Feb

28

Tax advantaged Stock Options

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It’s that time of year again. April 15th fast approaches and it’s almost time to celebrate “Uncle Sam” day and go through the familiar right of passage-paying taxes. You know, time to pay your trading partner his part of your gains. Of course, you can avoid all that by not having any gains, but that’s not the preferred solution.
Ordinarily, trading stock options would cause about a 35% tax on trading profits (ouch!) but there are some special types of options which can qualify for more favorable tax treatment: the QQQQ, IWM and the DIA index funds.
As the reader may recall, the QQQQ is a trust set up to match (as closely as possible) the returns of the S&P 100. Likewise, the IWM and DIA are trust funds set up to mirror the Russell 2000 (IWM) and the Dow Jones Industrial Index (DIA also known as “Diamonds”). These trusts are advantaged under IRS regulations.
Under IRS Code Section 1256, these assets receive special tax treatment. For example, if a trader owns stock in any of these three investment vehicles-even for just one day- only 60% of gains are taxed at the 35% rate. That figures to be a taxation of only 23% if you are in the 35% tax bracket. Normally, assets need to be held over one year to receive the benefit of being considered a long term investment. This tax advantage is only for the options and not the stock.
Moreover, the gains are subject to “mark to market” rules, which means that all an option trader needs to do is take the starting balance in the trading account, adjust for additions or subtractions of cash that was made during the year, and subtract the ending balance in the account to determine the trading profit. Section 1256 transactions are reported on form 6781

The first thought that passed through my mind was, “why not just stick to these options and reap the automatic tax advantage on all gains”? It could mean an additional 12% (difference between the normal 35% short term tax rate and the advantaged taxation of 23%). As the section 1256 assets are indexes, there would seem to be a fairly good correlation (inverse) with the VIX and implied Volatility with these indexes. Of course, trying to correlate a linear function to an non-linear market can be misleading.
As an index is a composite a individual stocks, it should have less variation and using Bollinger bands should have more validity. (Maybe somebody has done a statistical study on this?). So, I have been experimenting (paper trading) with using a straddle strategy where if VIX is moving up or flat and Bollinger bands reveal a current index price near the middle or higher of the centerline (mean), I will sell an in-the-money put and buy an out-of-the-money call, expecting the index to move down toward the lower Bollinger Band because increasing VIX relates to decreasing market prices. Conversely, if the VIX is coming down and the price is below the mean band, I will buy an in-the-money qqqq call option and sell an at-the-money qqqq put. I may be all wrong, but over the past five trades, I have a net profit of 12%. Of course, this is a small sample, but maybe somebody else out there has been doing something similar?

To help me see the actual tax savings, I now have a column in my trading journal that provides profits net of capital gains tax. It doesn’t make a trader feel any better (yields are lower but more real). After all, what you keep is really what you made-your real return. Your partner’s profit portion doesn’t count.

Feb

27

A Simple Spread Strategy for High Volatility

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Maybe I’ve just been lucky, but I subscribe to the KISS principle. Recently, the markets have been sloshing around like a fat person settling into a full bathtub. To most traders, that can be a bit intimidating, as it should be.
But for me, it’s been fun. Fun in the way that as volatility and uncertainty increase, so too does emotion in the markets-namely fear. And that can make for real opportunity.
 
RSI (Relative Strength Index) has always been one of my favorite technical indicators in that it pretty well tracks the cyclical emotional rollercoaster that most investors and traders exhibit in trading behavior. It’s all rather Newtonian. What goes up comes down, even if it’s just momentarily. Good news passes quickly and the momentum with it. The same happens with bad news.  But, if fundamentals are good, eventually, prices will settle back to an attractive price and the process starts all over again.
 
RSI is a good measure of how investors and traders feel-at the moment- about a stock. Naturally, if there is a good feeling, volume of buying picks up. If things are still good but the buyers have done their thing, price can move back down or stabilize just out of buying fatigue. The same works for a stock that has grown unpopular. Prices move down quickly but eventually reach a price where the bargain hunting buyers come back in.
 
I have been using a fairly simple screening program to track down good stocks to straddle-either with a short or long bias. First, I screen for beta. I want a stock that’s active and ready to rock’n roll. Then, I look for a stock that is either near its high or low. The next thing to check for is what the news is on the stock. I don’t want a stock that has a high public profile. I am looking for more of a fatigue factor-either over bought or oversold. Next, I look at the short term RSI cycle and try to find a “double tap” where the RSI has either gone up over 80 or below 20 and has recently been tested. Next I look for the stock with the highest Implied Volatility. These stocks have the higher probability of rapid and forceful movement.
 
If the RSI is on the low side (20 or less), I look at buying an in-the-money call and buying an at-the-money put. Both positions are for the same month. If the RSI is in an over-bought condition (80 or more), I will buy an in-the-money put and buy an at-the-money call. Because volatile stocks move more quickly, the stock option trader will have to keep engaged with a trade based on volatility and be ready to close out the positions rapidly.
 
So, if you have the time and disposition to stay strapped in and close to your computer, using a straddle to ride the volatility to glory can not only be fun for the CRT hugging crowd but also helps option traders tap into the fast and hard stock price break downs that can be very lucrative. But most importantly to me, it points out the fact that somebody’s gloom and doom can be another’s lip smacking opportunity. Just think, with stock options there is never a reason to feel left out or cut off from the market. Any way it goes, up, down or sideways, an option trader can make some hay.

Feb

26

Implied Volatility and Choosing a Spread

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Some people’s garbage is another’s treasure. Make a silk purse out of a sow’s ear…..put lipstick on a pig. You get the picture. But for some reason, most stock and option traders seem to have a bias toward spotting the special situation where a stock price will be moving up in value and try to identify the buy low and sell high strategy.  This natural predisposition is probably because most people aren’t interested in stocks that are losing value or in a state of stagnancy. Not so for the intrepid stock option trader! In fact, there are many more stocks that do little or nothing. And an option trader knows how to make lemonade out of these “unattractive” situations. Moreover, stocks that break down and head rapidly south are more likely to make bigger moves and in a shorter time than stocks that are moving up in price.
 
Take the situation of a sideways to declining market. Most advisors may advise to stay away from the market or go to cash. But to a stock option trader, the slow and gradual downward movement offers an opportunity for an option trader to capture some time premium decay as well as the downward movement of the stock. For example, the sell-write is an excellent strategy here; however, not everyone is in a position to finance shorting a stock as this requires purchase of the full value of the shares. As a cost effective alternative, an option trader can make use of a vertical “bear spread”.
 
This strategy uses a vertical spread to allow the trader to take advantage of the stagnant to declining underlying stock movement. When constructed properly, the vertical spread will allow for premium collection in a situation where a stock has a slow, consistent, gradual downward movement. But the key to which vertical bear spread strategy to use depends on implied volatility. In other words, does the trader think the stock break down and make a rapid downward plunge or will the stock just drift lower.
 

For example, if a trader thinks that implied volatility is likely to increase, the trader can set up a vertical spread to capture downward movement in price. An option trader does this by buying an in-the-money put option and selling an out-of-the-money put option against it. The trader expects the stock to go down significantly. However, if a trader feels that implied volatility will decrease or stay relatively flat, the trader can set up a premium capture strategy by construction a vertical spread by selling an at-the-money put option (premiums are highest when ATM) and buy an out-of-the-money put option to protect against a large downside move and a possible assignment. However, in both of these particular strategies, there is some risk to price reversal.

Feb

19

Option Volatility and Price

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Movement -or the lack of it- in the underlying stock is what option trading is all about. Sometimes a stock option trader wants a lot of movement and sometimes no movement is the desired quality for an option. For option traders who need a move into-the-money, the trader wants movement-usually, the more the better. For option traders who want to collect premiums, the trader wants as little movement as possible.
 
Volatility is a statistical measure of how much variation a stock exhibits as it moves around its mean. For example, if a stock has an average price of $40 and has a low of $20 and a high of $60, this stock exhibits much more volatility than a stock which has a similar average price but has a low of $30 and a high of $50. From a stock option point of view, if a trader wants an option to move into-the-money, or deeper into-the-money, an option trader wants an underlying with high volatility. Why is that?
 
More volatility means a greater chance that the option will move. However, it has nothing to do with predicting the direction of the movement. That is the option trader’s challenge; to divine the direction and when the movement may take place. If there is a good probability of a stock moving up, the more movement can translate into more profits. On the other hand, the movement could be counter the expected direction. This factor of rapid movement in the unwanted direction adds risk to the equation. However, because more movement can mean more profit (if the direction is predicted), volatility is more desirable. And more desirable usually means more expensive. And so it is with stock options: higher volatility equals higher option pricing.
 
If the option strategy is to collect premium, volatility is not a desired quality. As you may recall, premium collection on stock options needs little to no movement of the stock during the option period. Of course, with low volatility, the price of the option should be less expensive. However, an option premium collection strategy would like to employ as high a premium as possible without creating too much risk. To achieve this, an option premium collection strategy usually requires that the strike selection be as close to at-the-money as possible. This is the point where time value (extrinsic value) is highest. But another strategy to boost option premium prices
 could be to select a higher volatility stock, which is further out-of-the-money.
 
Implied Volatility
Options University defines Implied Volatility (IV) is a value derived from the option’s price. It indicates what the market’s perception of the volatility of the underlying stock will be during the life of the option contract. If the market perceives increasing volatility, the extrinsic (time value) value increases. As a result, the price of the option will also increase. But some-times this perceived volatility (as compared with the Statistical Volatility) can be overstated and make an option overpriced. How do we know when an option is overpriced? Answer: by comparing with the Option Pricing Model. If the model produces a premium of $3 and the actual premium is $4, there is most likely an extra dollar of Implied volatility (IV)
 
Implied Volatility is the only way to measure whether or not a stock option is overpriced. And there is a strategy to take advantage of high and low IV: sell overpriced options and buy under priced options.

Feb

18

Leaping For Profits

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It sounds almost too good to be true. Buy a LEAP call option and sell a near term call option and let time decay put money in your pocket. Over and over.
 
As you may recall (if you don’t, you probably need to brush up on your basic option theory), Theta-the value for time in option pricing-goes to zero as the option approaches expiration. Simply put, if an option has an extrinsic value (time value) of $3, that value will go to zero as time runs out on the option. An out-of-the-money option has only extrinsic value. An in-the-money option has intrinsic value and time value. Again, if a stock option that is in-the-money has a premium value of $8, which is made up of $5 intrinsic value (above strike price) and $3 time value, at expiration the stock option will have a value of $5 due to the total loss of extrinsic (time) value.
 
One way of using this property of time decay is to set up a strategy known as a Time Spread. A profit is made when the front decay increases the spread between the font and back months. For example, suppose a front month out of the money call is sold for $4.00 and the back month is purchased for $6.00. A profit is made when the front month expires with zero value and the back month still has value. In our example, the net cost of putting on this long time spread is $ 2.00. If the front month expires at $0 and the back month is at $5, the position has made a $3 net profit. So, logic says that the more stable the back month remains in price, the greater the spread. Thus, consider the LEAPS (Long-term Equity AnticiPation Securities).
 
Theta in a LEAP is very stable because there is a long time until expiration. On the other hand, the Theta for a near month is on the normal exponentially decreasing curve for an expiring option. Thus, the rather stable LEAP premium and the deteriorating near month can supposedly optimize the time spread.
 
When screening for a good front month candidate, a trader wants to locate a fairly stable stock but with a decent enough extrinsic value. As you may recall, extrinsic value is highest when the strike and the stock are at-the-money. So, to maximize premium value, a trader would want to locate a call option near or at the money to sell. However, the option should have a much implied volatility but not too much to move the stock too much into the money to possibly trigger an assignment.
 
For example:
IBM: Current price: $105
 
First trade
Sell (3) IBM March 08: Premium: $4.70 x 3 contracts x 100 shares= $1410             
Buy (1) IBM Jan 2010: Premium: $10.50 x 1                 x 100          = ($1050)
         
If Front month expires, trader keeps: $1450 premiums; net +$ 360
 
Second trade:
Sell (2) IBM April 08: Premium: $ 5.00 x 2 x 100 = $1000
No need to buy call to protect upside movement because you already own it.
 
If front month expires without being assigned, new balance is $+ 1360
 
Trader can repeat this reselling of OTM front month calls or puts to be as close to at-the-money as possible. The back end Leaps are perhaps traded once for each three or four front end sales.

Feb

17

Taking the Short Plunge

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Like Slim Pickens in Dr. Strangelove, shrieking while riding an H-Bomb as it plunges down to its point of nuclear detonation, some crafty option traders take a similar plunge when riding the misfortune of some stock as its price plunges down. But traders shriek for joy and not fear from becoming extra crispy but because the intrepid trader is making money. Being in position to ride a plunging stock can be a thrilling and profitable strategy for nimble option traders.
 
Once a stock “breaks down”, there can be a stampede for the exits and this helps create a sudden and usually exaggerated fall in price. As a result of the hysteria, shorting a stock can normally produce higher profits in a shorter period of time.
 
It seems to be a natural mindset for traders and investors to constantly think about upside potential much more often than downside profit potential. Maybe it’s the paradox of something decreasing in value but at the same time increasing in value.  But when analyzing the mechanics of going short and how a profit is made can clear things up.
 
When shorting a stock, a trader will borrow the stock from the broker at a certain price and then hope to sell the stock back to the broker at a lower purchase price…..but the broker has to re-purchase the stock back at the original price when the stock was lent to the trader. In reality, the trader sells the stock back to the broker for the price it was borrowed but the trader can go into the market and purchase the stock at a lower price (after it has gone down) and make a profit on the difference between the price it was borrowed for In effect, it is the same thing as buying low and selling high.
 
For an option trader, there are several ways to make money from a declining stock. Perhaps the most simple is to purchase a put. The risk is limited to the put premium no matter what happens to the stock. Another strategy is to set up a straddle where a put and a call are purchased at the same strike price. This helps protect against an unforeseen reversal. The risk is limited to the total cost of the put and call. Yet another strategy is to short the stock and protect against an upside move by purchasing a call.
 
When using any short strategy, the trader must be nimble as most down breaking stocks are usually an overreaction as fear takes over and exaggerates the movement. Usually, when the fear subsides a bit, buyers start to creep back in and the price starts to rebound. For this reason, short players need to be quick on the trigger to take profits.
 

In some stock option strategies, writing naked puts can be part of the strategy, and this can be dangerous. As mentioned, stocks in a down break move rapidly and if a put is written without protection, the writer of a naked put may have to go into the market to cover an assignment and may pay heavily for the stock. Therefore, anytime a put is written, it is a good idea to have it hedged either with the purchase of an out-of-the money put or the stock itself.

Feb

16

Stagnant Can Be Sweet

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To me, what really makes stock options so fantastic is that a trader can make money from companies who are dead in the water and going nowhere fast. As a matter of fact, there are many more stocks in a sideways or stagnant period than there are stocks moving up or down.
 
There are many ways to make money trading stagnant stocks. The idea is to sell (write) options to other traders who believe that the stock may move and if the stock doesn’t move into the money to the extent of being exercised, the stock option will expire worthless. In this way, the option writer can keep the premium. The profits from premium collection aren’t usually very high, but they can be very repetitive. If the stock option has some implied volatility, that will help to boost premium prices and premium prices are what an option trader is after when it comes to stagnant stocks.
 
There are many strategies for stagnant stocks but perhaps the simplest one is to write a covered call. But there are others-such as the poetically named “butterfly” that really works well with stocks that are stagnant but with some implied volatility.
 
For example, suppose IBM came off an excellent quarter and prices had moved well to the upside. The stock has now moved into an over bought condition as indicated by the RSI. Moreover, there is no more anticipated good news expected to be released soon about the company. The stock has moved sideways and is still above its 30 day moving average. The near term probabilities of the stock moving up are not as high after the stock price has discounted the good news. Now might be a good time to put on a Butterfly.
 
If a trader is trying to collect premium but wants to protect against any unforeseen factors that might make the stock move, a butterfly offers some nice insurance protection. Here is how it works.  If the price of IBM has stabilized around $110, a trader would put on a long Butterfly by purchasing one in-the-money IBM call with a strike price of $107. This protects against unexpected upside moves. Then the trader would sell two $110 IBM calls.   As the highest premiums are usually found at-the-money, the selling of two contracts near or at-the-money boosts the premium and helps to offset the long purchases. To also help protect against a move above the selling prices, another one long IBM call is purchased at $112 strike. If the price goes, down, not a problem; the middle sold options will expire worthless and the premiums minus the premiums for the two calls can be kept. If the price moves up and into-the-money, the in-the-money long call and the out-of the money long call will help protect the position. The Butterfly is considered to be a very conservative strategy. Keep in mind that there are a total of four options purchased in the same month. The center two are sold for premiums and the bottom and top long calls acts as protection against counter moves.
 
A simpler strategy, which accomplishes about the same thing, is to buy the stock and sell the option. This is called a covered call. It is also hedged like the butterfly, but this strategy requires more capital than that of the conservative Butterfly. This is because to initiate a Covered Call (buy-sell) requires that the stock be owned outright and a call be written.
 

Another way to capitalize on a stagnant stock, which lies somewhere in complexity between the Butterfly and the Covered Call is to sell (write) an at-the-money call and then purchase another cheaper out of the money option call-also in the same month (a spread). Of course the spread between the premium collected for the sold ATM call, OTM call premium paid and transaction costs must justify the trade.

Feb

15

Cheap Options Can Be Expensive

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It’s perhaps the greatest misunderstanding in the options trading world: the best way to make money in options is not buying out-of-the-money options. On the contrary, if you want to have more winning trades you are better off to buy in-the-money positions. “But it costs more”, you say. Actually, it probably costs much more to buy out-of-the-money options. Here’s why.
 
In-the-money options have high delta. It’s as simple as that. As you may recall, options with a high delta have a high probability of expiring in the money. For example, an out-of-the money option costs less, but its delta is low. That means that it has a low probability of moving into-the-money before expiration. That usually means that the chances of making money on the trade are also low. Yes, it is cheaper to buy out-of-the-money options but the probability of winning are lower. So, even though you may lose less per trade, you will lose more often and the cumulative losses will surpass the high probability in-the-money trades even though they do have a lower return on investment (ROI). However, that lower ROI, multiplied many times over, yields much better annualized returns-over time.
 
Another important misunderstanding about buying out-of-the-money options is that the relationship between a stock and its derivative option has a linear relationship. What does this mean? You see, delta also demonstrates the relation between the movement of the underlying stock and the option. For example, an out-of-the-money option with a delta of .4 means that the option will only move about 40% of the movement of the underlying. If the stock moves up $1, the option will move up 40 cents. An in-the-money option with a delta of .9 will move 90% and move 90 cents to a $1 move in the stock. Yes, indeed, you get what you pay for.
 
Of course, stock options have many strategies that can use lower cost options but if the typical trading strategy calls for high probability winning trades, it is best to go with the odds and buy in-the-money options. Simply put, winning trades are more likely to happen with in-the-money options.
 
The basic tenant of a trader is to have as high a win-loss ratio as possible with profit margins greatly exceeding the losses over the inevitable losing trades. Higher win-loss ratio is a function of higher probability trades. Delta measures that for the trader. So, option traders shouldn’t look so much at the price of an option but at the delta of an option and what the potential profit margin should be.  
 

So, while it is true that a trader can have a higher return on investment if using out-of-the-money options, what would you rather have: a trade that has a 90% chance of finishing in-the-money or a 40% chance? However, on a deeper level, out-of-the-money option traders may very well just be non- believers who are thinking more about hitting a “home run” and don’t understand the superior strategy of “hitting for average”.

Feb

14

Understanding the Basics in Trading Options!

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Is your understanding of stock options built on a foundation of sand? If you don’t have a good grasp of the “Greeks” and the Stock Option Pricing model, you, indeed, are “hanging out there”.
 
Many option training courses “de jour” don’t seem to cover the rather complex but necessary subjects of the Option Pricing Model and the component Greeks that are produced in the process of using the Option Pricing Model.
 
The Greeks are variables that allow an option investor to know how an option and its price will be affected by key variables. Not only can the Greeks forecast what probability the option has of finishing in-the-money, they can also demonstrate how time and volatility will affect the price of the option… Unfortunately, not enough option traders seem to be aware of the importance of this essential information. This lack of understanding is most probably due to the lack of confidence that the option education industry has in option traders to have the patience, interest or time to learn about these concepts. And, of course, the less the general option trading population knows may be to the benefit of the “other side” normally taken by the professional option traders.
 
Be advised, do not trade options unless you have taken a course or studied to the point of a clear understanding the basic building blocks of stock options: the Option Pricing Model and the Greeks. If you trade options without this information and how to use it, you will be trading stock options with one hand tied behind your back. It will cost you money.
 
Before deciding to become a serious stock option trader, you should commit to the idea of continuing education about options and try to hook up with a provider that will help keep you up-to-date and constantly learning about options. Moreover, to become a successful option trader, it would also be a good idea to also commit to learning and applying the many strategies to option trades. Don’t get locked into a certain strategy or style of trading just because you understand it better than other strategies. Learn to analyze a stock and then to choose the best strategy for the situation. Also, learn how to appraise the best risk-reward scenario comparing different strategies for similar situations.
 

The great strength of stock options is the flexibility they offer. But to learn about the various strategies that can be used, requires a solid and ongoing education, which first builds upon the basic building blocks-the Pricing Model and the Greeks.

Feb

13

Don’t be a One Dimensional Options Trader

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Do you choose the trade to match your strategy or the strategy to match the trade? Options are fantastic in their flexibility but to take advantage of this wonderful quality, an option trader must be knowledgeable about their many applications.
 
Recently, Options University published an interesting free report on the most common mistakes made by option traders. The first mistake was sited as not fully understanding the implications of the Greeks and how they can affect the movement of an option in relation to its underlying stock. The second common fault with most option traders is the idea that many traders become locked into a particular style of trading options. They may try to find an option strategy that they are comfortable with and then look for stocks to fit the strategy. While this approach can work, it is not the most effective way to trade options and optimize returns.
 
Stock options are more complicated than just trading stocks or mutual funds. They are more complicated because they can do so many more things than just buy and hold. Once an option trader learns about the many strategies for making money with options, they wonder why an investor would want to trade anything else. But to come to this realization takes some time and effort to learn the many ways to use stock options. If an option trader becomes fixated on a particular strategy-either because it is easy to understand or the strategy has been successful in the past-a trader can become misled by thinking that one strategy fits all. Trading options is much more akin to playing chess. It takes an analytical trader to asses the various strengths and weakness of a stock to determine the best “move”. An able stock option trader fits the strategy to the stock, not the other way around.
 
As an example, if a trader is just looking to profit from stocks that are poised to increase in value, a trader can miss many more opportunities to profit from the much greater selection of stocks which are stagnant. By the same token,
 a stock option trader who doesn’t understand that a stock which is breaking down has a much greater probability of making more money in a shorter time than “going long”, may miss those opportunities, also.
 
Trading stock options does require more study and constant review to be able to implement the many strategies available to option traders. Moreover, stock option traders should guard against getting too inflexible in their trading strategies. If a trader is always looking for a particular chart pattern they may become “myopic” and miss other trading opportunities; making a square peg fit into a round hole, if you will.
 

To optimize the power of trading options, option traders should plan on becoming lifelong students and continually maintaining and adding to their knowledge. As option trading is active investing, traders should plan on using all the tools in the option trading tool box and to do so requires continuing education-just like any other profession.

Feb

12

Common Mistakes Stock Option Traders Often Make

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Are you a “crispy” options trader? Options University recently came out with a very informative free report named “The 7 Deadly Mistakes People Make When Trading….and How to Avoid Them”. Of course, there are probably more than seven, but the ones discussed in the report are indeed common….and if not deadly, they are probably a major cause for crispy (burned) option traders. For all of us optionaholics, it’s probably an excellent idea to review these topics.
 
The first “deadly mistake” discussed in the report is about traders who don’t fully understand the implications of Theta (time) and Vega (implied volatility). Let’s review.
 
Say you think XYZ Corp will trade up from its current price of $37. You decide to buy a one month call with a strike price of $40 with a premium of $2.
As time passes, the stock price for XYZ moves up to $39 but the call option is now worth only $1. What happened?
 
Of course, many “unschooled option traders” may not realize that an option’s price depends on much more than just the price of the underlying stock. An option’s price is also affected by the passage of time (Theta) and implied volatility (Vega).
 
In our example, even though the stock went up, we have a low Vega (correlation of the stock’s movement and its corresponding option’s sensitivity to that movement). Just because the stock moves up $ 2 doesn’t mean that the option will mimic that movement. Also, the option losses value as it nears expiration; it has less time to move into the money. Both of these factors affect the independent movement of the option from its underlying stock.
 
One of the uses for the Stock Option Pricing Model is used by option traders to ascertain the various “Greeks” that must be taken into consideration when choosing an option. Surprisingly, many new option traders don’t fully understand how important the Greeks are and how they can become easily discouraged by the seemingly random movement of the option even though they may be correct about what will eventually happen to the underlying stock.
 
This lack of understanding is made most obvious by the amount of stock option traders who buy out-of-the-money options. They feel that the cheaper the option premium, the greater the return on investment. And, of course, this sentiment is correct in a logical way. But in the real world of stock options, out of the money options have lower delta’s (probability of finishing in-the-money) and the probability of actually realizing a profit on the option is much lower with cheaper, out-of-the money stock options. As a result, most successful traders prefer to spend more money on at-the-money or in-the-money stock options and have a higher probability of profits than have a higher return on investment but with a much lower probability of actually happening. This, too, is logical.

Feb

11

I Believe in Vega!

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If you trade stock option time spreads, you should probably name your next daughter Vega. Vega is one of the well known Greeks spawned by the genius of the option pricing model. As you may recall, there are four principle Greeks of option legend: Delta, Gamma, Vega and Theta. Each one of these variables provides important clues about the future behavior of the stock option they constitute. Today, we talk about Vega and how it can help the stock option time spread trader.
 
As you may recall, Delta demonstrates the relationship between the movement of the underlying stock and its option. Usually, the higher the stock option approaches in-the-money, the higher the correlation between the movement of the stock and its derivative. For example, an out-of-the-money option may have a low correlation of .4 (the option will move about 40% of the movement of the underlying). As the option approaches in-the-money, the correlation increases. Somewhere a bit above in-the-money, the correlation will approach .9 to 1.00. At a correlation of 1.0, the movement of the option mimics the underlying; if the underlying moves up $1 so does the option premium. Of course, when an option is in-the-money it might be assigned or called away. This is not particularly desired in that the trader may have to lay out additional funds to place the stock if the underlying is not already owned. As most option time spread traders are long, the front month (naked call writing) is for premium collection. So, a time option trader needs to be aware of what will happen to an option when it moves from at-the-money (where time premium is at its maximum) into an area where an option might be assigned. This is where Vega can be very useful.
 
Let’s suppose you see that the front month of the option spread is moving up toward becoming in-the-money. It would be good to know when the stock price might carry the written call option into-the-money. To do this, the option trader needs to understand what Vega means and how to apply it. Vega, as you may recall, represents how much correlation- in terms of money- will the movement of the underlying affect the option. For example, a Vega of .15 would mean that a $1 increase in the underlying would move the option up 15 cents. 
 

So, if the front month option of the time spread is at-the-money and the Vega is .30, the underlying might move up a dollar but the option would move just slightly. As a matter of fact, if delta is below 1.00 at that time, it also tells the option trader that there is not a 100% probability of the option finishing in-the- money. But needless to say, once an option nears in-the-money and a delta approaching 1.00, it might be a good time to close out at least the front month to avoid being assigned. Call it being chicken but it’s the only way I know to avoid the possibility of having to hit my account to fulfill my obligation as a naked option writer. Now, I am sure there are other ways to roll into or out of the situation but I m not familiar and would like to hear how more experienced and knowledgeable option time spread traders might do it differently.

Feb

10

Straddle

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We all want a situation where we can “play both ends against the middle”. It has a certain “check mate” ring to it. I don’t know where the saying originated but it must have come from someone who traded stock option straddles. “Win-win” is another positive cliché. It means you can’t lose. You win or….. …..you win. This quaint saying may have also come from the mouth of a straddle option trader. Not that you can’t lose trading straddles, but the concept is spot on.
 
One of the beautiful things about stock options are the marvelous range of strategies they offer. The straddle can be used in two very different situations: when the option trader believes that a stock is ready to make a pronounced move-either up or down- or when a stock is in a stagnant period.
 
Let’s say XYZ is trading around $ 58.50 and is going to come out with earnings that may greatly exceed the guidance target. Volatility has been increasing in the stock and you want to take advantage of the high probability of a jump in the stock price. If you purchase both the July 60 call and the July 60 put simultaneously in a one to one ratio, you would have a long Straddle. The July 60 call trades at $3.13 and the July 60 put trades at $2.47. The combination of these two prices accounts for 5.60, which is the cost of the Straddle. If the stock spikes up, you are there. If XYZ fools everybody and comes out with lower earnings and spikes down, you are there with the put. Win-Win. But not so fast.
 
Unlike many other stock option spreads, the straddle requires that the option trader act quickly if the stock does indeed spike-in either direction. Most often, once the big burst has happened the stock can rebound. A straddle play requires nimble action. Also, if XYZ comes out with rather mundane results and the stock barely twitches, the straddle could be in danger of expiring worthless. Of course, the maximum loss is the cost of the spread. So, a long straddle is indeed playing both ends against the middle. The worst case scenario is if the stock remains stagnant. The best case is if the stock spikes-in either direction. Either way, if the stock spikes, the option trader must be ready to pull the trigger and close out the position.
 
On the flip side, a stock option trader can use a straddle to take advantage of a stagnant stock. A short Straddle is when the option trader sells a call and sells a put for the same stock for the same month in an attempt to capture the premium and have the short Straddle expire worthless; allowing the stock option trader to keep the premiums.
 

As there are many other stock option strategies that can be used to capture premium, the straddle may be best applied when trying to capture a big move-either up or down.

Feb

9

Time Spread Option Trading Land Mines

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Time Spreads are cool. Maybe it’s just that I like the idea of the illusion of “certainty” because time decay happens to every stock option. At least it’s something with an extremely high probability of happening and that’s what a trader likes. Of course, there is more.
 
Just to review how a time spread works, an option trader looks for a stock that has low volatility, in other words, stagnant. But it’s also OK to use a slightly bullish underlying (if you are using a long time spread). The most common way that a long time spread option is constructed is the purchase of a call for the out month and the sale of a call for the front month. Both calls are for the same stock at the same strike price in a one to one ratio. As a play on the inevitable decay of extrinsic value (time value) as an option expires, the higher priced premiums to sell are usually located close to or at-the-money. However, there are some specific risks that can ruin your strategy.
 
The first unique risk to a long time spread is if the call is sold in an ex- dividend month. Some investors might want to exercise the front month-particularly if it is ATM or ITM to capture the dividends. (To receive the dividends, the stock must be owned before ex-dividend date.) If the trader has written the front month, and it is close to or at ATM, it’s probably a good idea to exit the front month, otherwise the trader may need to go into the market and sell stock at the market price if the option is assigned. This could be costly. The chance exists. So, stay away from front months that are ex-dividend.
 
Associated with an ex-dividend threat, is the possibility that the front month will move deep into-the-money enough to trigger an assignment. Again, if the front month is naked, there is the chance of having to go into the market to sell shares (or exercise the out month). Either way, it will require a large cash outlay. The way to protect against that is to watch Gamma and Delta of the option. Delta, as you recall, measures the correlation between the underlying stock and option price movement. Moreover, it measures the probability that the option will expire ITM. Gamma is closely related to Delta (second derivative) and measures how much Delta will move up or down as the price of the underlying stock moves up or down $1. For example, if Gamma is .35 that means that if the underlying moves up $1, the Delta will move up .35. So, if you have a front option that has a Gamma of .35 and a Delta of .65 and the underlying moves up $1, the delta will become 1.00 and at that point the option has a 100% chance of expiring in the money. When that happens, chances for an assignment may increase. Again, the best option is probably to exit the position if Delta goes to 1.0. If you are trying to save capital or trading options with a limited amount of capital, you might consider getting out of any naked written calls before they hit 1.0. Gamma will give a good indication before it happens. For instance, if Gamma is .15 and Delta is currently .65, there is little need for concern.
 
If you are not familiar with the use of time spreads, there is so much more to learn and I suggest that if these terms sound like Greek to you that is because they are. To learn more about the Greeks and much more about advanced option strategies, I suggest taking one of the many online courses and webinars offered by Options University. Stock options are marvelous instruments but they are not very intuitive; to use them requires specific knowledge and study.

Feb

8

Beware the Short Time Spread

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There is danger in a little knowledge. If you trade time spreads….listen up.
 
As you recall, a time spread is a position where either calls or puts of the same stock option are bought or sold at the same strike price but in different months. Moreover, each end of the position has equal number of contracts.
But knowing the difference between a long time spread and a short time spread can make a big difference in terms of risk.
 
A trader may be tempted to put on a short time spread because it involves an immediate credit to the trader’s account. A seller of a time spread writes a call for the back month (usually much higher premium) and buys the front month. As the out month usually has a larger premium, the trader has an immediate net credit and no out-of pocket expenses. For example, if a stock is currently at $49, a trader may buy a call at a $50 strike for the front month at a cost of $ 2.00 and sell (write) the out month for a premium of $4.00 for an immediate credit of $200 per contract. When the front month expires, the trader will then be left with an un-hedged out month position. If the out month happens to move into-the-money, the trader may have to go into the market to purchase stock if the option is exercised.
 
When a trader is long a time spread, the potential maximum loss is just the cost of the spread. A long time spread involves the sale of the front month and the purchase of the out month. For example, if a trader does a long time spread on the example used for the short time spread, the trader would sell the front month for $ 2.00 and buy the out month for $4.00 for a net cost of $200 per contract. However, when the front month expires, the trader is left with a hedged position. If the option goes into the money, more profit. If it expires worthless, only the premium is lost.
 
What are the advantages of using a short time spread? You tell me.
 

Once again, options are fantastic investment vehicles but they need to be studied and understood. The first blush impression that a stock option is a cheap surrogate for a full priced stock is true but dangerously naive. If you plan to trade options, take the time and learn about the many sides of stock options before trading.

Feb

7

Profit in Death

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I know what every stock option will do at expiration. And if every stock option does it, why not make money on that certainty. What I am talking about is the fact that every stock option will expire with zero extrinsic value. Not just a high percentage, but every single stock option. That being the case, is there a way stock option traders can take advantage of this fact?
 
As you recall, a stock option has two types of value: intrinsic and extrinsic. Intrinsic value is when an option is “in-the-money” and has acquired additional value in respect to strike price. Extrinsic value is basically time value. That is to say, traders will pay a premium to have access to the rights of the underlying stock in hopes that the option will increase in value over the time period of the option. As an option closes in on its expiration date, there becomes less and less probability that the option will increase in value until there is zero chance of it increasing at the time of expiration. As a result, extrinsic value will be zero at expiration. The option is” dead” and there is no chance for any further movement of the option.
 
Another high probability event is that as the option comes within about 30 days from expiration, the extrinsic value decays at an exponential rate and really noses over within the last two weeks or so. Below is the famous option time decay chart (Extrinsic value).

P&L Chart

Writing covered calls is one way to benefit from this phenomenon. As you may remember, writing a covered call means the trader purchases the underlying stock and then writes (sells) a call on the stock for the premium amount. If the call option expires without moving into the money, the option writer
can keep the premium and the stock. Many investment advisors consider writing covered calls as a “conservative” strategy. But this strategy demands that the call writer purchase the underlying stock, which can require considerable capital. It’s a nice strategy but there is a much better strategy to also take advantage of time decay and a stagnate stock. But this system requires a small fraction of the capital required by a “buy and write” strategy. I’m talking about an option Time Spread.
 
A Time Spread involves the purchase of one option and the sale of another in different months, but with both having the same strike. You can construct a time spread using either calls or puts. The caveats are: the same strike price and an equal number of contacts.
 
For example, a trader will look for a stock that is rather stagnant and will hopefully be so for at least several months. The trader will then look for a strike price close to being at-the-money (premiums are at peak value when ATM). Then, the trader can compare the spread between different months at the same strike price. As extrinsic value does its swan dive in the last 30 days or so, as a result, the trader wants to have a front expiration month which will expire within a month or so. The back month will normally be out at least several months. When the front month goes to zero extrinsic value, which will leave the trader with one position with a little changed premium-at least in comparison to the front month. This position now represents a profit if the back month premium is more than the net cost of the spread position.
 
For example, let’s suppose a trader sells (writes) a front month call option with a strike that is just out of the money for $2.00 (a time spread can be done with OTM, ITM and ATM). Simultaneously, the trader buys a call option on the same underlying at the same strike price but several months out for a paid out premium of $4.50. The trader will buy the same number of options for each month. As the larger premium is for the purchase, there is a debit of $2.50 per share to assume the spread. When the front month expires, the trader has a debit of $250 for one call. However, the back month should still have a value near its original premium of $4.50. If the back month is closed out, there would be a net profit of $2.00 or $200 per contract. The big difference between writing a covered call and a long time spread is the cost of purchasing the stock to hedge the written call. Without the stock to protect the written call, the trader might have to cover if the stock option is exercised.
 

There is much more to learn about time spreads and they can be a very cost effective way to use what happens to every stock option.

Feb

6

Second Tier Greeks

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According to Options University Guru Ron Ianieri, an ex option market maker and author of the University’s Advanced Option Strategy Course, most option traders aren’t being taught correctly. For instance, Ron begins with the option pricing model and builds up to strategies. Most stock option courses focus on strategy while understanding the importance of risk evaluation goes by the board in an attempt to pitch a system or software. For example, Options University’s Advanced Options Strategy Course begins up front with understanding the subtleties of the Option Pricing Model and the many treasures it reveals. For example, Second Tier Greeks are discussed in detail. Most option traders aren’t even familiar with the First Tier Greeks much less the second tier. Are you?
 
For stock option traders, it’s a must to understand the concepts of the Greeks. The most notable of them are: Delta, Gamma, Theta and Vega. These “First Tier Greeks” are key to evaluating pricing and options sensitivity to changing variables. As a quick refresher (if the Greeks are something new, you need to take the course immediately-it’s that important) let’s review the most widely known Greeks as revealed in modern stock option pricing models.
  1. Delta is known as the first derivative. Delta tells us how much an option’s price will change with a movement in the underlying stock price.
  2. Gamma tells us how much the option’s Delta will change with a one-dollar movement in the stock.
  3. Theta means time decay and tells us the rate at which an option’s price will decay on a daily basis.
  4. Vega is The amount that the price of an option changes  
 
All of the First Tier Greeks are the first derivatives of the Pricing Model and are crucial to the analysis of stock options-particularly Delta. But the Second Tier Greeks are hardly mentioned anywhere. Ron Ianieri feels that is a big mistake. What are the Second Tier Greeks, anyway?
 
The Second Tier is the second derivatives of the First Tier Greeks. More specifically, they measure, using a number, the change in a first-tier Greeks caused by changes in volatility and time. 
 
Meet the Second Tier
  1. V-Delta (V-Del) measures a change in volatility’s effect on Delta.
  2. T-Delta (T-Del) measures the passage of time’s (Theta’s) effect on Delta
  3. V-Gamma measures a change of volatility’s effect on Gamma
  4. T-Gamma measures the passage of time’s effect on Gamma.
  5. V-Theta measures a change in volatility’s effect on Theta.
 
V-Delta connects volatility and Delta. A positive V-Delta (or V-Del) tells the trader that for each tick that volatility moves, Delta position will either increase or decrease by a set amount. This becomes important when a stock has a major volatility move.   I am not talking a tick or two. I’m talking a minimum of 10 to15 ticks, a 20, 30, 40 percent increase. A trader should know what real Delta is at a new volatility level. V-Del tells you that. 
 
T-Delta, measures the Theta to Delta relationship. It tells option traders how their Delta position will change (by what amount) with the passage of time. T-Del helps when you are going to be away from your position for a time. T-Del tells traders what they can expect when they return.  
 
V-Gamma is not as important as V-Del, but according to Ron, option traders need to know what their position’s Gamma is at all times under every condition in order to trade it effectively.
 
T-Gamma works in a similar way as V-Gamma, except that the T-Gamma relationship is not evaluating changes in implied volatility. 
 
V-Theta measures the affect of a change in volatility on Theta.
When implied volatility goes up, prices go up; when implied volatility goes down, prices go down. V-Theta, or the volatility to Theta relationship, basically tells the option trader, with a number, how much your decay is going to change with a movement in implied volatility?
 
 Ron Ianieri, designer of the Options University Advanced Options Strategy  Course states upfront that stock option traders need to be properly instructed on how different changes in the different influencing factors of option pricing will affect their stock option positions and that understanding what these measurements tell the option trader needs to be understood before discussing strategies. More specifically, second tier Greeks help the option trader understand what can happen to positions before it happens-not after.

Feb

5

Staying in the Stock Options Game

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Are you going to be another victim? You don’t need to be. Being a successful trader requires a good system and the discipline to follow it; good money management and of course, some “fortuitous prognostications”. There is a lot of emphasis on trading systems and software but very little about the importance of good money management. What do we mean by good “money management” within the context of stock otpions traiding?
 
For traders of all ilks, “money management” has basically two main components:
  • Draw down
  • Position Size.
 
Both these components are closely related. Drawdown refers to how much money can be comfortably lost by a trader before stepping back and re-evaluating the system or the trader. There is a dismal statistic floating out there that about 90% of new stock option traders are quickly and effortlessly ejected from the game because they run out of money, will or most usually both. Why is this?
 
There is a slight conflict of meaning when stock option traders are told that trading assets for otpions or other “speculative” investments should be money that can be lost with no real impact on the lifestyle of the options trader. In other words: “throw away money”. Get in there and hit a home run! But real option traders hit for average over the long term. They do that by pacing themselves financially and accepting the fact that losing is part of the game. The trading philosophy for real option traders is to choose high probability trades and cut losses quickly. Another main pillar for trading success is to stay in the game. How do you do that?
 
Establishing a Drawdown limit:
 
First, an option trader (or any trader for that matter) needs to take a look at what amount of capital can be allocated to trading activities. Further, how much of those funds could be lost before the trader becomes un-comfortable. As each trader has a different risk profile, this question is subject to many variables, but some very successful traders have come out with proven ideas of what works for them. Even though there are some variations, the following is an objective snapshot of what the principles are.
 
Chance is a 50/50 proposition. Flip a coin over a sufficient number of times, and it should come up heads about 50% of the time. “Over time” is the key phrase. An option trader could have a run of bad luck and suffer many losing trades in a row; hit a cold streak. But over time, it the odds can work out about can work out above chance (50%). Hopefully, a trading system will yield a better than chance performance, but even then, profits can be made. For example, if a trader cuts all losses with at 6% and all profitable trades average to be 20%, the trader will have an overall net of 14%.
 
So, number one on the option traders “things to do list” is not run out of money. Successful trading is all about perseverance and staying in the game. Check the table below. It demonstrates that when losses get below about 40%, it takes a heroic run of good fortune just to climb back out of the hole.  

Loss Table

 

Once a trader can establish their trading account drawdown limit, then they can go on to develop position size, which will be establish the maximum trading position size to allow the trader to suffer losses without getting down to the drawdown limit. Normally, most traders try to limit position size to about 1-3% of total capital on any one trade at any one time. So, between a conservative draw down and a cautious position size, traders can give probability to work in their favor. Remember, trading may be short term positions but it also means long term aggregate profits.

Feb

4

If you don’t know Delta, You don’t Understand Options

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What do Greeks and stock options have in common? If you don’t know the answer to this question, you need some very important education about stock options.
 
Many “self-taught” stock option traders think that the game is to find a stock (the underlying) that is going to move up or down within a certain period of time and purchase an inexpensive call option or put option in hopes of capturing the movement. In general theory, if the stock (underlying) moves up or down, so will the stock option. While there is some truth in this theory, sadly it is only partially true. You see, a stock option trader may indeed correctly choose the stock, direction of movement and period of movement but not make any profit. That’s because inexpensive stock option premiums are usually out-of-the-money. That is, the stock price is higher (in the case of a call option) or lower (in the case of a put) and has not reached the option strike price. Even though, the underlying may move in the desired direction this does not necessarily mean the option will follow ; thus, debunking the common understanding of what stock options are supposed to do.
 
A stock option is a derivative of the underlying stock and not an exact surrogate. There are several key factors that decide how a stock option will relate to the underlying stock and this can be computed by using one of the many Stock Option Pricing models like the famous Black-Scholes model. I can see the reader’s eyes start to glaze over and the intellectual interest drain from the topic. But stop reading at your trading peril!! This is important stuff if you want to be successful at trading stock options.
 
The purpose of this article is not to talk about the complexities of stock option pricing models but to introduce the key concept of Delta. You see, Delta is one of the “Greeks” revealed in the process of valuing a stock option.
The most common Greeks are: Delta, Gamma, Vega and Theta. The most important for this discussion is Delta. What is Delta?
 
Delta measures the correlation of movement between the underlying stock and a corresponding option. When a stock option is out-of-the-money (OTM), it has a lower correlation to the underlying. This means that if the underlying stock moves $ 1 a corresponding out-of- the- money option will move only a percentage of the underlying. For example, an OTM option might only move about 30% or in our example the premium would only move about 30 cents. But an interesting thing happens when the option approaches in-the-money (ITM); its Delta rises. For example, when an option reaches at-the-money (ATM), its Delta might be as high as 70%. When the stock option moves high into-the-money, the stock option is usually at or very close to 100% Delta. At this point of high correlation, the option is a close surrogate for the stock. If the stock moves up $1, so will the option premium.
 
While it might be true that buying a cheap OTM option might provide a higher return on investment, the probabilities are much lower that an actual profit will be made. That’s because of Delta. That is why many seasoned stock option traders much prefer in-the-money options because they understand the higher probability of having success. Moreover, if an ITM stock expires, it will still have value whereas an OTM has zip.
 

Another important aspect of an option’s Delta is that it can define the probability of the option finishing in-the-money. For example, if a trader has an option with a Delta of .50, the option has a 50% probability of finishing in-the-money. Likewise, if a trader has an in-the-money option with a 95% Delta, the trader has an option that has a 95% chance of finishing in-the- money. This is extremely important for traders.

Feb

3

It’s A No Brainer to Trade Options!

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It’s a no brainer. If you have an investing time horizon of less than two years, you are much better off using stock options. If you are a “buy and hold” investor, than you are basically looking for the long term average annual growth rate of about 12.5%-if you’re lucky. But if you are an active investor looking to optimize your investment dollars, there is no doubt that using the stock option strategy called “Stock Replacement” is a smarter and cheaper way to go. It’s smarter in that investment dollars are leveraged to optimize return and diversification and it is much less expensive because an investor can get the same affect of owning the stock but at a huge discount. Like I said, it’s a no brainer.
 
The Stock Replacement strategy holds that an investor/trader purchases either an in -the-money-call option (if the investor is bullish) or an in-the-money put (if the investor is bearish). The reason a trader purchases more expensive in-the-money stock options is that a trader wants the option to mimic, as closely as possible, the movement of the underlying stock. In other words, the educated trader wants what is called: “High Delta”.  
 
If you are an “educated option trader”, you may recall that Delta is one of the famous Greeks, which measures the correlation between the movement of an option and its underlying stock. Many stock option traders may not have learned about the more sophisticated aspects of options and may not realize that just because the trader may have chosen an option that does what was hoped for, that doesn’t mean that the option will capture the same amount of movement as the underlying. For example, a trader may have purchased the cheaper out-of-the-money option but become confused when they find out that the underlying might have moved $1 but the option premium only moved 40 cents. This demonstrates that an out-of-the-money option would have a Delta of only 40% (.40). Whereas an in-the-money option will have a much higher Delta and more closely mimic the movement of the underlying. Let’s look at an example.
 
Suppose you purchased an out-of-the-money call option for a premium of $3.00 ($300 for one contract). The stock is currently at $ 105. If the stock moves up $3 to $108, the trader’s $3 OTM call option may move up just $1 (a Delta of .33). On the other hand, if a trader had purchased an in-the-money IBM call option for $10 premium per share, the ITM call option would have moved up perhaps $ 2.75 in sympathy with the underlying (Delta of .83) In other words, an ITM option call (or put) can be a close substitute for the underlying stock but at less than 10% the cost. To own 100 shares of IBM would cost about $10,500 and to own 100 shares under option would be about $1,050.  While it’s true that a greater return can be made with a cheaper premium but the probability of it actually happening is much less than buying an ITM option. If a stock option has a Delta of .83 that means that the ITM option has an 83% chance of being in the money at expiration. For option traders who like to have a longer time horizon a long term option called LEAP (Long-term Equity Anticipation) can allow an option trader to hold an option for over two years!

For example, if an option trader thinks IBM will move up within the next two years, the option trader can own the rights to 100 shares of IBM for over two year for about $1400 (in-the-money call option expiring Jan 2010) Contrast this cost with the  $10,500 it would take to purchase the stock outright. Just think of the other opportunities a trader could have with the capital saved by using LEAPS options. The option trader could diversify among other stocks or other types of investments. Indeed, if you have a time horizon of two years or less, it makes solid sense to look to options.

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