they know about a landmark study that showed that over 90% of the returns on an investment portfolio comes from how- not what- you own in your portfolio.
That’s right. Not the hot picks, top rated or whatever system stock picker gurus use. While most “lay” stock and option investors watch the flash- bang of Wall Street marketing, the buttoned down mathematicians and portfolio managers quietly put the new theory to use. There’s probably a good reason why most investors don’t know about this remarkable study and the importance of Modern Portfolio Theory (MPT). You see, there is a huge industry dedicated to telling you how to invest and what to buy.
MPT is a major tool for professional investment managers and this fact might also be another factor that keeps it mostly invisible to the average retail customer. Up until recently, the sophisticated Nobel Prize winning strategy needed somebody with an MBA or PHD to implement the strategy. But now the tools needed are accessible and easy to use for almost any non-egghead stock or options investor.
Modern Portfolio Theory for dummies
In a nut shell, MPT says that to minimize investment risk and optimize portfolio returns, close attention needs to be paid to the proper balance of asset classes within a portfolio. This is not to be confused with asset diversification. Asset class means types of investments with varying correlations. For example, you don’t want too many investments that move together in sync. That’s O.K when the market is going up and positions are long. But if things turn dicey, closely correlated investments all go down together; eggs in the same basket sort of thing. Investment asset diversification only pretends to give that sort of protection. Having different asset classes with varying correlations in a portfolio does. The important thing is that varying correlation promotes lower overall risk which helps allows an investor to add some kick to the portfolio and boost total returns.
More kick in your portfolio
Listen to this: a study done by the Chicago Mercantile Exchange demonstrated that a portfolio with as much as 20% of investment assets in futures and options yielded up to 50% more than a portfolio limited to low and moderate risk investments.
Options are perfect for the 10-20% of a portfolio balanced for risk reduction. Options offer high leverage so the 10-20% of a portfolio can represent a much larger percentage of assets held. For example, if you have a portfolio with $200,000 in assets, if 10% of the portfolio is in options, the $20,000 alone could provide up to an additional $200,000 or more in rights to stock assets on top of the value of the balance of the portfolio. In this case, 90% of the portfolio would be invested in stocks, bonds and mutual funds and $200,000 in rights to stock through options for a total of $380,000 from which to obtain returns.
Used together with Modern Portfolio Theory, using the flexibility and leverage of options makes for a potent strategy. Consider the important fact that even a slight increase in portfolio returns can make a big difference over time. More investors should take a look at ways to optimize return and reduce risk. MPT and options is a strategy worth investigating.
Dec
28
Fundamental Considerations When Trading Stock Options
Filed Under Option Trading Articles | Leave a Comment
Do the numbers tell it all? When you read something about a company, do you really believe it? How do you make a decision about what makes a good investment opportunity? For most traders, technical analysis takes center stage and some times the fundamentals are pushed to the back or forgotten all together. But there are some important fundamental factors that an option trader should always keep in mind.
1) Every trader or investor should know what is happening within the company and the industry to confirm why the stock or option is behaving as it is or if there are any possible events which could affect the stock or option price. Going to the company website and contacting the Investor Relations department is a good idea before entering into a trade. Its a little time consuming but this step may save you from any surprises and help to confirm your analysis. Of course, consider the source.
2) Investors and traders need to know when a target company comes out with financials such as earnings estimates, quarterly and annual reports and files SEC documents. The SEC regulations are designed to provide investors and traders with transparency. However, if a trader or investor isn’t aware of SEC filings by a company, the trader-investor may overlook important information that is revealed in the required documents. A company could say “it was there for the entire world to see”. It’s caveat emptor, baby.
3) Option traders should be aware of “Triple Witching” dates. This scary sounding day is indeed something to avoid and it happens on every third Friday of expiration months. “Quadruple Witching” day happens when several types of options and other derivatives expire on the same day. This happens on the third Friday in March, June, September and December. Triple or quadruple witching days see volumes and volatility increase, which is largely due to investors “rolling” existing options positions to new expiration months and exercising option contract rights. With the advent of single stock futures (SSF) and improved technology, many feel that the Triple and Quadruple Witching days are no longer quite the chaos they were in the past. However, it’s a good idea for the options trader to be aware of when the witches come out to play.
4) Decide if the stock and its options are overpriced. Look at the last 12 months price range for the stocks and see what the options have been doing in various expiration months. If the price is currently near the top end, consider buying on pullbacks.
5) Check the volatility of the stock. If it is above normal for the stock, there could be some information out there that’s not readily apparent.
6) Check and see if insiders are buying or selling the company stock or exercising or selling options.
7) Review the Annual Report called the 10K or Quarterly Report (10Q) and particularly to the section usually titled “ Management Discussion and Analysis” (usually in the front of the report). This will give a good synopsis of what the company management team feels about the state of the company and what future prospects are.
Check the company Income Statement and Balance sheets. The Income Statement (also called the Operating Statement) shows the profitability and expenses of the company operations and the Balance Sheet shows the financial strength of the company. If you don’t know how to read financial statements, there are plenty of free sources to teach you. 9) Check out the competition in the Industry. How does the target company compare to its competitors? How does the company Price-Earnings ratio compare with that of the industry. The same holds for EBIT (Earnings before Interest and Taxies) profit percentage.
These suggestions should be part of an option trader trading due diligence and incorporated into a checklist from to be checked-off before entering into any trade. Trading strictly on the technicals could miss factors not fully discounted into price. Do both Technical and Fundamental analysis and then make your opinion.
Dec
27
The Sinking U.S. Dollar-an opportunity for Option Traders
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“Oh, my God, the sky is falling in! It could mean the end of the United States as we know it. The strong U.S. dollar-representative of the strongest economy on earth-is crumbling and with it the future”. The alarmists and conspiracy theorists are jumping for joy. “We told you so. And yes, we’re smarter that the lot of you,” they say under their collective breath. Pure, unadulterated hogwash.
The “chicken little” run for the hills thinking offers investors a real opportunity. You see, the U.S. dollar is just making the long sought after correction needed to make U.S. exports much more competitive. From 1995 to 2002, the U.S dollar rose over 35% in relation to other floating currencies, namely the Euro and Canadian dollar. Since 2003, the U.S. dollar has fallen back 35% from what most economists felt was an overvalued U.S. dollar.
While there are problems with the U.S. Federal Budget Deficit and trade deficits, they pose not imminent crisis. No doubt better fiscal policies need to be enacted in Washington but the real pain in a falling dollar lies with our trading partners who hold huge reserve of U.S. dollars. They don’t want to see a large devaluation and they don’t want the dollar to become too competitive either. That’s the real truth. And that is the reason that our trading partners will keep buying U.S. treasuries while more responsible heads try to sober-up the drunken sailor. So, shun the panic and look for the opportunities.
Most of the U.S trading partners in Asia and Latin America have more or less pegged their currencies to the U.S dollar. This means that most of the current devaluation is not exported as price increases to the U.S. As a matter of fact, export opportunities for the U.S. are increasing with each down tick of the dollar against the “floating currency countries”-more specifically Europe. Stocks of U.S. companies who produce and export things such as transportation equipment, computer and electrical products, chemicals and industrial machinery will greatly benefit from a falling dollar. These in-dustries provide 70%-80% of U.S. exports to Europe and Canada. These same industries provide 68% of U.S. exports to China who has recently revalued their currency. As U.S. exports go up, profits go up, employment goes up and tax revenue to help balance the federal deficit go up. On the other hand, in exchange for the benefits of a lower dollar, U.S. travelers going abroad-particularly to Europe and Japan- will find it more expensive overseas. Sounds like a good trade-off.
A good strategy for stock option traders would be to locate solid U.S. ex-porters in the industrial sectors mentioned and consider buying long term out-of-the-money call options or bullish spreads. To many “in the know”, a weaker dollar-even though it sounds bad-is mostly a good thing. The only danger is if trading partners and foreign investors lose confidence in the dollar and flood the currency market with a tidal wave of dollars which could have a disastrous effect but not only the U.S would be hurt but also the World as foreign dollar reserves plunge in value. Moreover, the U.S. dollar is the world’s trading currency. To replace it would require much more crisis management and political investment that it would cause tremendous disruptions. To let the dollar crash would be a foolish mistake.
Traders love it when panic and emotion cloud the thinking of the market place and create real opportunities. Trust in the basic fact that most investors will do what is best for them when they understand what they must do to protect their own interests. This means that there won’t be a run on the dollar. When other investors wake up and act logically and without fear, the window of maximum opportunity usually has already slammed shut.
Dec
26
When you first realize it hits like a ton of bricks. So simple yet so true. About 80% of stocks follow the trend. We all know the “the trend is our friend”. Can you smell a contrarian in the wood pile? Well, if 80% of stocks move with the trend that must mean that only about 20% of stocks or options will move against the trend on a normal day. There must be a way to use those favorable odds. And with options, there is.
An option trader can take advantage of this knowledge and use it to make a profit against the market trend. The trader can write (sell) an out-of-the-money put. This is also called a “naked put” because the writer does not own the underlying stock (it doesn’t mean the option must have been written in a state of undress). If the price of the stock goes up-as is expected-the trader who writes (sells) a put will keeps the writing premium just as long as the price does not go down below the strike price and into-the-money. Given that 80% of stocks move with the trend, the probability of the stock moving against the trend and the writer can be very small. However, to make this sort of trade, the trader needs to have a good understanding of what the short and long term trends are and if there is any possible news (earnings reports, adverse news, etc) that might send the stock reeling backward. This is one of the more risky strategies because if the put goes in-the-money and the option is called, the writer must purchase the underlying stock to place with the option buyer.
A much safer way for an option trader to make money going against the trend is to write a covered call. If the underlying stock is owned by the trader (thus, the put is “covered” in case it is called away), the option call writer is hoping that some other trader believes that the underlying stock will go up in value as will the derivative option. But if the owner knows his stock very well and believes that its usually docile behavior will keep it away from reaching a certain strike price, the call writer will make money when the option expires if it doesn’t get into-the-money and get called away. For example, if the long term trend is up but the shorter term trend is in a correction phase, the trader can write the covered call with an expiration date that will fall within a time frame that should see the correction move back toward the long term trend. Using the promise of a substantial move upwards into the money, the call writer hopes to lure in a trader who doesn’t understand the stock as well as he. Once the option expires, the call writer keeps the premium and if things still look good, (not much upside movement) he prepares to do it again, and again and again. Given that there are option expiration dates for almost every month, the return can be quite impressive over the long term. If a covered call writer is unlucky and his stock gets called away, well he gets to keep the profits and the premium. The only thing he might lose is the opportunity cost of a large move in the underlying stock.
Dec
24
When you learn about options-really learn- you’ll understand why they have become so popular. Don’t let the word derivative scare you. Read on and find out whey options are the way to go. Most importantly, options provide investors with the flexibility to choose from a wide range of strategies. In this short article, we’ll discuss some of the more basic and easy to understand ways to employ stock options.
Long Call
The most basic and easiest to understand is the long call. This is when an option is purchased with the idea that within a certain period of time the value of the option will increase and profits can be made with a much smaller investment than would be needed to purchase the underlying stock. For example, if the underlying stock is currently trading at $30 and you expect the stock to go up to $40, a trader can purchase long call options with a strike price of $ 31 that would expire in some future month. If the option moves past the strike price ($31) the stock option owner can either exercise the option and acquire the underlying stock or hold the option and take advantage of the option premium appreciation.
Long Put
Traders who believe that the future price of a stock may go down in value within a certain period of time can buy the right to sell the stock at a certain price. As in all options, the option holder has the right to sell the stock but not the obligation.
If the market price goes down as anticipated within the time period of the option the premium price will increase and the trader can profit from the difference of the purchase premium and the current premium price. If the price does not increase, the trader can let the contract expire or sell it to someone else.
Short Call ( aka “ Naked call)
When a trader sells (writes) an option, he can either own the underlying stock- which case it is called “covered” writing and or in the case of a “naked” writer, an option is written without actually owning the stock. In the case of writing a naked call, if the market price of the underlying stock decreases, the short call writer will profit by the amount of premium change. If the price of the under lying stock increases, above the strike price of the option contract then the short call will suffer a loss. The short call writer is betting that the stock will not go up. If the short call is exercised then the writer is obligated to buy the underlying stock and honor the option contract specifications. This is perhaps one of the riskiest strategies because of the potential of having to purchase the stock in the open market and then transfer the stock to the short call option holder.
Short Put
If a trader believes that the future price of a stock will increase, they can sell (write) the right to sell the stock at a certain price. If the stock price goes up, the short put position makes a profit on the premium. Conversely, if the price goes down below the strike price, the put writer (same thing as short put) loses money.
To summarize, to be long is to purchase a call or a put. To be short is to sell (or write) a call of put believing that the price will not move in the direction of the call or put. Shorting is a contrarian strategy with a high probability of being correct if going against the prevailing trend as 70% to 80% of stocks move in sync with the strong underlying market trend.
Dec
23
Selling Stock Options
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You can’t believe it’s happening. The stock is starting to move up but the option premium is falling. That’s not supposed to happen, or is it? Stock options are quirky when it comes to time left in the option period. It’s really different than investing in stocks. One of the vital concepts that stock option traders learn about and need to understand is the time value of an option. They learn that as an option contract approaches its expiration date, it loses value because there is less time for the option to move as forecast. The Chicago Mercantile Exchange once did a study that demonstrated that over 80% of all options expire worthless. Does that mean that 80% of option traders lose money? Not really; and in certain cases, expired options are far from worthless. To an option seller, expiring options are all about profits. An option seller under-stands how to make a profit with stock options- even if the market doesn’t move!
When buying an option, the time value works against the buyer as the chart below depicts. The closer to expiration, the more the time value of an option decays until reaching zero at expiration.
The premium value of an option is composed of intrinsic value and time value. Intrinsic value is the in-the-money portion of the option premium. For example, if you buy a call stock option at a strike price of $25 with the underlying stock’s market price at $35, then the intrinsic value of the call option is $10 (in-the-money). If the option contract premium is $12 per share, the additional price component ($2) is the time value-the more time left before expiration date, the higher the time value.
An option seller (also known as the “writer”) wants the option he/she has sold to expire worthless so the premium paid to the writer for the option can be kept. In-the-money or out-of-the money options can be written. If a writer of an option already owns the underlying stock, this strategy is called writing a “covered option”. If the writer doesn’t own the underlying stock, the strategy is called writing a “naked option”. Using this strategy debunks the idea that expiring options are worthless. In fact, option writing is an excellent strategy when you believe the underlying stock is going to move in one direction (or not at all) and you write an option for potential movement in a contrary direction. It’s important to understand that 70% to 80% of stocks move with the trend. For example, if you are bullish, you would sell (write) an out-of- the-money put option. As long as the underlying stock doesn’t go down and into-the-money (hits its strike price) before expiration, you keep the premium paid for the put option. The risk of writing the covered position is having the stock called away if it is in-the-money and the un-covered position is that you might have to purchase the underlying stock if it moves into the money and is called away. In reality, writing a covered option is considered a conservative strategy. Writing uncovered is more risky.
Another nice thing about selling (writing) an option is you don’t have to worry about when to get out. You make money just by not moving into the money. You don’t even have to be correct about the magnitude or direction of movement; just as long as the option doesn’t get into the money. Remember, 80% of options expire worthless. The odds are definitely in your favor if you are going against the trend but that in no way relieves the responsibility of doing the due diligence. The trader needs to not only look at the technicals-particularly Relative Strength Index (RSI) but also fund-amental issues like any potential situations that could cause the stock to reverse direction.
Selling out-of-the-money options can be much less stressful because it only requires an analysis of identifying the high probability of little or no significant movement. The profits are fixed and there is none of the usual conundrum of when to exit a trade. Just ride the time decay curve to the end and ring it up. If you do it successfully enough times, you’ll be a happy camper and probably become a died-in-the-wool contrarian.
Dec
22
The Big Picture: Losing is Part of Winning in Options Trading
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This is what it’s like to be an option trader. You’ve done all the due diligence. You’ve checked the stock and option charts and studied the fundamental issues of the underlying stock. The March out of the money- option looks like a good time interval and strike price to move into-the- money and hit your target price. You decide that it looks like a good option trade and you have three of your four technical indicators supporting your decision. You’re just waiting for the stock price to move through the 20 day simple moving average (SMA). As, you watch the stock price move up to touch the SMA line, you call your stock broker and place a market order for five March 50 strike price call option contracts along with a 7% trailing stop loss. You get a confirmation and you sit back to watch the action. Your heart is beating faster and you move closer to the screen. “Come on, babies, show me the money”, you murmur to yourself.
You’ve told yourself that keeping glued to the scream is something you want to avoid but for some reason you get hypnotized by the promise of seeing the stock and its option price move in your favor. Finally, the option price starts moving up slowly. You feel excitement and a sense of anticipation. You did exactly what your options trading system procedures called for and a surge of confidence brings a smile to your face. You decide to tear yourself away from the screen and go for a walk to enjoy the feeling and relieve the tension.
When you return to the computer, you gasp in horror as you see that the option price has retraced and is nearing your stop-loss. You quickly check the news and the charts for some indication of what’s happening. Nothing. As a matter of fact, you notice that the RSI (relative strength indicator) has moved down. Maybe this is the testing before it really takes off. “But what if I get stopped out before it makes the move back up?” you ask yourself. You quickly call your broker and ask him to move your stop-loss lower to give your position some room to breathe. You know you shouldn’t have done it but you did it anyway.
Within several hours, the price of the underlying stock is starting to move up and you watch with hopeful anticipation for the options to follow suit. But as you watch in horror, the option prices not only blow past your original stop- loss but also scoot right past your adjusted stop. Before the first day is over, you’re out of the game and score some red on the trade. You’re angry and confused. All the study and preparation for what? You should have listened to others and stayed away from options trading. No more options trading for you!
This scenario is too typical and is what separates successful traders from the majority of stock option trader “wannabees”. Listen, losing is part of trading. As a matter of fact, a trader who has an option win-loss ratio over 60% is probably making good profits over the long term. The idea is that if you cut your losing option trades quickly and without second guessing yourself, and let your winners run, you will do well.
The key to becoming a successful options trader is being able to “stay in the game”. Simply put, staying in the game is a matter of setting up a strict policy regarding the amount of trading capital allowed for each trade and religiously “punching out” when a stop loss is hit. Most successful option traders limit their trading capital to about 5-8% of the option trading account on any one trade. If they draw down the option trading account below 30%, most option traders will stop trading and go back to redesigning their trading system or adjusting their heads. Simple rules to trade by, but most new traders don’t go into options trading with these sorts of con-straints in place. And even if they do, many let the emotions take over and will violate their own option trading system to save their egos or try to salvage money they shouldn’t be trading.
In options trading, losing is part of winning. Nobody wins ‘em all, and any trader with a win-loss ratio over chance (50%) is usually doing well because the average losing option trades lose much less than the average winner. For example, if average losers have an 8% loss and the average winner gains 18%, multiply that average margin difference (in this case, 10%) by the number of contracts traded over time and that is what it’s all about. It’s not about hitting home runs, but hitting for average.
Dec
21
If you don’t know much about stock options, wait until you read this! Most investors think that the only way to profit from investing is when the price increases (long position) or when price decreases (short position). However; with stock options, an investor can make money when there is no or little movement in a stock market or individual stock price. Consider the simple strategy of writing a covered call. (The term “covered” means that you own the underlying stock of the derivative stock option).
Writing an out-of-the- money call option
One of the many inviting strategies that can be used when there is little price movement in an underlying stock is to “pledge” the rights of your ownership to others. Some investors in the vast universe of stock option investors might believe that the stock you own may experience an increase in price within a certain time period. In order to position themselves to take advantage of their analysis, they look to purchase a call option(s) contract on the stock.
An option contract is composed of the temporary ownership of the rights to an underlying stock issue. To do this, they pay a premium for each share of stock. For example, a call option for a certain month may cost $2. This means that to borrow the rights for the underlying stock, an investor will pay $2 per share for 100 shares per contract; one contract would cost $200 plus transaction costs. If a stock has a current price of $32, 100 shares would cost about $3200 to purchase. On the other hand, to have the rights for 100 shares of the same stock would cost only $200 for a specific period of time. The cost of the premium depends upon if the option is in- the-money (ITM), out-of-the-money (OTM) and length of time left on the option. Of course, demand for the option is the major determinant.
The owner of a stock can “write” an out-of-the-money covered call whereby he/she pledges the rights to the stock in exchange of a premium payment. In the example above, the owner of the stock would receive the $200 premium for the rights to 100 shares if the stock for the specified time period. If the stock moves from OTM to ITM, the holder of the option may call away the stock and the writer of the call option must pass ownership of the stock to the option holder for the current market price of the stock. However, if the stock option does not move into-the-money, the option can’t be exercised; the premium and the stock stay with the call option writer.
Covered call writers can repeat the process many times over with the same stock and still maintain. For example, if the owner of the stock had paid $3000 for 100 shares of XYZ and then writes 3 covered call contracts per year at the same premium price of $2 per share, the writer of the call options would realize an annual return of 20% including any appreciation which didn’t trigger a call away of the underlying stock. However, the risk of writing covered calls is that if the stock appreciates and the underlying stock is called away, the owner would then lose the opportunity of taking advantage of the underlying stock appreciation.
Writing an in-the-money call
Here is another interesting way to take advantage of the tremendous flexibility of stock options. Instead of paying a broker to sell a stock position, why not make a profit by writing an in-the-money call.
Example:
Suppose the owner of 500 shares of Home Depot (HD) wants to sell the shares… Instead of calling his/her broker and telling the broker to sell the shares, the owner can write an in-the-money call. Keep in mind that ITM calls have higher premiums because of intrinsic and time value.
The owner of the shares discovers that an in-the-money call of the stock costs a premium of $9 per share for an HD-EG-E (May contract month with a strike price of $ 35, which is in the money because the current price of HD is $39.25). For the five contracts (500 shares), the owner would get a premium of $4500 less commissions for writing ITM options for the 500 shares he/she owns. The stock price is currently $39.25 and the calls will probably be exercised and the 500 shares will have to be assigned for the strike price of $35, and, therefore, the owner will lose $4.25 per share ($39.25-$35) for a loss of $2125. But the difference between the premiums ($4500) for the ITM covered calls and the projected loss of $2125 still gives the owner a net profit of $2375 and would give the owner a 12.1% return just on the sale of the underlying stock instead of selling at the current market price of $39.25 and paying commissions to sell the stock. What makes this covered call attractive is the time value of the option.
Dec
20
The Importance of Keeping Score When Trading Stock Options.
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Do you hold yourself accountable for your performance? Does your ego keep you from acknowledging the truth? The basic premise of a successful investing strategy-particularly for short-term investing (trading) – is that by cutting losses as quickly as possible and letting profits run, over time, there will be a pre-ponderance of profits over losses.. Having losing positions will happen, no matter how well the system or the trader. It’s a fact of life. To help keep perspective, a trader must constantly keep in mind that the “name of the game” is to have higher margin winning trades than minimized losses on the losing trades. Losses will happen. Even a 50% win-loss ratio can be a winner over the long term!
When trading options, traders should be constantly aware of: 1) the percentage of profitable option trades they expect to generate, as well as the profit margin of the average profitable option trade compared to the average losing option trade; 2) how many estimated option trades will be made over a specific period. With these two statistics, an option trader can get a sense for the estimated profit potential for trading options over a specified period of time. This estimation can serve as an important, measurable goal and used to help set-up psychologically expectations.
For example, let’s be conservative and say that 50% of your option trades would be winners with an average net profit margin (profits less transaction costs) of 14% and losing option trades to have an average net loss of 8%; the trader can expect a net return before taxes of 6% on 50 % of the total amount invested in total trades. If the trader anticipates making 5 trades per month at an average premium of $1,000, then the trader can expect to make about $150 net profit per month (2 winning trades = $2,500 x .06 = $150). Of course this depends on how long positions are held. Annually, this would translate into $1,800 on an account of let’s say $5,000 (in this example, the trader would have an account of $5,000 but only use an average of $1,000 as a maximum for each trade). This translates into an annual return of 36% on the account capital. If you have a system with a 75% win-loss ratio, then your estimated monthly return would be $225 with an annual net of $2700 for a return of 54% on the account capital of $5000. The variables are: win-loss ratio, premium capital to be used, and profit and loss margins. (In the above example if you used $50,000 in premium capital and traded 10 contracts with the same other variables, profits would be 10 times greater or $27,000. But don’t quit your day job just yet.
Of course, the above example is a simplification of the option trading premise but the concept can be used to help set option trading goals to shoot for. Moreover, after each option trade is completed, the trader should track- at least: win-loss ratio, profit and loss dollars and percent for each trade and cumulative trades. Creating benchmarks and using metrics to track variations on a trade-by-trade basis is essential to help the option trader measure the performance of the system; moreover, the option trader must assess how closely trading parameters and procedures are followed for each trade.
The idea is to track the option trading system’s performance and not the trader’s. It’s like using a mathematical function; use a consistent system of indicators and plug in the numbers and look for a consistent result. If the trader alters the parameters and procedures, it only measures the option trader.
The idea is to identify high probability option trades and use consistent option trading procedures. If the trader’s system is good, it will produce a win-loss ratio of over 50%. Some successful traders who have learned to identify high probability trades and execute an option trade with consistent discipline have win-loss ratios above 70%.
Dec
19
Options-Time is Money
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Don’t just stand there, do something! If you want to invest and just wait for the rising tide to carry your boat, stock options probably aren’t for you. Nowhere is it more obvious that “time is money” than in trading options. Traders are faced with not only correctly predicting the underlying security’s future price, but also choosing the appropriate option time period for the price change to take place. Once that’s established, the trader can then decide which option strategy is best to capture profit while minimizing risks. Some stock option traders mistakenly figure they can easily make the transition from stocks to options. As easy as falling off a log, right? Maybe not. There are differences that option traders need to keep in mind when making the transition to stock options.
Stocks Don’t Expire. Options Do
The major difference between stock and option trading is the impact of time on stock and option prices. With stocks, time is a trader’s ally, as the stocks of quality companies tend to appreciate in value over time. However, with options, time is an "enemy." As each day passes, there is a decline in the value of the time pre-mium for the option. An option trader must not only correctly estimate the direction of price movement the option but also the time frame for the movement. The more time an option has to make the hoped-for movement, the better the chances of it happening. Conversely, as time on the option decays, the probability of the movement happening diminishes; thus, the importance of the “time value” of an option. Because of time value, as an option moves closer to expiration date, the time component of the premium declines more rapidly. An option trader who holds a position for too long will face the inevitable decline in premium value.
Given the accelerated impact of time decay, the closer the options are to the expiration date, option buyers are well advised to purchase more time before expiration than will be needed. Normally, once into the last month of an option period, time decay picks up speed and the option can lose value rapidly. That is why it’s a good idea to “buy time” in an option even though the option premium will be higher. This allows the option buyer to avoid the especially painful time decay, which occurs in the final month before expiration. Moreover, thegreater the certainty about an option’s value at expiration will usually produce a lower premium time value; the greater the uncertainties about an option’s value at expiration, the greater the premium time value.
When an option is in the money, premium time value also decays more rapidly.
The market usually views an in-the-money premium time value as less a factor and holders of in-the-money options who wish to close out their positions will usually discount the time value to attract buyers.
There are ways to profit from out-of-the money options. For example, Credit spreads (one type is a spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating) can offer a trader a profit if they expire out of the money. The time premium (net options value) that a trader collects when establishing a spread will fall to zero ifthe spread remains out of the money upon expiration. The premium initially collected is thus retained as profit. Another potential happy camper is the writer of covered calls when they see the time premium portion of the option go lower as this improves the probability that their underlying stock won’t be called away and they can keep the premiums they’ve received and the stock they had pledged; win-win. Without a doubt, in the world of options, “time is money”.
Dec
18
As an Options Trader, Are You One of “Them”, Too?
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Are you one of the “misinformed? Are you losing the tremendous opportunities that using stock options can offer? No, options are not one of the more risky investments. “Oh, yea” you say sarcastically. “That’s why my broker looks down at the floor as he hands me a risk disclaimer statement which warns the reckless investor about the dangers of trading stock options”, you say. Well, I say to you, dear reader that most investors don’t want to take the time to learn about options-one of the most versatile in-vestment tools available. Too many investors go into trading stock options without adequate education and take the fall. They blame it on the vehicle….not the driver. Like anything, lack of knowledge can cause problems and that holds in spades for options.
Consider the fact that the risk of purchasing an option is limited to the premium paid. Owning stocks, however, usually have a much larger ex-posure to risk.
For example, if you purchase 100 shares of Home depot (HD) you might pay around $ 3400. To purchase an option contract for the rights of 100 shares of HD for a specific time period, you might pay about $ 200. If properly set up, the most you could lose on the option contract (100 shares) would be the $200 premium (premium is the same as the option cost for 100 shares). On the other hand, it’s possible for you to lose all-or certainly a large percentage of your $ 3400 on the purchase of the 100 shares of HD. A sudden bankruptcy or some unforeseen event can make this unlikely event a reality; it has happened before and will happen again. The risk exists. Not so for stock options; the maximum risk is the option contract premium which is a fraction of the cost of buying the underlying stock. It’s a fact.
Options and other derivatives probably get a bad rap because investors, option traders and speculators focus on the leveraged reward options offer but lack the knowledge to control the risk side of the option equation. Fortunately, it’s just a matter of education.
Stock Option Basics
There are many ways to take advantage of the tremendous flexibility of options. Some of the most common strategies employing options are: 1) To hedge an existing long or short position in the underlying equity (like purchasing insurance.) 2) To leverage a position either short or long; 3) to make a profit by selling the rights to the underlying stock. With options, a trader can make a profit when the market is going up, down or flat. But for the most part, options are high leverage-controlled risk investments with the potential for high returns.
Options can be an effective way to leverage investment assets that can reduce shorter term risk while freeing up assets to purchase for the longer term. For example, an individual investor could use 10% of investment funds allocated for equities to purchase volatile, higher risk-reward, options (volatility is good for trading options) and use the 90% to purchase positions in less volatile, long term positions.
As trading options is more complex than trading stocks, bonds, or mutual funds, many investors don’t want to spend the time to become better educated on the mechanics and benefits of trading options. But as returns on most traditional investment products become anemic, investors are starting to look at options as a way to boost profits with the least risk. Options offer a very attractive way to accomplish this goal.
Our modern times require more education for those who want to participate in the benefits that a more complex society can offer. Many have been forced to become computer literate and found out they could make the transition with little or no difficulty. What might at first seem to be daunting can turn out to be easy and interesting. At no time in history can it be more app- ropriate to say that “knowledge is power”, and learning to trade options is an excellent example.
Dec
8
Laddering Hedging Strategy
Hedging is so versatile that we can even create hedges where we get our money back and actually increase the amount of reward. Using the above example, when you originally sold the 300 shares of stock, you could have swapped it for a higher number of contracts, such as four $70 calls instead of three. This still produces a guaranteed return to your account (although lower) but now adds some leverage if the stock should continue its bullish trend. When the stock hits $75, you could add more leverage and roll up from four $70 calls to say, five $75 calls. When you swap or roll up to a higher number of calls (or down for puts), that’s called a laddering strategy, which implies that you’re changing the risk at each rung or step of the roll-up process. There is no set amount or percentage that needs to be applied. As long as you are rolling up to a higher quantity of long positions, it’s a laddering strategy. Each choice presents a different set of risks and rewards, and it’s entirely up to you which is best.
Selling Spreads Against Stock
Chapter Nine introduced you to vertical spreads. As with all option strategies, they can be applied in unimaginable ways and the vertical spread is a perfect example. How many people would think of selling spreads against a long stock position? And what do you suppose it would do to the shares of stock you own?
The following is a real case study that we used for a client in a private mentoring service. The client had 500 shares of WMT at $53 and it was now $56.50. He felt the stock was going to trend sideways for some time and may even fall substantially. He was obviously afraid of losses but didn’t want to pay for the put. Is there an option strategy we can develop that will profit from a sideways stock price and protect the downside risk? Table 10-7 shows the actual option quotes at the time:
Table 10-7: Wal-Mart Option Quotes
We purchased five puts to protect the downside risk he feared. In order to generate enough cash to pay for the put and provide a return in the event the stock price moved sideways we sold 10 – twice as many – $55/$60 vertical call spreads:
Buy 5 $50 puts at 0.55 = -$275
Sell 10 $55 calls at $3.20 = +$3,200
Buy 10 $60 calls at 0.85 = – $850
Net credit = +$2,075
Figure 10-8 shows the effect of the previous three transactions against the long stock:
Figure 10-8
The long puts have completely protected the downside risk, and the sale of the vertical call spreads generated enough of a credit to shift the entire profit and loss curve above zero and create substantial profits if the stock price stays still as projected. As a bonus, the investor still maintains all of the upside potential. We must remember that these benefits did not come for free. If we overlay the original stock position, we can see the tradeoffs clearly in Figure 10-9:
Figure 10-9
Figure 10-9 shows that the investor hedged all of the downside risk and will profit nicely if the stock price stays still, which is exactly in line with his outlook. He accomplished this at the expense of giving up some (not all) of the upside potential. He has sacrificed the very best profit potential in exchange for a guaranteed a return on his money and still has the opportunity to earn more money if the stock price rises. The best news is that similar vertical spreads can be sold month after month, which allows the investor to continually shift the profit and loss curve higher, protect his downside, and still have the potential for unlimited gains.
What would happen if the investor sold 20 spreads instead of 10? Figure 10-10 shows the effect of buying the five puts but selling 20 $55/$60 vertical call spreads:
Figure 10-10
This type of a strategy can be used if the investor is far more bearish on the stock and willing to give up much more upside in exchange for more profit to the downside. What if the investor wanted to actually profit from a fall in the stock’s price? He can do that, too, by purchasing 10 puts rather than five. Figure 10-11 shows the effect of buying 10 puts and selling 10 $55/$60 vertical call spreads:
Figure 10-11
The purchase of 10 puts actually allows the investor to profit to the downside at the expense of profit at the center and to the upside. The possibilities are endless for those who take time to explore the world of options. As stated at the beginning, this chapter is not designed to be a full course on hedging techniques as an entire book could be written on that subject. Instead, we wanted to introduce you to advantages that options provide by allowing you to buy and sell risk. As you continue to learn about options, you will find that all other strategies will be self-evident if you understand the fundamental concepts presented in this book.
In order to succeed in the financial markets, you must invest relatively large dollar amounts and let the profits run. However, we also know that our risk-averse natures won’t allow that to happen. We feel much more comfortable placing small bets and being assured that it is the most we can lose – even if it means we will most likely lose it. By trying to avoid risk, most investors and traders actually place their money in maximum jeopardy.
All hope is not lost. In order to reach for bigger profits, you must remove the fear of loss. You must hedge your bets and bet against yourself. And the only way to do that is with options, since they are the only asset that allows you to buy and sell risk. Once you’ve locked yourself into a guaranteed winning position, hang on. Remember that trends last longer than we expect. Keep the position alive but continue to take profits and cover risk by additional hedges. Options remove fear. Use them conservatively to make money.
Edgar Watson Howe, a famous American writer, once said, “A good scare is worth more to a man than good advice.” If you learn to hedge your trades, you’ll never have to go through a good scare, and that is the best advice that the Options University can give.
Dec
7
Let’s use eBay as an example. Between October and December 2002, eBay made a phenomenal run from around $50 to $70, which you can see in Figure 10-1:
Figure 10-1
Assume you purchased this stock during the uptrend at $55; it would certainly be tempting to take the profit at $70. After all, eBay made a substantial move and it’s sensible to think it will pull back. But if you accept the fact that you’re probably not at the very top, the more prudent move is to stay in the trade but protect the existing unrealized profits. We can do that by utilizing a stock swap strategy. It’s very simple and here’s what you do: Sell all your shares and buy an equivalent share amount of call options. In effect, you are “swapping” your stock for calls.
Incidentally, these two trades, selling your stock and buying calls, can be executed simultaneously through most brokers. Let’s assume you originally purchased 300 shares of eBay at $55 and it’s now $70. That means you have an unrealized profit of $15, or $4,500. To execute the stock swap, you’d sell your 300 shares and simultaneously buy three calls. If our goal is to get a lot of cash off the table, we would probably consider buying the at-the-money $70 call. The actual quote for an eBay January $70 call at that time was $2.75.
Selling your shares will bring in $21,000 (300 * $70) cash and buying 3 $70 calls costs $825 (300 * $2.75), which means you get a net credit of $20,175 cash to your account. The shares originally cost $16,500 ($300 * $55) so you’ve now locked in a profit of $20,175 – $16,500 = $3,675, or 22%. But not only did you lock in a profit, you are still effectively long 300 shares of stock. Any increase in eBay only increases your profit, and there is no risk of losing your original principal; it’s sitting safely in the money market. Figure 10-2 shows graphically the effect of our hedge:
Figure 10-2
The straight shaded line represents the original long stock position at $55. The solid line is our new long $70 call including the net credit we received from selling the stock. Effectively then, we own 300 shares of stock at a cost better than free; we cannot lose and we may make more. Notice that the trade eliminates the downside risk at the expense of reducing the upside potential, which fits our definition of hedging. In other words, for all stock prices above the $67.25 crossover point we would be better off holding the stock as its profit and loss curve sits higher on the chart. But it’s not the fear of lost opportunity that drives us to get out early; it’s the fear of loss and the stock swap hedge removes all that fear. Now we’ve changed our perception of the trade and made it less risky. We can now stay in for much longer than we normally would and possibly catch a huge homerun trade.
Notice, too, that the hedge does not rely on timing. With the stock at $70, are we at the top of a peak? Statistically speaking, probably not. It’s much more likely that we didn’t sell at the highest point. However, our risk-averse nature prods us to take the sure $15 profit and run. Rather than take the $4,500 gain, we hedged the position and captured a sure gain of $3,675. We now can gamble in hopes that we were not at a peak and try for some real money.
As the stock rises, we would continue to roll the calls up as discussed in Chapter Eight. Each roll-up generates more cash and shifts the profit and loss curve higher. For example, assume that eBay moves from $70 to $75 and we roll the position up for a net credit of $3.50. While this is a hypothetical credit, we can use some option-pricing theory to justify it. To roll the position up you would sell the $70 call to close and simultaneously buy the $75 call to open. Now, just look at that trade disregarding the “opening” or “closing” designations. The trade is selling the $70 call and buying the $75 call – a short $70/$75 vertical call spread.
What is this spread worth? To make it easier, imagine that you were long the $70/$75 spread with the stock at $75. We know it must be worth more than $2.50 (the halfway point) but less than the full $5 difference in strikes. So to buy this spread would cost somewhere between say $2.50 and $4.50 depending on how much time is remaining, which is why we assumed $3.50. Therefore, if you sell this spread, you will receive a credit in the same amount. If we were looking at actual quotes, you’d find that the roll-up must be executed at a price very close to this. Again, this is why it is so important to understand the fundamentals presented in this book as the strategies will become second nature to you.
If you roll up for a net credit of $3.50 on 300 contracts, that will generate an additional 300 * $3.50 = $1,050 to your account. You had locked in $3,625 from the first roll to the $70 call and have now locked in another $1,025 from the second roll to the $75 call for a total guaranteed profit of $3,625 + $1,025 = $4,650. However, because you are still effectively long 300 shares (long 3 $75 calls) you will continue to profit if the stock price should continue to climb. The profit and loss graph will shift from the shaded line to the bold line as shown in Figure 10-3:
Figure 10-3: Effect of Rolling from $70 Call to $75 Call
Notice that the new bold line has been shifted higher as shown by Arrow A representing the higher guaranteed return. No matter how low the stock’s price may fall you are now guaranteed to receive $4,650. And if the stock price rises, you will benefit in an unlimited way. The tradeoff is that the bold line has been shifted to the right as shown by Arrow B. For all stock prices above the $73.42 crossover point, the previous profit and loss curve would have performed better. But notice the relatively small space lost by the shift at Arrow B compared to the relatively large space gained by Arrow A. It is a small sacrifice of upside potential in exchange for a much higher guaranteed return. You have hedged your investment and it was done without losing control of the 300 shares.
What if you were more concerned about protecting profits? We could use other hedging strategies as well. For instance, when you rolled up to the $75 call, you could also sell the $80 call, thus creating a $75/$80 vertical call spread. Assume that you could sell the $80 for $1. Selling three of these calls would generate an additional 300 * $1 = $300 profit but it would also limit your upside potential. If you rolled up to three of the $75 calls and sold three of the $80 calls then the profit and loss curve in Figure 10-3 would look like the one in Figure 10-4:
Figure 10-4: Effect of Rolling Up to Three $75 Calls and Selling Three $80 Calls
Figure 10-4 shows that you have increased your guaranteed return by another $300 at the expense of limiting your profits for all stock prices above $80. If you don’t think the stock price will rise above $80, why not sell that part of the range to someone else in the market? Try doing that with stock.
If the idea of completely capping your upside potential is unappealing, then you can hedge that bet, too, and roll up to three of the $75 calls but perhaps sell only two of the $80 calls. Your profit and loss curve would then look like Figure 10-5:
Figure 10-5: Effect of Rolling Up to Three $75 Calls and Selling Two $80 Calls
The bold line has shifted higher by $200 from the sale of the two $80 calls at $1 each. Because you control 300 shares and have sold off 200 shares, you are still net long 100 shares for all stock prices above $80 and that’s why the profit and loss curve doesn’t flatten out like it did in Figure 10-4. The possibilities are endless once you understand the fundamentals of options.
Figure 10-6 shows why hedging is usually the best choice. Trends usually last longer than most people expect and eBay was no exception. The arrow shows the point where we were considering selling the stock. But the stock swap and subsequent roll-ups allowed us to capture a guaranteed profit and hold on through August to the price of $110 (eBay had a 2:1 split at this time, so Figure 10-6 only shows a $55 price):
Figure 10-6
No matter where you may decide to completely exit this trade, you are better off than if you sold the stock at $70. The stock swap and roll-up hedges allowed us to capture a profit of over $10,000 with no downside risk of principle. The cash from the stock swap and roll-ups was always sitting safely in money market.
Dec
6
What Kind of Risk Takers Are We?Every day we’re faced with making decisions about risk. You may not realize that you do, but subconscious calculations are always taking place regarding which risks to take and which to avoid. Walking across the street is, technically, risking your life to get to the other side. On one hand, you may think that sounds farfetched, but it is the worst thing that could happen from crossing the street. However, despite the risk, we walk across streets countless times because, intuitively, we know the probability of that worst-case scenario is very, very low. It’s an acceptable risk, so we choose to take it. Depending on the situation, people tend to avoid risk, accept risk, and in some cases, even seek to take risk.
Psychologists have created three general categories to classify these risks:
1) Risk-averse (those who avoid risk)
2) Risk-neutral (those who accept reasonable risks)
3) Risk-seeking (those who accept high-risk situations)
You are risk-averse if you buy insurance and you are a risk-seeker if you skydive. You are probably risk-neutral about crossing the street. In most cases, people have different attitudes toward risk and it’s not easy to say if they are risk-averse, risk-neutral, or risk-seeking for a particular event. That is, until it comes to money. When it comes to money, people become very predictable and display a consistent view of risk. It is this view of risk that causes many mistakes in trading. Do you fall into the same category as most people? Here’s how to find out: An eccentric millionaire asks you to choose between the following two choices. You only get to play the game once. Which would you choose?
A) $500 gain for sure
B) Flip a coin and get $1,000 if heads and nothing if tails
Both choices are similar in the sense they have the same long run average. In mathematical terms, they are said to have the same expected payoff, or expected value, which is nothing more than a mathematical long-run average. If you were allowed to play this game thousands of times, you would expect to be up $500 per try regardless of which alternative you choose. Obviously, Choice A always yields $500 with each try. Choice B, on the other hand, yields $1,000 half the time and nothing half the time so, in the long run, you’d be up $500 per try.
A risk -verse person will only take Choice A while risk-seekers will choose Choice B. A risk-neutral person would be indifferent between the two choices.
We Really Despise RiskDr. Robert Anthony said, “Most people would rather be certain they’re miserable, than risk being happy.” Sadly enough, most of the research in the field of behavioral finance shows this to be true. In fact, in 1979, two famous psychology researchers, Daniel Khaneman and Amos Tversky, published an influential paper in The American Psychologist showing our risk-averse natures – and with a remarkable twist. In that study, the researchers gave subjects a choice between the following two alternatives that we saw earlier:
A) $500 gain for sure
B) Flip a coin and get $1,000 if heads and nothing if tails
Most people picked Choice A without hesitation. This was no surprise to the researchers as they were aware of our risk-averse tendencies. However, the researchers added an interesting twist and asked the following intriguing question:
C) Take a $500 loss for sure
D) Flip a coin and lose $1,000 if heads and nothing if tails
By similar reasoning with the first set of choices, the second set encompasses an average loss of $500 regardless of which you choose. The difference here is that Choice C results in a guaranteed loss. Choice D may be a $1,000 loss, but it could also result in no loss, both with equal probability. The two researchers expected that if subjects displayed a risk avoidance behavior as with the first set of questions, they should still avoid risk and accept a $500 loss for sure. But oddly enough, the researchers found that most subjects selected Choice D – they accepted the gamble to try and avoid the loss! This means that investors’ aversion to loss overcomes their aversion to risk. The paradox is that we detest risk so much that we’re willing to take risk to avoid it.
This is a fascinating observation about human nature that demonstrates why it’s so important to hedge trades. If a trade is moving against us, it’s our nature to try to gamble our way out. It goes against our makeup to take the for-sure loss. Likewise, when we have winning trades, it goes against our nature to hang on – we’re too afraid of losing the gains we already have. Hedging your positions prevents both of these behaviors and allows you to capture bigger profits.
How many times have you heard “you can’t beat the professionals” or “the market makers always win” or other similar phrases? The reason they are basically true is that professionals know how to hedge. Retail investors end up taking the risky side of the bet and are in trades too soon and out too early. They rely too much on timing and direction and end up losing. Add to this our risk aversion and willingness to gamble our way out of losing situations and you have the very reason so many investors and traders miss their goals with investing.
Hedging is a powerful tool and the key to financial success. Options were designed to hedge. It’s now time to discover the option secrets used by professional traders.
Stock Swap
Of all the hedging techniques, this is the probably the simplest and most useful for most traders so it is a great place to start. Unfortunately, it’s also the least used. Anybody who trades stocks needs to understand this strategy
Dec
4
Chapter Nine Answers
1) If you buy a $50 call and sell a $55 call it is a:
c) Long vertical call spread
Whenever you buy a vertical spread, you are always buying the more valuable option. For call options, that will always be the lower strike, which is $50. So buying the $50 call and selling the $55 call is a long vertical call spread.
2) Spreads always involve:
d) Buying of one option and the selling of another of the same type
There are many types of spreads but all of them involve the buying of one option and selling of another.
3) A vertical spread is:
a) Buying one option and selling another within the same month
4) If you are short the $100/$105 put spread you are:
b) Short the $105 put, long the $100 put
Short vertical spreads are always executed by selling the more valuable strike. For puts, that will always be the higher strike put. So if you are short the $100/$105 put spread, you are short the $105 put and long the $100 put.
5) If you buy the $100/$105 call spread you are:
c) Long the $100 call, short the $105 call
Whenever you buy a vertical spread, you are always buying the more valuable option. For call options, that will always be the lower strike, which is $10050. So buying the $50 call and selling the $55 call is a long vertical call spread.
6) Vertical spreads have:
d) Limited risk, limited reward
7) If you buy the $50/$55 vertical call spread for $3.50, the breakeven point is:
c) $53.50
If you buy the $50/$55 call spread you are effectively buying the $50 call for $3.50. The sale of the $55 call just helps to reduce the cost of the more valuable $50 call. If you pay $3.50 for the $50 call then the breakeven point is $50 + $3.50 = $3.50.
The maximum a vertical spread can be worth is: b) The difference in strikes
The very most any spread can be worth is the difference in strikes.
9) If you buy a low strike option and sell a higher strike option of the same type and same expiration it is a:
c) Vertical bull spread
A vertical bull spread is always constructed by purchasing the lower strike option and selling a higher strike option.
10) Long vertical spreads are always constructed by:
b) Buying the more valuable option
Whenever you buy the more valuable option you have a long vertical spread
11) Credit spreads should be used:
b) When the risk is greater than the corresponding debit spread
Credit spreads should be used when it provides a greater reward than the corresponding debit spread.
12) If you buy the $70/$75 vertical call spread you have the:
c) Right to buy shares for $70 and the obligation to sell for $75
If you buy the $70/$75 vertical call spread you are long the $70 call and short the $75 call. You have the right to buy shares for $70 and the obligation to sell shares for $75.
13) Buying the vertical call spread is identical to:
a) Selling the corresponding put spread
14) Debit spreads are used to:
b) Reduce the cost of the long option
One of the motivations for using debit vertical spreads is that they reduce the cost of the long option.
15) Credit spreads are used to:
a) Reduce the risk of the short position
Credit spreads are initiated by selling the more valuable option which subjects you to unlimited risk. Buying the lesser valued option reduces the risk of the short position.
16) If you sell the $30/$35 put spread for $2, the most you can lose is:
b) $3
If you sell the $30/$35 put spread you are short the $35 put and long the $30 put. You have the obligation to buy shares for $35 and the right to sell shares for $30, which leaves you with a $5 loss. Because you were paid $2 for the spread, the most you can lose is $3.
17) ABC stock is trading for $74. What would you expect the value of the $70/$75 vertical call spread to be?
b) More than $2.50
If the stock were at the midpoint of the spread ($72.50) you would expect the $70/$75 spread to be worth $2.50. However, if the stock price were higher than $72.50, you would expect the value of the spread to be worth more than $2.50.
18) If you sell the $80/$85 put spread for $2, what is the breakeven point?
c) $83
If you sell the $80/$85 put then you are short the $85 put, which means the stock can fall by the $2 premium to a price of $83. If the stock is $83 at expiration, the long $80 put expires worthless and the short $85 put is worth the intrinsic value of $2. You could buy back the spread for $2 thus breaking even.
19) If both strikes are in-the-money, what happens to the value of a vertical spread near expiration?
d) Converge to the difference in strikes
If both strikes are in-the-money then the value of the spread converges to the difference in strikes as the time premium slowly decays.
20) The value of a vertical spread tends to change:
d) Slowly over time
The two options counteract each other as the stock price changes so the value of vertical spreads tends to change slowly over time.
Dec
3
Chapter Nine Questions
1) If you buy a $50 call and sell a $55 call it is a:
a) Long horizontal call spread
b) Short horizontal call spread
c) Long vertical call spread
d) Short vertical call spread
2) Spreads always involve:
a) Buying of a put and call
b) Selling of a put and call
c) Buying of a call and buying of a call in a different month
d) Buying of one option and the selling of another of the same type
3) A vertical spread is:
a) Buying one option and selling another within the same month
b) Buying one option and selling another within a different month
c) Selling one option and selling another month and strike
d) Buying one option and buying another
4) If you are short the $100/$105 put spread you are:
a) Short the $100 put, long the $105 put
b) Short the $105 put, long the $100 put
c) Long the $100 put, long the $105 put
d) Short the $100 put, short the $105 put
5) If you buy the $100/$105 call spread you are:
a) Short the $100 call, long the $105 call
b) Short the $105 call, long the $100 call
c) Long the $100 call, short the $105 call
d) Short the $100 call, short the $105 call
6) Vertical spreads have:
a) Unlimited risk, limited reward
b) Limited risk, unlimited reward
c) Unlimited risk, unlimited reward
d) Limited risk, limited reward
7) If you buy the $50/$55 vertical call spread for $3.50, the breakeven point is:
a) $46.50
b) $51.50
c) $53.50
d) $58.50
The maximum a vertical spread can be worth is: a) The strike of the short less the time value
b) The difference in strikes
c) The sum of the strikes
d) The strike of the long plus the time value
9) If you buy a low strike option and sell a higher strike option of the same type and same expiration it is a:
a) Neutral spread
b) Vertical bear spread
c) Vertical bull spread
d) Diagonal spread
10) Long vertical spreads are always constructed by:
a) Buying the lesser valued option
b) Buying the more valuable option
c) Selling the more valuable option
d) Selling the lower strike option
11) Credit spreads should be used:
a) Always because they are better than debit spreads
b) When the risk is greater than the corresponding debit spread
c) When the reward is greater than the corresponding credit spread
d) When there is a short time until expiration
12) If you buy the $70/$75 vertical call spread you have the:
a) Right to buy shares for $70 and the right to sell for $75
b) Right to buy shares for $75 and the obligation to sell for $70
c) Right to buy shares for $70 and the obligation to sell for $75
d) Right to sell shares for $70 and the obligation to sell for $75
13) Buying the vertical call spread is identical to:
a) Selling the corresponding put spread
b) Buying the corresponding put spread
c) Selling the corresponding diagonal spread
d) Buying the corresponding horizontal spread
14) Debit spreads are used to:
a) Reduce the cost of the exercise
b) Reduce the cost of the long option
c) Increase the premium you receive
d) Decrease the risk of early exercise
15) Credit spreads are used to:
a) Reduce the risk of the short position
b) Reduce the cost of the long option
c) Increase the premium you receive
d) Decrease the risk of early exercise
16) If you sell the $30/$35 put spread for $2, the most you can lose is:
a) $2
b) $3
c) $4
d) $5
17) ABC stock is trading for $74. What would you expect the value of the $70/$75 vertical call spread to be?
a) $2.50
b) More than $2.50
c) Less than $2.50
d) More than $5.00
18) If you sell the $80/$85 put spread for $2, what is the breakeven point?
a) $78
b) $82
c) $83
d) $87
19) If both strikes are in-the-money, what happens to the value of a vertical spread near expiration?
a) Converge to the difference in strikes less the premium
b) Converge to the midpoint of the strikes
c) Converge toward zero
d) Converge to the difference in strikes
20) The value of a vertical spread tends to change:
a) In a steady, reliable way toward the difference in strikes
b) Quickly for longer-term but not shorter-term spreads
c) Quickly over time
d) Slowly over time
Dec
2
How Much Time?
When investors and traders learn about spreads one of the first questions asked is how much time to buy or sell. This is a very tough question to answer for spreads. As with any strategy, each set of strikes and time frames creates a unique set of risks and rewards. If both strikes are in-the-money then shorter time frames provide a better chance for the spread to expire with intrinsic value. In other words, if both strikes are in-the-money then shorter terms vertical spreads are less risky. As the risk-reward relationship shows though, these spreads may not provide a very big reward. If you wish to increase the reward for any given set of strikes then you will need to increase the expiration date.
For instance, assume ABC stock is trading for $54 and the one-month $45/$50 vertical call spread is worth $4.50, which means the most you can make is 50 cents per spread. A longer-term contract will trade for less than $4.50 thereby providing a larger reward. Why is this? It is riskier to hold with more time remaining. If the $45/$50 vertical call spread were to expire right now then the spread would be worth the full $5 value. However, as you increase the time remaining on the spread then that just provides a chance for the spread to fall out-of-the-money so it becomes riskier.
On the other hand, if you are buying out-of-the-money strikes then buying longer time frames will give you a better chance for the strikes to expire in-the-money. Providing a better chance for intrinsic value is the same as saying it is less risky, and that means the spread will not provide as much reward.
The trick is to balance the risk and reward to suit your tastes. In our Google example, most traders would never use a vertical spread with that much time remaining. However, by selling that much time, it allowed us to get strikes very deep-in-the-money and still provide a very nice return. If we would have considered a shorter time frame, we would find that the reward was less than $3. It’s all about risk-reward tradeoffs and it is up to the investor to decide which to buy or sell.
When it is time to exit the spread, you simply enter the reverse set of transactions that got you into the trade in the first place. For example, 35 days later, Google was trading for roughly $308. If you wanted to close the spread, you would enter the closing transaction in one of two ways depending on your broker’s platform:
1) Buy the Google January $250/$260 vertical put spread at market (or net debit limit)
2) Buy to close, Google Jan. $260 put and simultaneously sell to close the Google Jan. $250 put at market (or net credit limit)
Figure 9-9 shows that 35 days later the $260 put could be purchased for $20.90 and the $250 put could be sold for $17.40 for a net debit of $3.50:
Figure 9-9
This clearly demonstrates that despite a positive move in the underlying stock from $293 to $308 that the spread would not be profitable. The spread was sold for $3.00 and purchased back for $3.50, a loss of 50 cents per spread. The reason this happened is because there are still 494 days remaining until expiration and a $15 move in a stock like Google is not significant relative to that amount of time remaining. If there were a shorter amount of time remaining, say three months, then the spread would definitely be profitable. But at this time, investors and traders were bidding up the value for the out-of-the-money $260 put for insurance, and that created the 50-cent loss. In other words, on a net basis, the amount of time premium owed on the short $260 put increased, which is bad for you as the seller.
The main reason we explained this is to emphasize the fact that spreads need time to pass before they become profitable. Many traders who are short-term in nature are disappointed to find that the stock has moved in their favor yet the spread is at a loss. So be aware that you will need to wait until very close to expiration before you realize the full value of the spread.
Vertical spreads allow you to profit on outlooks covering specific ranges of stock prices. They are also a perfect solution for times when you find options that you may consider too expensive or too risky. Option trading goes far beyond the purchase of a call or put to capitalize on a directional outlook. The main purpose of this chapter is to allow new investors and traders a glimpse into the world of options trading at a higher level. Options create opportunities that cannot be found with stock or any other asset. Once you master the concepts presented in this book a new door will open and you will find that vertical spreads are just one of many fascinating opportunities available to you.
Key Concepts
1) Vertical spreads have limited risk and limited reward.
2) Vertical spreads have a bullish or bearish bias.
3) Vertical spreads allow investors to buy long options for less money (debit spreads). They also allow investors to sell options for less risk (credit spreads).
4) Buying the call spread is identical to selling the corresponding put spread and vice versa.
5) The higher the reward that a vertical spread offers the riskier the position.
6) Spread values tend to move slowly. If you wish to collect the full value of the spread (assuming it has moved in your favor) you must wait until very close to expiration. Otherwise, you will receive less than the maximum reward.
Dec
1
Risk and Reward Revisited
Many traders who see spreads as in this example believe that it is a “terrible” or “unfavorable” risk-reward ratio. They reason that it doesn’t make a lot of sense to put $7.00 at risk in exchange for a $3.00 maximum profit. If you remember back to our lesson on risk and reward, you should realize that the reason the market has bid this spread to a relatively high level is because the stock price is $293 and is well above the short $260 strike. If the stock price rises, stays still, or even falls to $260 the trader will make the full $10 on the spread ($3.00 profit). When viewed in this light, you can see why the market is willing to pay a relatively high $7 price in exchange for a relatively low $3 reward. It is not an unfavorable risk-reward ratio but, instead, a reflection of the relatively low risk in the position.
You can verify this by considering a different vertical spread. Rather than selling the $250/$260 vertical spread, you could sell a set of strikes that are closer to the current stock price, thereby accepting more risk. For example, you may decide to sell the $280/$290 vertical put spread instead. You could sell the $290 put for the $38.50 bid and buy the $280 put for the $34.50 asking price for a net credit of $4.00. The profit and loss diagrams of the two vertical put spreads are compared in Figure 9-8:
Figure 9-8: Short $250/$260 Vertical Put Spread (Shaded Line) Compared to Short $280/$290 Vertical Put Spread (Bold Line)
Figure 9-8 shows that selling the $280/$290 vertical put spread (bold line) does have more reward than the short $250/$260 vertical put spread ($4 versus $3). Selling the $280/$290 vertical put spread also has less of a downside ($6 versus $7). On the surface it seems like you get the best of both worlds – more reward, less money to lose. However, you must remember that we are not comparing the same strike prices, which means there are different sets of risks and rewards. You are more likely to end up with losses on the $280/$290 spread because the short $290 strike is very close to the current stock price of $293. The $250/$260 spread will not fall into losing territory until the stock price hits $260, which is $30 away from the current price, which means it is less likely to happen. The $280/$290 vertical spread is riskier and that’s why it has a higher reward.
Don’t get trapped in believing that the spreads with the highest rewards and the lowest downside are superior. They are simply riskier and it is up to you to decide which sets of risks and rewards to take.
As a general rule, if the stock’s price is exactly halfway between two strikes, you will find that the maximum gain and loss will be equal to half the distance of the strikes. For instance, if Google was trading for $295, then it would fall exactly halfway between the $290/$300 strikes. Because there is a $10 difference in strikes, then half that amount, or $5, would be the maximum gain and maximum loss for the $290/$300 vertical spreads (calls or puts). In other words, if the stock’s price is exactly halfway between strikes there is a 50-50 chance that it will make or lose money so the cost will be 50% of the distance in strikes.
If the stock’s price were below the halfway point, you would find that the maximum gain for the bull spreads is greater than $5 (and the maximum loss is less than $5). Why does the maximum gain rise as the stock price falls further away from the strikes? If the stock price falls, the long call spread (bull spread) is becoming more out-of-the-money and is therefore riskier, so it will trade at a discount from $5. If you can buy the $10 call spread for less than $5 then you must end up with more reward. The long put spread, on the other hand, becomes more in-the-money as the stock price falls and trades at a premium to $5 since it is becoming less risky. Therefore, if you sell this spread (bull spread), you will be receiving more than $5, which is your reward. So the further below the stock price is from the strikes of the bull spreads, the riskier they become and the more reward they offer.
The opposite is true if the stock price rises above the halfway point of the strikes for the bull spreads. As the stock price rises, the long call spread (bull spread) is becoming more in-the-money and is therefore less risky. It will therefore trade at a premium to $5 and consequently have a reward less than $5. On the other hand, as the stock price rises, the long put spread becomes more out-of-the-money, which means it is worth less than $5. Therefore, if you sell the put spread (bull spread) your reward will be less than $5 just as if you had purchased the call spread. The further above the stock price is from the strikes of the bull spreads, the less risky they are and the less reward they offer.
Figure 9-8 confirms these risk-reward relationships and shows the $250/$260 vertical spread has less reward than the $280/$290 vertical spread. Why? Because the stock price is so much further above the $250/$260 strikes, which makes these strikes trade at a premium (gives you less reward) and makes the put spreads trade at a discount, which gives you less reward.
Let’s work through one quick example to be sure you understand how this principle applies to vertical spreads. Assume that ABC stock is trading for $47.50. What do you suppose the $45/$50 vertical call spread will cost? It should cost $2.50 and therefore have a reward of $2.50. However, if the stock is $55 the vertical call spread will cost more than $2.50 and offer a lower reward. The reason is that it is getting less risky since the call strikes are in-the-money. As the risk decreases, the price goes up. If the stock price is $40, the vertical call spread will cost less than $2.50 since the calls are out-of-the-money and the spread is relatively riskier. As the risk increases, price decreases.
Once you understand how these relationships apply to the long vertical call spread, the answers are opposite but work for similar reasons for the long vertical put spreads. For instance, if the stock price is $55, the long $45/50 vertical put spread is riskier since both strikes are out-of-the-money. It will therefore cost less and offer more. On the other hand, if the stock price is $40, the long $45/50 put spread is in-the-money and is therefore less risky. It will cost more than $2.50 and offer a lower reward.
Price Behavior of Vertical Spreads
Vertical spreads converge to a specific value as expiration nears. What is that value? Think back to the mechanics of long calls and puts. As expiration nears, all in-the-money options converge to intrinsic value while all out-of-the-money options converge toward zero. In the same way and for the same reasons, vertical spreads converge to either intrinsic value or zero.
For example, let’s go back to our $250/$260 vertical call spread that was trading for $7.20. With the stock at $293, both of these calls are in-the-money, which means the spread must converge to the $10 difference in strikes as time goes by. If the stock price remains at $293, the long $250 call is worth the intrinsic value of $43 at expiration while the $260 call is worth the intrinsic value of $33. Since you are long the $250 call you will collect $43; because you are short the $260 call you will owe $33 and your net gain will be $10. After subtracting the $7.20 cost, your profit is $2.80. As long as the stock price is above the short strike ($260) at expiration this spread will slowly start to increase to a maximum value of $10.
Why is the spread not worth $10 today? The answer is time value. The long call has time value of $37.40 ($80.40 premium – $43 intrinsic value). The short call has a time value of $40.20 ($73.20 premium – $33 intrinsic value), which is an amount you owe. Because you owe $40.20 of time value and own $37.40 worth of time value, the net amount you own is $40.20 – $37.40 = $2.80, which is exactly the amount of your maximum gain. Your maximum gain is simply earned by the passage of time. As the long and short time values fall toward zero, the amount you owe is reduced by a net of $2.80 and that’s when the spread will converge to the full $10 difference in strikes.
What if the stock price is between $250 and $260 at expiration? In this case, the vertical spread will converge on the intrinsic value of the long call. For example, if the stock is $258 then the long $250 call converges on the $8 intrinsic value while the short $260 converges toward zero since it is out-of-the-money. You will collect $8 and owe nothing for a gain of $8. After subtracting the $7.20 cost, you are left with an 80-cent profit.
If the stock price is less than $250 at expiration, both the long and short calls will converge toward zero since they are both out-of-the-money. As time passes, the value of the spread will therefore fall toward zero. The same reasoning exists for the vertical put spreads.
The important point to understand is that vertical spreads do not respond quickly to changes in the stock’s price. The reason is that vertical spread consists of a long and short option. As the stock price moves in any direction, one option increases in value while the other loses value so the net change to the vertical spread is small. Further, the time value does not become zero until expiration so the full value of the spread cannot be realized until expiration. (It is also for these reasons why it is not a big risk to enter a “market” order.) As with any option position, you can certainly close it prior to expiration; however, do not expect it to be worth the maximum value. While vertical spreads do allow investors and traders to enter into option positions cheaply, they do come with a drawback in that you should not expect to exit with a profit unless a very favorable price change has occurred relative the time remaining on the option.
