Mar

31

More about Delta

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Delta has three definitions: 1) Delta in reference to change: if an option has a delta of 50, if the underlying moves $1 the option will move 50 cents. 2) Delta is also a measure of chance. If an option has a Delta of 50, that also means that the option has a fifty percent chance of being in the money at option expiration. 3) Delta hedge ratio defines how many calls or options are needed to offset the total risk. For example, if you have 500 shares of underlying and you want to hedge the position with an option with a Delta of 50, you would need 10 option contracts to provide a delta of 100 for all the underlying. For example if you buy puts, if the stock goes down, the increase in the price of puts will offset the decrease in the underlying one for one because you have hedged to a 100% correlation.
 
But there’s more.
 
Options University states in their course “Options 101”, that calls are a long instrument so calls have long Deltas. Obviously, calls with different strike prices and different expiration months will have different Deltas. When trading calls, buyers of calls acquire long Delta positions while sellers of calls acquire short or negative Delta positions. It is important to remember that call Deltas are positive. Any call, whose strike price is lower than the current stock price, is considered to be an in-the-money (ITM) call and will have a Delta above sixty. The deeper in-the-money you go, or the lower price strike price you look at, the higher the Deltas will be until they finally approach a hundred.
 
Any call, whose strike price is higher than the current stock price is said to be an out-of-the-money (OTM) call and have Deltas less than forty. The further out-of-the-money you go, the lower the Deltas will be until finally reaching 0.
 
Likewise, puts are a short instrument so puts have negative Deltas. Obviously, puts with different strike prices and different expiration months will have different Deltas. When trading puts, buyers of puts acquire short Delta positions while sellers of puts acquire long Delta positions. It is important to remember that put Deltas are negative.
 
There is an extremely important Delta connection that exists between a call and its corresponding put. First, what does corresponding mean? Corresponding refers to two options, one a put, the other a call, in the same month with the same strike price. For instance, the January 20 call’s corresponding put is the January 20 put. The important thing to know here is that when looking at the Deltas of a call and its corresponding put, the sum of the absolute value of a call plus its corresponding put must equal one hundred.
 
Position Delta:
When we talk about position Delta, we take a net total of all the Deltas of the puts, of all the Deltas of the calls, and the entire Delta we have in the stock and add them together. When we do that, it will give us one number, one Delta number plus or minus and that is our position Delta.
 

For example, Position Delta tells us that if our overall position is long a thousand Deltas and the stock goes up a dollar, we will make one thousand dollars. If we are long one thousand Deltas, and the stock goes up fifty cents, we will make five hundred dollars.

Mar

30

Delta

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If you don’t understand Delta, you don’t understand stock options.
 
Delta
According to Options University, Delta explains or measures the price movement of an option relative to movement in the underlying stock. That is the generic description. Delta has a total of three definitions that are all important.
 
Delta - percent change

Delta tells us how much an option’s price will change per a one-dollar movement in the stock. For example, if we are looking at a fifty-Delta option and the stock moves a dollar, the option should move fifty cents. If we are looking at a thirty-Delta option, and the stock moves one dollar, we are looking at a thirty-cent move. This brings up an important misconception that many beginning option traders don’t understand. If you purchase an out of the money option, it does not move commensurate with the underlying stock. For example, an out of the money option may have a Delta of only .40 which means that if the underlying stock moves a dollar, the option only moves 40 cents. If a trader wants to have a greater probability of being in the money at the end of the expiration period, it is best to buy an in-the-money option or very close to in-the-money. Of course, in-the- money options are more expensive. So the trade-off is to buy a less expensive out- of-the-money option and have a lower chance of finishing in the money; or purchase a more expensive option but have a better chance of finishing in the money. Out-of-the-money options have a better ROI but a lower probability of being in-the-money. As trading is all about probability, in most situations, it is best to pay more for higher probability-if being in the money is an important factor.
 
Delta –percent chance

Delta is also defined as percent chance. A fifty-Delta option has a fifty percent chance of finishing in-the-money. A thirty-Delta option has a thirty percent chance of finishing in-the-money. A ten-Delta option will have a ten percent chance of finishing in the money and so on. A stock can be in-the-money but not have 100% chance of ending the option period in-the-money.
 
Delta- hedge ratio

Delta’s last definition is that of hedge ratio.   If we were long 800 shares of stock (or 800 Deltas as each share of stock is equal to one Delta), and we wanted to hedge our position, we know we could sell some calls to hedge that position. The question is – how many calls? We could do it one-for-one. Or…….
 
If we did that, we would still be long Delta. On the other hand, we could sell enough Deltas through the calls to perfectly hedge the Delta risk of our stock. The answer is in Delta’s definition of hedge ratio. Hedge ratio tells us how many calls we need to sell-or puts to buy to become Delta neutral.
 
For example, say we were looking at a 40 Delta call. The 800 long Delta position from the stock, divided by the 40 Deltas of the call will equal 20. That is how many calls we would need to sell – 20. Thus, if we sold 20 of the 40 Delta calls, we would be short 800 Deltas that would perfectly hedge our long 800 Deltas from the stock.
 
To learn more about Delta and the other important “Greeks”, contact the Options University at www.optionsuniversity.com.

Mar

29

Do the Bear Call

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Sometimes you find a strategy you have an affinity for or maybe you find a pretty “reliable” system. But before I share my system with you, I need to roll out the old disclaimer. You know what I’m talking about: the universe is uncertain and whatever happened did just that and may not be repeated exactly the same way. Caveat emptor, dude.
 
As you may recall, a bear call spread is used when an option trader feels that the underlying stock will be more or less stagnant during the option period. Of course, there is the natural ebb and flow of price movement, but for the most part, the option trader believes that the probability of keeping the premium has a high probability. So, an at-the- money call is sold. However, just to make sure that the trader doesn’t get caught in a surprise strong upward move, an out-of- the- money call is purchased for protection. The brass ring is that the price will end up near or below the strike price of the short call.
 
The big concern is that there will be some unexpected event to push the stock higher but even that can be ok.  If the price moves above the strike price and there might be the threat of assignment, the long call could come into play and the short call can be bought back and the once out-of-the-money call can move into-the-money.
 
Because ETF’s, Index funds and Holders are traded in the European style, assignments only happen after expiration. So there is usually plenty of time to close out the position or just buy back the short call and let the long call run.
 
Signals to look for
The trader looks at the 1 year, 3 month and 30 day chart and checks the 20 day SMA, the short term cycle, the RSI and Bollinger bands. What the trader would like to see is the price at or above the 20day SMA, the short term cycle near its peak, the RSI between 50 and 90 and the price above the Bollinger Band mid line and moving toward the upper band.
 
Of course, the trader wants to make sure there is no imminent news that might push the stock up (surprise earning reports, etc.) and the 3 month trend is flat to down. Because the trader doesn’t want the price bouncing off of support, it’s best to be looking for price to be between support and resistance levels. Also, a trader doesn’t want too much implied volatility
 
Let’s look at an example of a Bear Call Credit spread,
 
 XYZ is currently at $58.
Sell $ 60 call @ 2.75
Buy $ 65 call @ .50
Net Credit= $2.25
Breakeven= $ 62.25
Potential Max Gain: $ 2.25, Max risk: $ 2.75

Mar

28

Strangle it

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If volatility is on the rise, strangle it. A Long Strangle anticipates an aggressive increase in price of the underlying. On the other hand, if volatility is dead in the water and the stock is going nowhere, sellers of the Strangle can smell blood in the water.
 
The long strangle tries to make a profit from market movement in either direction. In this respect, the long strangle is similar to the straddle. However, from a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than more expensive at-the-money options as is the case with a straddle.
 
A strangle has unlimited profit potential on both the upside and downside. To set up a long strangle and if the underlying shows a lot of volatility and the stock could break either way, a slightly out-of-the-money call and put can be purchased on the same underlying for the same expiration month. For example, suppose that a company is about to come out with news and the reaction could go either way In this case; a trader would like to capitalize on the possibility of movement -either way. It’s a win-win scenario. Suppose the stock is currently at $ 63. A trader would purchase a call at $64 and a put at $ 62. Of course, the trader needs to compute the breakeven for each position.
 
XYZ current price: $63
$64 call = $3.00
$62 put= $ 2.50
 
As the combined premium cost is $550 for both contracts (200 shares) is $2.75 per share, a trader would start making money when the price goes beyond the upper breakeven price of $66.75 or down to $ 59.25. Once past these breakeven points, the position will be making a profit.
 
The maximum risk happens if the stock does not move out of the band ($ 66.75- $59.25). In which case, at expiration the loss would be the combined premiums of $ 550. Profits, however, are theoretically unlimited in both directions.
 
A short strangle is a bit different. This strategy is usually used when not much movement is expected from the underlying. In other words, the short strangle is a premium collection strategy. The call and put are both sold.
 
ABC current price $ 63
Sell $ 64 call= $ 2.00
Sell $ 62 put= $ 1.50
 
As two contracts were sold, a total credit of $ 350 divided by 200 shares is $ 1.75 credit per share. Therefore, the upper breakeven is $ 65.75 and the lower is          $ 60.25. Opposite to the long strangle, if the price goes beyond either of the breakeven prices, the position starts to lose money.
 
Maximum profit of $ 550 is made if the price of the underlying is within the band ($ 65.75-$60.25) at expiration.
Maximum loss is theoretically unlimited once outside of the breakeven band.
 
 

Mar

27

Iron Butterfly Risk Analysis

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Of all the premium collection strategies, the Iron Butterfly is one of the most
popular. It’s touted to have the best risk-reward profile of all the complex neutral strategies. That certainly sounds nice but there is risk and plenty of it. That’s why all option traders should always figure out the maximum risk for each trade position. Moreover, it’s important to make sure to figure the profit range by working up the lower and upper breakeven for each position.
 
So, in the name of review, let’s go over an example. Let’s suppose we enter into a an Iron Butterfly where the current price of ABC is $146.70
 
We buy a Put with a strike of 140 for $ 2.45
Then we sell the 145 Put for $ 2.40
We also sell the 145 Call for $4.90
And finish up with buying a 150 Call for $3.10
 
Max Profit= Net Credit t= ($4.90 + $4.20 – $2.45 – $3.10 = $3.55 per share)
 
Max Risk= Difference in Strikes – Net Credit ($5- $3.55=$ 1.45 per share)
 
Upper Breakeven= Short Call Strike+Net Credit= $145+$3.55= $148.55
Lower Breakeven= Short Put Strike-Net Credit= $145-$3.55=$141.45
 
So, you might want to subtract one dollar from each and set an alert at about
$148 and $ 142. Ideally, a trader makes the maximum profit if the price is at $145 at expiration. A trader will lose money anytime the price of the underlying is outside of the range of profitability (upper and lower break-even).
Some other things to take into consideration are:
 
  • Higher commission costs because of the four positions.
  • Low credit collection may be insufficient to cover costs
  • If not trading an Index or ETF, the body call can go well into the money and be assigned.
  • The credit received will usually be smaller than the Max Risk.
 
An Iron Butterfly is used when the underlying is expected to trade in a narrow range within the option period. If volatility increases, the prices of option will go up and closing out the position can have an added cost affect when closing out the position. However, if the trader stays on top of the position and keeps an eye on volatility and profit range, the Iron Butterfly can prove to be a very effective strategy.

Mar

26

Butterfly Breakeven

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Butterflies are indeed beautiful. Some novice stock option traders consider the Butterfly a complex option strategy worthy of sidestepping but many, many use this stock option strategy and its derivative-the Iron Butterfly- on a daily basis.
 
As we all know, what makes up most successful trading systems-discipline and consistency-is even more important when using complex spreads. What I am referring to is taking the time to analyze profit potential and “punch-out¨ targets before entering into the trade. But with complex trades, it is essential to also essential to figure out the “profitability band” as delineated by the upper and lower breakeven prices. Why is it important to know the breakeven?
 
Well, one of the main benefits of using spreads is they offer a way to define the range of profitability on any particular trade. With a Butterfly spread, that range can be quite broad and it is important to be aware of when the position is starting to lose money starts. It’s not usually as clear as with other less complex positions.
So, with the intention of presenting a little review, let’s go over an example of figuring out breakeven for a Butterfly
 
Example: Butterfly
As you recall, a Butterfly can be classified as Long Butterfly, where an option trader buys one low strike, sells two medium strikes, and buys one high strike with the strike prices equally spaced. The center strike typically matches the current price of the stock. And of course, all are calls or puts purchased in the same month and in the same number of contracts
 
An option trader can use a Short Butterfly where the position is constructed in the opposite way from the Long Butterfly. The Short Butterfly will always be short the outer strikes and long the center strike. As is with both, either all calls or all puts are used in each position.
 
Current IBM Price is $ 104
B/S
C/P
SP
Premium
$
B (1)
C
100
4.50
($450)
S (2)
C
105
2.35 @
$$470
B (1)
C
110
.50
($50)
 
 
 
Net cost
($30)
 
 
 
 
 
 
 
 
As you can see from the table, one call at purchased at strike $100; sold two calls at $105; and bought one call at $110. The temptation is to ballpark the breakeven points such as $100 and $110 which bracket the position. To figure breakeven, we need to do some additional simple math. First, we need to figure breakeven from the lower strike price: add the net debit to the ITM call. In this case it would be $100 + .30 or $100.30. Now we need to figure the breakeven for the upper strike price: subtract the net debit from the Upper Strike price: $110-.30 or $109.70. Therefore, the profit range is between $100.30 and $109.70. Now, you can set alerts for both the high and low ends of the spread.
 

A disciplined routine needs to be followed and refuse to take shortcuts. Do your analysis the same way every time.

Mar

25

Stock Option Trading Journal

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Live and learn. Learn and earn. One thing for sure about trading stock options is that learning about stock options requires a certain level of commitment. Options are not for everybody and, for the most part, they are more for the academically inclined and those who like the challenge of continual learning.
 
What makes stock options so powerful are the many strategies that can be used for just about any stock market condition: Up, down, sideways. There is always an opportunity if a trader understands the concepts that support these versatile investment vehicles. But, like all forms of trading, stock options require a disciplined system of implementation.
 
Because options-if not fully understood-can be misused and cause some real financial damage, they demand enough dedication to go through a specialized course of study. First, an aspiring options trader should take a basic course in stock options similar to that given by Options University, they call it Options 101. After the concepts are fully understood in Options 101, the student should take the Advanced Options course similar to that offered by Options U. Once the more complex strategies are understood, then the blossoming trader should undertake a protracted time to do some extensive paper trading.
 
Paper trading allows the student to try all different types of strategies and find out the ones they might be partial to. Learning how to incorporate the theory into practical real-time trades requires considerable practice. It’s every bit as important as learning how to use the training received in the online classes.
 
Each and every trade should be entered into the trader’s trading journal-without failure. If the journal has not been completed, the trade has not been completed. But a trading journal is not only about a forensic review of each trade but also a check on the trader’s psychology-their frame of mind.
 
Most long term successful traders will readily admit that a trader’s under-standing when not to trade is a key factor in long term trading success.
By taking the time to do a self-appraisal-both before and after every trade- a stock option trader learns to become self-aware of the inevitable human factors that can distort the consistent application of a trading system.
 
To help give an idea of what an option traders Trading Journal should look like, see the figure below.
date
symbol
# contracts
buy price
total $
sell price
total $
fees
net profit/loss$
ROI
Buy
Sell
 
 
 
 
 
 
 
 
 
 



Trade Comments:

 
  1. How did you feel before the trade?
 
  1. Did you follow the system?
 
  1. If you did something different, what did you do and why.
 
  1. How did this trade vary from what was expected?
 
  1. Is there specific information you need to consider the next time you have a similar trade?
 

If you are a frequent trader, you might not be able to do your journal after each trade but make sure to record all closed out trades within 48 hours so you won’t lose the memory of how you felt before and after the trade.

Mar

24

Some Technical Indicators for Trading Stock Options

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There are many ways to skin a stock. If you are an option trader, you are looking for movement, direction and time period for the move. And, of course, we want an underlying stock that has option derivatives. The following is just one way to analyze a potential stock option trade.
 
First, the intrepid option trader should consider a one month time period for the trade although we want to be out of the trade before expiration. We also want an underlying with some volatility. To begin with, look at the stock’s beta. The option trader needs to get an idea of the general trend of the stock so look at the 1 year SMA (simple moving average). The trader also takes note of the regular short term cycles (usually three weeks from peak to peak. If the market- in general- is moving opposite the stock, it’s best to go with the general trend and look for another candidate. Then look at the 20 day SMA and note where the price is. The trader wants the price to be well below or above. Then look at the RSI (Relative Strength Indicator) to see what the sentiment consensus is. The trader wants the RSI to either be near 20 % for a potential upward movement or 80% for a potential downward move. We then look at the Bollinger Bands. The option trader would like to see the price near an upper band for a potential downward move or near the lower band for a potential upward move.
 
If a trader sees all three indicators lined up, that is: price above 20 day SMA, RSI near 80% and price near the upper Bollinger Band, we will have a high probability of a short term downward correction if trading volume is average or below.
 
In this scenario, an option trader could buy a put or for a more conservative strategy, sell an in-the-money call. Or even better, do both at the same time. The sale from the call will help reduce the cost of the trade and boost up the potential ROI (Return on Investment).
 
If the price is below the SMA, RSI near 20% and price is near the bottom Bollinger Band, an option trader can go the other way-anticipating an upward movement. So, the trader just turns the strategy around: sell an at- the-money put and buy an at-the- money call.
 
Of course, there are many other strategies that can be applied to the same situation and this is what makes stock options so fantastically flexible. But whatever strategy an option trader uses, it still depends largely on determining movement, direction (including no movement) and time frame.
 

Mar

23

Bottom Fishing with a Safety Net

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Can you feel it? All the negative news about the credit crunch. Hundreds of Billions in disappearing assets moving to the back pages. A yawn at the demise of Bear Sterns. Yes, the media battered John Q. American Investor has grown some pretty thick skin. Some might say it’s just another sign of investor ignorance, corruption and greed and the ultimate crash of Sodom. But there is another side.
 
The side that says that investing is all about sentiment. Maybe, just maybe, the investing public in its mindset of everlasting good times and the continual passing of one “disaster” after another have embraced the opposite of what has been a plague upon the past generation-the fear of another depression;  and today’s forty somethings think that it can’t happen again. Underneath it all, to many of today’s investors, the glass is half full and problems have solutions and set backs are only temporary. Personally, I prefer that naiveté to the Chicken Little syndrome. After all, reality is what you choose to perceive that said, maybe its time to go fishing.
 
When we begin to see the VIX coming down into the low twenties, its time to go fishing. You see, the chances of more bad news sending panic through the markets are greatly reduced after a prolonged period of bad news. Chances are good that any good news will spark a wave of optimism and positive sentiment. When we see the surf starting to build, like surfers preparing to catch the wave, we should be in position to catch a ride.
 
Wisdom says not to attempt to time the market. But then market wisdom can always be turned inside-out. But, I say, a stock option trader has a distinct advantage at trying to time a market reversal: The Straddle.
 
As you may recall, a Straddle sits atop an at-the-money (or as close as possible) with one leg hoping for a continued down move (put) and the other leg hoping for a reversal (call). Yes, you could say as long as there is movement; it’s a win-win strategy. But that is the hooker; the stock must have a lot of volatility. The worst case scenario for a straddle is stagnant price movement. But in even that case, an option trader will only lose the premiums paid for both legs. Considering the possibility of catching a big move in either direction makes the Straddle a particularly interesting strategy for the current market situation.
 
If you are wrong, and something happens to scare the market even more, you are in position for a down move. If the reverse happens and all the money that ran to the sidelines comes rushing back in, you are there, too. Each opposing leg acts as an insurance policy for the other. Pretty darn elegant, don’t you think?
 
So, intrepid option trader, get ready and watch the VIX. Look for a really volatile stock and get ready for a real opportunity to make some quick profits. But once in the position, be ready to take profits as soon as the big move hits a support or resistance level. As always, there is no guarantee but you already know that.
 

Mar

22

Trading Index Options

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When you think about it, it makes a lot of sense. Why spend all that time analyzing an individual company and hope the data they provide is accurate or that you are really being manipulated? Why worry about what level of management expertise is running the company? Why try to understand the technical aspects of complex products and services?  Instead, why not understand what an industry sector does and just analyze how well the entire sector is doing or might be doing.
 
Trading Index Options allows the trader the opportunity to ignore the micro issues and focus on the much more obvious issues faced by the entire sector. Of course, by focusing on the industry a trader will give up the opportunity of hitting a “home run” but successful trading is much more about consistency and not so much about success in having a good eye for the occasional winners. No doubt in my mind, it is easier to put your arms around what is happening to an entire sector than it is to divine the “filtered” intricacies of an individual company. Moreover, there is less chance for the influence of specific isolated events, which can have such an impact on individual stocks.
 
Sector rotation also provides an almost continual menu of opportunities. No matter what is happening, there is usually one sector or another which is affected by events in different ways. If a stock option trader has a good feel for the macro effects of events, then the complexity of analysis is greatly reduced. Remember the “Razor of Occam”? (Usually, the simplest explanation is the most correct).     
 
And here is an added bonus to trading Index options: favorable taxation.
Stock Index profits are taxed at a lower rate than profits gained on individual stocks. Under IRS Tax Code Section 1256, profits gained from trading Index Options are taxed differently. Normally, capital gains for short term trades are taxed at about 35% depending on your individual tax bracket. For example, if you have a capital gain of $500, Uncle Sam gets $175. However, with Index Options, only 60% of the profit is taxed at the short term capital gains tax (in this case 35%). So, if the option trader has a $500 profit on an Index Option trade, taxes would be $105-a savings of $70.
 

So, from my viewpoint-as simplistic as it might be-trading Index options are not only easier to analyze and understand but also can provide a more favorable net after tax profit. As a matter of fact, I’m sure you’ll agree that it is the money you can keep that really counts. To help impress the option trader with this fact, I suggest that in your trading journal you add an extra column and figure out the ROI on an after tax basis. What you might see-as I have seen-is that Index options may not only have a more favorable overall net tax return but by their very nature pose less risk. In sum, trading index options may offer a higher net return with lower risk.

Mar

21

Options are Optimal

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When you look under the hood, options are amazing. The problem is that most people don’t take the time to look under the hood. There is a reason for that; it is complicated to the untrained eye.
 
It takes time to learn about options. Moreover, trading options is based upon a firm understanding of a rather complex mathematical model- the Black-Scholes Option Pricing Model. It’s not that options are for rocket scientists but they definitely aren’t for everybody. Most probably, your typical retail client probably isn’t academically prepared to tackle the intricacies of stock options. The retail brokerage industry realizes this so they usually don’t take the time (and cost) of training their retail brokers about the marvels of stock options.
 
Because it is pretty easy to comprehend the high leverage offered by stock options and how this can offer big rewards, the retail brokerage industry has taken the philosophy that a little knowledge can be a dangerous thing. They know that if investors and brokers don’t have an adequate understanding of stock options, they are best to stay away from them. That’s why if a client wants to trade options, the brokerage prefers to protect themselves from any potential liability by issuing a booklet on the dangers of options and having the client sign a statement granting the broker freedom from any responsibility. Not a bad idea given the probability of shooting oneself in the financial foot if unschooled in stock options
 
However, serious investors may miss an opportunity to discover the truly incredible investing strategies offered by stock options. You see, stock option offer an investor the opportunity to profit from stocks that are stagnant (about 80% of stocks don’t move in synch with the market), stocks that move up of down and a way to protect unrealized gains. In other words, there is always a trading opportunity with stock options.
 
Stock options may be somewhat akin to handling a firearm. If you don’t have some training, you might hurt yourself.  But once trained, it becomes clear that stock options aren’t anywhere near as dangerous as many believe and reinforced by the disclaimers and highly publicized percentage losers who trade stock options without taking the time to fully understand them.
 
I fully recommend that if you have the time and inclination to become actively involved with investing your money, you should look into stock options. Although they might be a challenge at first, the patient student will find stock options not only elegant in their function but also profitable with an attractive risk-reward profile. If you don’t believer me, consider this: in principle, you can sell stock you don’t own taking in a premium for lending the stock you don’t own. Your investment is zero! Of course, this is a simplification but it is true. Of course, things can go wrong. Is this something you would like to find out more about? If you think that is a pretty cool strategy, this is just one of many strategies that stock options can offer. However, the investor-trader must become educated before trading options.
 

Trust me when I tell you that learning about options is well worth the time and expense. Once you learn about these ingenious investment vehicles, you will become hooked but be prepared to spend some time studying.

Mar

20

A Kiss Goodbye

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If you buy and sell stocks, this article is going to make you instant additional profits.
 
Normally, when you want to sell your stock, you call your broker and produce an order to sell the stock-at the market or at a limit. When the stock is sold, you are credited with the cash and your account is debited for commissions. But as you will see, you can be giving money away.
 
What I’ talking about is selling your stock by writing a deep in-the-money call and having the option exercised. You receive a premium for the option, which includes the intrinsic option value and the extrinsic option value (time value). When you sell stock the traditional way by asking your brokerage to sell it at the market, you only collect on the intrinsic value of the stock.
 
Let’s look at a comparison of using the option selling method vs. the traditional brokered sale.
 
Assume: 300 shares of IBM currently selling for $115
 
Brokerage: 300 shares x $115= $34,500
                       Less Commission - $123
                        Net sale                $34,377
 
Writing 3 in-the-money IBM calls @ $105
                      Premium collected $ 13.50 @ share x 300= $4,050
When contracts are exercised, option writer hand buys 300 shares at $115
which = $34,500 to place with the buyer.
 
The true cost is $105 x 300= $ 31,500 less the market cost $34,500 =( $3,000)
 
But….the seller received $4,050 in premiums
 
Therefore the net of the transaction is: $ 1050 (less commissions)
 
So, by writing the calls and having them exercised instead of sold by the traditional way (broker) you can add an additional 3% to the total return instead of debiting your account.
 
Of course, you need to do the math before considering this method of cashing in, but for an extra 3% the time it takes can be well worth while.

Mar

19

The Real Skinny on Assignments

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Damn! What was I thinking! It sounded so good but when you stop and think about it, you could lose money-big time. At least that’s what logic tells you, especially when you get that scary assignment.
 
When you are starting out trading complex option spreads, it really is exciting to learn that a trader can make money “out of nothing”. Sell an option (write) and receive a premium! How cool. Write five IBM in the money puts and get a big credit in your account. Of course writing uncovered options can leave one obligated to fulfill the obligation of delivering stock if the buyer wants to exercise the option rights and take delivery of the stock. But most brokers will tell you that assignments rarely happen. The brokers tell you that with such conviction that you believe it. But then the assignment arrives and you panic.
 
You do some quick math in your head and you feel the lump in your throat start to grow. “Let’s see, I wrote three contracts and now I have to go out and get the stock I don’t own and turn it over to the buyer. Cash sucked right out of my trading account. Cash I might not have. How could I have been so stupid?” You stop to consider: I got $ 1200 in premiums but now I need to purchase $9000 in stock and then turn it over to the buyer. OUCH!
 
Relax. It’s not as bad as it seems. What your panic stricken mind tells you might be logical is not what happens. God bless the magic of transactional accounting. You need to understand it to see that there is a key technical step in the logical process that to most is not very intuitive.
 
Perhaps the best way to talk about it is to use an example.
 
Assume the current IBM stock price 114.00
 
Let’s say you’ve done your analysis and you think that IBM will stay within a narrow range for the next several weeks. So, you decide to short 1 IBM March 140put @ premium price of $ 26.00 per share. This produces a nice chunk of change; $2,600 to be exact (not including commissions). Nice, selling something you don’t own. But, behind the scenes, indeed you do. Even though you didn’t buy the stock, the Option Clearing Corp will make a digital notation in your account. You didn’t buy it, but if needed, you will-and at the strike price you sold the put. To keep things simple, we will also assume you have $0.00 available buying power in your account.
 
As luck would have it, with 21 days left until expiration, you are assigned…
 
When a short put is assigned, this means that you have the obligation to take ownership of the stock.
 
u>When you are assigned, you have the next day to trade out of any resulting stock position. 
 
So what is the process?
 
On the day of assignment, you take ownership of 100 shares of IBM for the price of 140; this means you have to pay out $14,000, which would take your account very negative. As a matter of fact in this case, you don’t have the money but through the magic of the system (Options Closing Corp), you are not really out this total amount money. On paper, you are to “be credited with the stock you now need to place with the option buyer. Watch this next step carefully.
 
Remember that you sold the call originally for 26.00 x 1 contract x 100 shares = $2,600.  Now you just need to make up the difference by selling out your newly “acquired stock” (given to you by the OCC).  Let’s assume the stock opens up the next day after assignment at the same price of 114.00 and you sell at that price; you take in $11,400 cash to close out that position.  Add to that what you initially took for writing the put ($2600) and then subtract the amount it cost you to “acquire” the stock and you have a surprising result… 
 
$11,400 value for closing stock position + $2,600 value for selling put initially – $14,000 cost of buying the stock after assignment = $0.00 !
 
So, after all of the big cash numbers, when we add it all up, the sum of the effect of the assignment is $0.
 
(Hallelujah)
 
Don’t feel stupid if you don’t get your mind around this at the first shot. As I said, it’s pretty counter intuitive until you walk through the steps and understand the important part the Options Clearing Corp plays in making the whole thing work.
 
Consider this fact: it is estimated that about 27% of in-the money- options get exercised before expiration and this is usually more likely for ITM puts than calls.
 
About 98% of all ITM options get exercised at expiration. So make sure to close out any ITM options before expiration.

 

Mar

18

Blind Sided by a Butterfly

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They don’t talk about it enough! In fact, most of the time you hear that the risks with stock options are mostly limited to the premiums paid for the options. Like many things being written about trading stock options, this is only a part of the real world of options and depends very much on the specific situation. But if you plan to trade stock options, listen up.
 
One of the most popular strategies used by knowledgeable stock option traders is capturing premiums by writing options on underlying stocks, which display little or no price movement. They sell the rights of the underlying-either call or put-to other traders. The seller (writer) hopes that the option expires with a price that is close or at a particular strike price. This strategy is considered “conservative” because it is explained that the maximum risk to the seller is the cost of the premium if the option expires outside of the breakeven range. But there is a big risk not talked about in most of the popular literature. I’m talking about “getting assigned”.
 
Option buyers may purchase the rights to a stock for varying reasons. Maybe they think the stock will go up (or down) and they buy a call (or put) to participate in a leveraged play on the possible price movement. Maybe they buy an option with the intent of exercising it if a company is coming out with an attractive dividend. Or, maybe they just are hedging another side of a position. But sometimes, the buyer of an option may decide that they want to exercise their rights to the underlying and this can be a big hit to the seller.
 
Here is an example of what I mean. Let’s say that it’s February and an option trader decides to set up a long IBM Butterfly spread. About a week after entering into the position, the option trader gets a notice of assignment from the broker that the in-the-money call portion of the spread is being assigned for delivery. The shocked trader needs to purchase 300 shares of IBM at the market to fulfill the obligation (this assumes the seller wrote a naked call). The trader does some quick math and realizes that it will cost over $30,000 to cover! As it turns out, February is record month for dividends and many traders and investors are looking to own the stock and receive the dividends at ex-dividend date.
Lesson: make sure that you are not in-the-money during dividend month (not ex- dividend but dividend date).
 
 
Another consideration to the nightmare scenario of being assigned is when selling puts. A basic premise of investing is to “buy low and sell high”. Some patient investors like to lay in wait to pick up a good company at bargain prices. Also, many traders get to know the eccentric cycles of up and down of a particular stock and preposition to pounce. Some long term investors and funds cherry pick and by exercising their option rights.
 
The point is, getting assigned is can be a risk-particularly if you don’t have a hefty account balance. Most brokers will tell you that other than the dangers of dividend month, most in-the-money options aren’t usually assigned. But recent data shows that about 20% of options are exercised before expiration.
 
It’s not as bad as it seems when assignment does happen, but traders do need to be aware of the risk and plan accordingly.

Mar

17

Going Vertical

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Like to hedge your bets? Then, my friend, a vertical stock option spread should be of some interest to you.
 
When you think that a stock will stay range bound; that is in a more or less stagnant situation, that is the time when traders fancies turn to premium collection. Now, let’s say that you feel that the market is in a general up direction, you may want to buy some insurance just in case the stock breaks out of its doldrums. So, you say to yourself, “self, if there is going to be any movement; I think it will be in a slightly upward direction. Therefore, the probability is lower that the stock might have a tendency to move down than up. As a result, it might be a good idea to sell a put thinking that we will expire near or above the strike price. In which case, we keep the “premium”. (When you start using the plural form of me, you need to seek some psychological help.)
 
Now, to protect against a surprise reversal and a resulting downward plunge, an option trader can buy an out-of-the-money put. Of course, we put on the e “Bull Put spread” or “Vertical Credit spread” (we sell the option with the higher premium) – the premium from the sale more than offsets the premium paid for the out- of-the-money put). Be sure to make sure you are out of the spread position before expiration if any option is in-the-money just to make sure you don’t get assigned for the sold put if it happens to be just in-the-money. Many investors use puts to cherry pick their favorite stocks.
 
For example: Current price of XYZ is $ 45
(stagnant with a slight positive bias)
                                                Sell XYZ $45 Put @ $5.00
                                                Buy XYZ $42 Put @ $1.00
                                                Net Credit: $400
                                                Breakeven Price “near” $41 (because you have a net credit from the spread, the stock would need to go below $41 before you would be in a deficit position vis-à-vis the sold put at $45. but as you have a long put at $42, you would be offsetting some of the loss by an increase in the $42 long put).
 
On the other hand, if the option trader thinks that it is more likely that a stagnant stock is more likely to break to the downside than the upside, you could ask yourself: “self, let’s sell a call and protect against a strong up move by buying an out-of- the money call. If the stock goes down we keep the premium. This “Bear Call spread”-again a Credit spread, also allows us to collect some upfront cash.
 
For Example: Current Price of XYZ is $45
(stagnant with a slight negative bias)
                                                Sell XYZ $45 Call @ $5.00
                                                Buy XYZ $48 Call @ $1.00
                                                Net Credit: $400
                                                Breakeven Price: near $49 (we collected $400 which will offset an upward 4 point move, but we will also be in-the-money on out $48 long call.
 
One thing that bothers me when writing a call or put: what happens if you get assigned? That can happen if the option expires in-the-money or if some buyer just wants to take possession using the ITM leg (for dividends, etc). It used to send shudders up my spine because I used to feel that the naked seller would have to go into the market to make good, but I was wrong.
 
It took me some phone calls and demonstration of my slowness before I understood that logic can cloud the issue. You see, the Options Clearing Corp will give you a credit for the position you sold and you only need to make up the difference from that and the current price of the stock. If this confuses you, perhaps you need to do what I did and pigeon hole your broker to tell you exactly how an assignment works.

Mar

16

Making Something out of Nothing

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It’s amazing and so simple. Of course those are the words usually uttered after some sort of epiphany. And learning about stock options is loaded with epiphanies. Take, for instance, making money on a boring stock that moves only slightly-if at all. If a trader understands the nature of stock options, a tired old stock can make an option trader’s heart beat faster.
 
When learning about stock options and how they are priced, a trader learns that the premium paid for each option is composed of two elements. The first element is based upon the value of the option having some added value brought about by the current stock price of the underlying being above the strike price of the option. This added value is called intrinsic value and is normally a close correlation of the additional amount above the price strike.
 
The other principle pricing element is called the extrinsic value portion of the premium. Extrinsic value represents the value of time for the option to increase (call) or decrease (put) in value. The more time, the more the possibility that the option will move in the desired direction. So, normally, an option premium is based entirely on time or extrinsic value if it has yet to move into the money.
 
Once the underlying moves into the money, it adds value on top of the time value. For example, let’s say a stock option trader purchases a call for $4 a share and the underlying is below the strike price, the entire $4 represents the extrinsic value of the premium-the cost for the time until expiration. If the underlying moves above the strike price and into the money, the premium will now be made up of the intrinsic value and the extrinsic value. So, if the example stock moves $2 into the money, the total premium might be $6 where $2 is intrinsic value ($2 above strike price) and the $4 is extrinsic value (time value). But now comes the really cool thing.
 
As an option approaches expiration date, it starts to lose value because there are fewer days for things to happen the way the option trader wants. At first, about 3 weeks out from expiration, the extrinsic value starts to decay. At about 12 days out, the pace of decay really starts to pick up and accelerates toward zero as it reaches expiration. This happens no matter what happens to the underlying. Time decay of extrinsic value is a given. It happens every time.
 
To take advantage of this inexorable event, an option trader can profit from the decay of extrinsic value. This strategy is called a Time Spread and here is how it works.
 
Suppose you screen out a stock that is in a sector that is stagnant and not slated to do anything spectacular in the next few months. A trader then looks for a stock that has good option volume and mirrors the sideways movement of the sector. The trader wants the stock to just lay there and do nothing. Now, it is time to set up the position.
 

The time spread is made up of two options- one sold for the premium in a close month. The other purchased in an out month-usually three months or longer. Both options (both either a call or put) are made as close to at-the- money as possible. The out month will not undergo much time decay but the close in month will zero out at expiration. The net premium gained from the sale of the close month is kept. This can be done multiple times on the same stock unless it comes alive. Little or no movement is the goal to success in this strategy.

Mar

13

Sector Analysis, Bollinger Bands and Capturing Premiums

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Don’t you just love it! I’m talking about the stock option strategy of capturing premiums. It sounds so much less complicated and more logical. After all, most stocks spend much more time trading within ranges. All a trader needs to do is analyze if the underlying will stay within a defined range and look for a favorable spread between bid and ask. Right? Sounds so easy.
 
As I am fairly new to trading stock options, I have been spending time (has it become an obsession?) trying to do my own research in an attempt to define my own system. Call it false ego, but over my six decades of living, I find that if I can fit things into the way I think, I am usually successful or can find a weak spot that may discourage making a serious mistake. Screening software programs are nice tools that support a certain perspective of the author and one needs to understand the methodology before deciding if the program is in synch with you (or you with it). I’ll share with you (feel free to pick it apart) what strategy I have come up with for picking a worthy strategy for “neutral investing”.
 
To start, we assume that there are many strategies to use for premium capture (neutral investing). There are Birds, Butterflies (both with an Iron variety) and other assorted Bull and Bear Spread combinations. No matter which vehicle you choose to capture premium, all traders are looking for a nice ROI on a range bound underlying. So the first order of business is to locate a sector where things look a bit lagging or coming out of a period of growth spawned more out of emotion and hype than on real fundamentals.
 
A good source to start with is found at www.finance.yahoo.com or any number of financial analysis providers. The thing you want to spot if you are neutral is little to no movement for a stock within an expiration month you are interested in. Once that is spotted, find out what companies have higher volatilities as this helps determine the relative premium prices. The more volatile, the better. Once you have screened those companies out, its time to look for a few top companies in the sector. These companies should have plenty of liquidity. Once you have located several candidates, its time to pull out the microscope and home in on some technical indicators.
 
Typically, traders are looking for stocks moving sideways and in a well defined range. I find that RSI and Bollinger Bands help me a lot-particularly the Bollinger Bands as they define the bands of a one standard deviation move from the Bollinger center line. The way I understand it, from the lower to the upper Bollinger is a one standard deviation move. That’s to say that price movement within the bands has about a 68% probability of staying within the defined bands. Make sure the range of data will span the expiration period. So the Bollinger Bands can provide a handy price range which based upon the recent past (always the big problem with stats) should give a good estimate for the price range-if there are no surprises. Also, if the current price is near the top Bollinger Band and the RSI (relative strength indicator) shows an overbought condition, chances are even better that the price will move down and this is good for stocks in a weak sector for the trader who wants the price to stay on the Neutral to bear side. (Selling calls). If the current price is near the lower Band and the RSI is more towards oversold, this can bode well for selling puts.
 
Of course, you might have your own set of metrics you look at to help make a decision. Maybe my little contribution may help you. I hope so.
 
Maybe a little knowledge is a dangerous thing, but so far…..so good.

Mar

6

Iron Condor

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An Iron Bird shouldn’t fly, but the popular Iron Condor spread can soar with the eagles. Ok, maybe this statement is a little over the top, but for stock option traders with bulging trading accounts, the Iron Condor is popular for a good reasons.
 
The Iron Condor option spread is a credit spread. As a result, option traders
need to have enough resources to cover the margin requirements. Before using this strategy, it’s probably a good idea to check with your broker first.
 
This particular strategy is employed when a stock option trader believes that there will be little movement in the underlying stock. The Iron Condor differs from the plain old Condor spread because it buys out-of-the-money (OTM) calls and puts. Because of this fact, the profit potential is higher and the potential loss is lower than the Condor.
 
Setting Up the Iron Condor Spread
                                               
Buy to Open OTM Put (Lowest Strike)
Sell to Open OTM Put (Higher Strike)
Sell to Open OTM Call (Higher Strike)
Buy to Open OTM Call (Highest strike)
 
Example: Assume IWM current price: $ 69
 
Buy X Contracts of March $68 put @ $1.70
Sell X Contracts of March $69 put @  $2.03
Sell X Contracts of March $70 call @ $1.82
Buy X Contracts of March $71 call @ $1.42
 
As you can probably  see, the Iron Condor is composed of a Bear Call Spread and a Bull Put Spread.So, if the underlying is moving up, the option spread trader could close out the Call options and leave the Put options intact. Likewise, if the price of the underlying is moving down, the Put options can be closed out and the Call options left intact.
 
A key point is that the difference between the strike price of the short call option and the short put option determines the range within which the position will result in its maximum profit potential.
 
Iron Condor Math:
 
Establishing the Net Credit
Net Credit for the example trade= ($2.03+$1.82) credit – ($1.70+$1.42) debit= .                                                                                                            .73 x 100=$73
Profit Calculation of Iron Condor Spread:
Maximum Profit% = Net Credit =$73 (Not including commissions)
Profit % = (Credit Gained From Short Legs / Greatest Difference In Strike) x 100 ; $3.85/3= 128%

Maximum Loss Possible = Greatest Difference In Consecutive Strike – Net Credit: 1-.73 x 100= $27
 
To find the Profitability range:
 
Upper Breakeven= Short Call Strike + Net Credit= $70-.73= $70.73

Lower Break Even = Short Put Strike – Net Credit= $69-.73=$68.27

 
Range: $68.27-$70.73
 
Because of the four positions going in and out, commissions can take a big bite out of the profits of this conservative option trading strategy. However, the ROI and risks are appealing if you have the assets in your account to cover the margin requirements.

Mar

4

Is Your Option Selection Overpriced?

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It’s always a good thing when you can sell something that is overvalued. On the flip side, it’s also good when you can buy something that is undervalued. In the world of stock options, how does a trader know when an option is over or under valued?
 
Depending on the strategy being applied, traders may either want options for stocks that have a relatively high level of volatility. Other times, traders may not want high volatility as in premium collection strategies. To help option traders arrive at what an option price should be, there are several variations of the famous Black-Scholes Option Pricing model. Fortunately, there are many services and software programs that can do all the number crunching.
 
One of the principal variables in the formula used for stock option pricing is statistical volatility; the amount of variation a stock price moves around its mean. If a stock has high volatility, it directly affects the pricing model: higher volatility means higher price.
 
However, the nature of the market and the perception of volatility is always changing. As a result, an option can be overpriced or under priced in comparison with the static OPM (Option Pricing model). As in all variations from the norm, an arbitrage situation can use this information to seek profits.
 
Historical vs. Implied Volatility
 Is Your Option Selection Overpriced?
 
There are many services, trading platforms and brokerages that provide the ability to compare Historical Volatility and Implied Volatility (IV). As in the above chart put out by Ivolatility.com, it’s easy to see when IV is historically high. But to see how the current price compares with the OPM, one would need to find a more specific source that will compare the OPM price and the current price. For example, in the table below, we can see the difference between Statistical Historical Volatility (HV) and IV. Moreover, the IV is in the 97% percentile over the range of data. This is extremely high. So what?
 
 

Is Your Option Selection Overpriced?

 
An option trader can use an option and not need to select an overpriced strike. If an option is overpriced, look for a less expensive (lower IV) option that will fit the strategy. Another consideration is that an overpriced option is a good thing when selling; likewise, an under priced option is a good thing when buying.

Mar

3

Butterflies, Bulls and Bears

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I recently read an interesting article comparing the various complex stock options spreads available to those of the stock option persuasion. I can’t vouch for the correctness of the table but it does provide some food for thought.
 
 
Condor
Iron Condor
Butterfly
Iron Butterfly
Debit/Credit
Debit
Credit
Debit
Credit
Max Profit
Low
High
Higher
Highest
Max Loss
Highest
Higher
High
Low
Cost
High
Nil
Low
Nil
Profit Range
Wide
Widest
Narrow
Wider
 
Considering that all of these spreads are normally used when the trader thinks that there won’t be much movement of the underlying during the period of the trade, it looks like the Iron Butterfly needs to be explored a little further. The reason why we probably don’t hear much about them is that they create a fairly large credit when opening the position. As this isn’t what most brokerages want, they may restrict their use. Check with your broker first.
Butterfly
So before we fortify the butterfly with iron, let’s talk a little about the basic butterfly strategy. The Butterfly has three legs and is composed of a Bull call spread and a Bear Call spread.
·         Buy (1) ITM call at lower strike price
·         Sell (2) ATM calls at mid-strike price (closest to forecast average price)
·         Buy (1) OTM call at higher strike price.
 
The same pattern is used if using a call or put but all options must be of the same type and same expiration month. The Butterfly is a Debit spread because the ITM call causes an outlay of more funds than does the credit derived by the sold contracts. Moreover, the further the legs are extended from the mid price, the lower the risk.
 
 
Iron Butterfly
Anything with the word iron in it implies strength unless you’re talking about swimming. The addition of the “iron” prefix bespeaks the superiority of the Iron Butterfly over the non iron clad Butterfly. According to the chart at the beginning of the article, The IB has a lower Max loss and the highest Max profit than the other complex spreads. That’s the kind of optimization we want.
 
There are some distinct differences between the two butterflies. The Iron Butterfly is made up of a Bull Call spread (Buy Call sell a Put) and a Bull Put spread (Buy a Put and sell a call). Also, note that the Iron Butterfly has four legs instead of the Butterfly’s three.
 
  • Buy (1) OTM Put
  • Sell (1) ATM Call
  • Sell (1) ATM Put
  • Buy (1) OTM Call
 
The Iron Butterfly is a Credit Spread because of the two ATM and no ITM purchases.
 
Advantages Of Iron Butterfly Spread:
·       Able to profit from stagnant stocks.
·       Maximum loss and profits are predictable.
·       Being a credit spread, it reduces overall risk with a higher probability of ending in a profit than a debit spread.
·       Very versatile as the position can be easily transformed into a Bear Call Spread or Bull Put Spread.
Disadvantages Of Iron Butterfly Spread:
·       Larger commissions involved than simpler strategies with lesser trades.
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