Jan

29

Options 101 # 80

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Breakeven Return
Another calculation we’d like to check is the break-even return. This just tells us how far the stock can fall before we’d break even. In this example, the stock could fall by the amount of premium received from selling the call, which is $4.40. The $4.40 cash collected acts as a downside hedge in the event the stock falls. If the stock falls $4.40, that represents a drop of $4.40/$18.81 = 0.23, or 23%. Or if you prefer the second method of calculating the return, the ending price would be $18.81 – $4.40 = $14.41. If we divide the ending value by the beginning value and then subtract one we get $14.41/$18.81 = 0.7661. After subtracting one, we find the answer is -0.23, which is a 23% drop.

In other words, if the stock is $14.41 at expiration we will just break even on the trade since we effectively paid $14.41 for the stock. Remember, with the stock at $14.41, the $20 call will be worthless so there is no cost for us to get out of the contract. Any stock price below $14.41 at expiration will lead to a loss in the position. This calculation shows that we can afford for the stock’s price to fall 23% before the position heads into losing territory. Figure 7-2 compares a long stock position in AGIX at $18.81 (shaded line) to the covered call (bold line). The arrow shows that the breakeven point is reduced by 23%:

The breakeven calculation gives us an idea about the size of the downside hedge in the strategy. When we say the position is “hedged” that just means you are not losing money for some adverse moves in the stock’s price. If the stock price falls, that loss will be offset by the increase in the short call. The size of the hedge depends on the premium you received from the sale of the call options.

Max Gain, Max Loss
The maximum you can ever make from a covered call position is the amount of premium received from the sale of the call plus any potential capital gains that may be available as shown by the “return if exercised” calculation. Another way of looking at the maximum gain is that it is the difference between the cost basis of the stock and the exercise price. The maximum loss is the amount of the cost basis.

Do I Need to Stay in the Contract Until Expiration?
There is nothing that says you must remain in the covered call position over the next 29 days; you can always get out of the contract at any time by buying back the call option. Once you buy back the contract, the shares of stock are yours, free and clear, with no obligations attached. Of course, there is nothing that says you will be able to buy that call back at a favorable price. Whether you buy back the call at a lower or higher price depends on what has happened to the stock’s price and volatility of the stock during the intervening time. But you can always get out of the contract.

There are many scenarios we can create with buying back the call option since the option’s price can rise or fall all by itself (with no movement in the stock) due to changes in volatility. And if the stock’s price moves then it will definitely have an impact on the option’s price. Regardless of the scenario you choose, the calculation for finding your return is always the same. You simply take the cost basis of the stock and add back the purchase price of the call. Then you compare that figure to the current stock price and see what your return is.

For example, let’s assume the stock’s price stays the same at $18.81 but the value of the call is dropping due to time decay. At a later date, you may, for example, be able to buy back the call for $2, which is a favorable price since you sold the call for $4.40. In this case, your return is the $14.41 cost basis + $2 to buy back the call for a new cost basis of $16.41 on the shares of stock. You are now out of the contract and could sell the stock for the current price of $18.81, which represents a return of $18.81/$16.41 = 1.146, or 14.6%. Again, this shows that investors can make money on a stock whose price is not moving (or fluctuating sideways) over time by using covered calls.

If the stock’s price stays the same or relatively flat then time decay will erode the call’s price and the investor can buy the call back at a cheaper price. The reason this example worked out to be a gain is because the time premium was $4.40 when the call was sold but only $2 when it was purchased back. However, it is possible to profit from a covered call even if you buy the call back at a higher price. As you go through the following examples, notice it’s the net time premiums that determine whether or not the covered call is profitable or not. In other words, if you receive more time premium than you spend you will be profitable; otherwise, you have losses.

Example
Let’s look at an example assuming the stock’s price has moved higher. Assume the stock quickly rises to $20 and the option’s price rises from $4.40 to $6. If you wish to get out of the contract, you can buy back the $20 call for the current $6 market price. By purchasing the call option, you no longer have the potential obligation to sell your shares. Your cost basis is now $14.41 + $6 = $20.41 and you can sell the stock for $20, which represents a slight loss. The reason this scenario ended up with a loss is because of the relationship between the time premium and stock price. The stock’s price rose from $18.81 to $20, which is a $1.19 gain that certainly helps the long stock position. However, the time premium on the option rose from $4.40 to $6, which represents a loss on the call option since you must pay $1.60 more to buy back the call. The net difference is $1.19 gain – $1.60 loss = 41 cents loss. This 41 cents loss is exactly the difference between our $20.41 cost basis and the current market price of $20.

However, just because the stock’s price rises does not necessarily mean you will be left with an overall loss. Assume the value of the call is still $6 as in the previous example but this time it is mostly represented by intrinsic value. For instance, consider what would happen if the stock rose to $25 and the $20 call was $6. Now the $20 call has $5 of intrinsic value and only $1 of time premium. If you buy back the call, your cost basis is $14.41 + $6 = $20.21 and you could sell the stock for $25, which is a 23.7% gain. In this example, you still took a loss on the call since you sold it for $4.40 and bought it back for $6. However, the stock’s price rose substantially so the intrinsic value came back to you when you sold the stock. In other words, the $5 intrinsic value that you paid to buy the option was returned to you since you could now sell the stock for the current price of $25 rather than the $20 strike. You paid $5 to increase your sales price by $5, which is not a loss. It is therefore not enough to only consider whether the call was purchased back for a gain or a loss to determine profitability. The covered call strategy involves two assets – stock plus a short call – and it is the relative performance between the two assets that determines the performance.

To really drive the point, let’s consider a very high call price. Let’s still assume your cost basis is $14.41, the stock is trading for $40 and the $20 call is trading at parity, or $20. Is it a bad idea to buy back the call at a loss? Surprisingly, the answer is that it doesn’t matter from a financial standpoint. Many investors are inclined to believe so and just let their shares go rather than take this “loss.” But if you work through the math, you’ll find there isn’t a financial difference. First, if you choose to do nothing, you will be assigned on the call and receive the $20 strike price, which represents a gain of $5.59.

Now let’s take a look at your second choice, which is to close out the call with $20 intrinsic value. If you sold the call for $4.40 and bought it back for $20 then that is a huge loss for the call. Your cost basis on the stock rises to $14.41 + $20 = $34.41 but you can now sell the stock for $40, which still represents a gain of $5.59, or a return of $40/$34.41 = 1.1625, or 16.25%. Once again, the $20 cost of the option is returned to you since you can now sell the stock for $40 rather than $20. In other words, you spent $20 cash to free up $20 worth of intrinsic value. With this second choice, you are giving up $20 cash for certain in exchange for a $20 unrealized gain in the stock (it’s an unrealized gain until you sell the shares). Either choice nets you a $5.59 gain at that moment in time. The first choice creates a $5.59 gain for sure while the second choice results in an unrealized $5.59 gain. It’s a different set of risks and rewards, too, since you are still holding on to the shares with the second choice. But, financially speaking, there really is no difference between the two choices at that moment in time provided that you are still comfortable holding the stock.

The bottom line is that any intrinsic value in the call option will not hurt your performance if you buy back the call. The reason is that the call option’s price will reflect all intrinsic value (Pricing Principle #3 from Chapter Two) and that value is also reflected in the stock’s price. It’s only when you pay more time value to buy back the call that the amount of time value you received at the time of the sale will hurt the covered call’s performance.

We can show this easily by considering that an in-the-money call option’s value prior to expiration equals the intrinsic value plus some time value, which we can write as (S – E + T). Next, if you buy stock, S, and sell the call then you receive cash and your account has a value of stock + cash (S + C). Your account is therefore long (S + C) and short (S – E + T) since you wrote the in-the-money call. The value of the position today is then:

(S + C) – (S – E + T)
= S + C – S + E – T
= (E + C) – T

This shows the value of that covered call position (assuming the call is in-the-money) is simply the exercise price plus the cash you received from the sale of the call less any time premium you must pay to close out that call. Of course, if you wait until expiration and the call stays in-the-money then the time premium will be zero and the position is worth the exercise price plus the cash. This shows that only increases in the time premium will hurt your position since that is the only negative in the equation. No matter which scenario you construct with the call being at-the-money or in-the-money, we can immediately tell if it is a losing or winning situation by simply looking at the time premium you received versus the time premium you must pay to close out the call. If the scenario you create involves a falling stock price, then all we need to be concerned with is that the stock’s current market price remains above the cost basis.

As a recap, there are only two situations that a covered call can be in. Either the call is in-the-money or it is not in-the-money (which includes at-the-money). If the call is in-the-money we will have a loss if we close out the call by paying more time premium than we received. If the call is out-of-the-money, we will have a loss if our proceeds selling the stock and buying back the call are less than the cost basis.

To be continued…..

Jan

28

Options 101 # 79

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Assume you buy 100 shares of AGIX for $18.81 and then sell the October $20 call for the current $4.40 bid. By selling the call, you will immediately receive $4.40 *100 = $440 cash in exchange for the potential obligation to sell your shares for the $20 strike price through expiration Friday in October (29 days later). That $440 is yours for assuming the potential obligation to sell your shares of stock for the strike price if the long call holder decides to exercise the call.

The above transactions show up in your account as a long position of 100 shares of AGIX valued at $1,881 and a short $20 call valued at minus $480. New traders often wonder why they see a -$4.80 next to the short $20 call. After all, if they received cash, shouldn’t it be a positive number? The answer is that long positions show up as positive values while short positions show up as negative values. If your account shows that you are long 100 shares valued at $1,881 then that is how much you will receive if you sell those shares (100 shares at $18.81). On the other hand, the short $20 call is valued at -$480 because that is how much you will have to spend right now to buy it back (the current asking price). So where did the $440 cash go? If you look closer at your account, you will find that your money market has been credited with $440 cash. In this example, your account value will not immediately increase by $440. Instead, it will show a slight loss of $40 since you received $440 cash but must pay $480 if you wanted to close out the call right now. As the value of that call drops toward zero, your account will slowly increase by $440 assuming all other factors constant.

Because you collect cash, the cost basis (net cost) of your stock is immediately reduced. In this example, you paid $18.81 for the stock and then immediately received $4.40 cash, which means you effectively paid $18.81 – $4.40 = $14.41 for the stock. We will often make reference to the cost basis of the stock when talking about covered calls since it is an important characteristic of the strategy. Please understand the reason we can subtract the full $4.40 from the $18.81 stock price is because we have assumed you wrote one call against 100 shares of stock; that is, the calls were written in equal proportion to the shares of stock. As we said earlier, it is possible you might decide to write fewer contracts and we’ll find out the reason for that later. If you do write fewer contracts though, you cannot just subtract the option price from the stock price to find your cost basis. For example, if you bought 200 shares of AGIX for $18.81 and then wrote one call for $4.40, your cost basis is not $14.41. In these cases, we must find the weighted average by subtracting the $440 cash from the 200 * $18.81 = $3,762 total cost of the stock, which is $3,322. If we divide $3,322 by the 200 shares, we get $16.61 for the cost basis.

Let’s go back to our example of buying 100 shares of AGIX and selling one $20 call. By selling the $20 call, you are potentially obligated to sell 100 shares of stock for the $20 strike price no matter how high that stock’s price may be at expiration. This means the most you will receive from the sale of your stock over the next 29 days is the $20 strike * 100 shares = $2,000 (the exercise value of the contract).

From a profit and loss standpoint, this AGIX covered call looks like Figure 7-2:

The profit and loss diagram shows that the covered call provides for a limited upside gain. Notice that the “bend” in the profit and loss diagram occurs at the $20 strike. This shows that no matter how high the stock’s price may be at expiration, the most the covered call writer will ever receive is the $20 strike price at expiration. No matter how high the stock’s price may rise, the covered call writer can only gain a limited amount.

The profit and loss diagram also shows that the covered call writer is vulnerable to all of the downside risk in the stock; that is something you cannot forget when writing covered calls. We’ll talk more about this risk later but just realize that the covered call writer has limited upside potential and unlimited downside risk.

If the strategy has limited rewards and unlimited downside risk then why would anybody use it? Remember that all strategies are tradeoffs in risk and reward. The strategy is less risky that the outright ownership of stock yet it can yield some impressive returns. In this example, you have the potential obligation to sell your shares for a fixed price of $20, which is not a bad deal when you consider your cost basis is only $14.41. How good of a deal is it? For this, we need to turn to several performance numbers that will help you determine if a particular covered call will accomplish your goals.

Return If Exercised
One calculation you’ll want to make is called the “return if exercised.” To calculate it, you simply find the percentage increase between the cost basis and the strike price. In this example, you’d have a gain of $20 – $14.41 = $5.59 if assigned on the call. Because you made this $5.59 gain from a principal value of $14.41, this represents a $5.59/$14.41 = 0.39, or 39% return in only 29 days.

Another method for finding the return is to simply divide the ending value by the beginning value and subtract one. Here, the answer would be $20/$14.41 = 1.39. After subtracting one, we’re left with the same answer of 0.39, or 39%. Use whichever method is easiest for you to remember.

If we want to annualize the figure, we just need to find out how many “29-day” groups there are in a year, which is found by 365/29 = 12.6. This tells us that if we were able to replicate this same trade throughout the year we’d have 12.6 trades, so our annualized percentage return at the end of the year would be 12.6 * 39% = 491%. Of course, being able to replicate this trade for about 12 times during the year is an unrealistic assumption but it still allows us to make comparisons with other investments since rates of return are always posted on an annualized basis.

Notice that this rate of return is abnormally high, which should give you a clue to the risk in the position. Remember high rewards come with high risk. Why do you suppose these rates of return are so high? Because the last chapter just showed us the volatility on AGIX was very high and, in order to execute the strategy, you must be willing to own the stock. That stock was very volatile at the time, which means it could rise – or fall – substantially. We’ll look more at the risk in a covered call later but just understand you shouldn’t think this is a “conservative” strategy when you find rates of returns like this. There is a reason the market is willing to pay such high rates of return. That reason is risk.

Static Return
There is another calculation we can do to find out if a particular covered call strategy is appealing. That calculation is called the “static return,” which calculates the return if the stock’s price is unchanged or “static” at expiration. In the “return if exercised” calculation, we allowed for the stock’s price to rise from the current level of $18.81 to the $20 strike in order to calculate the return. For this calculation, we want to see how the strategy would perform if the stock closed at the current price of $18.81 at expiration. We know the cost basis is $14.41 so the static return is $18.81/$14.41 = 1.3053, or 30.5%.

The static return doesn’t assume the stock’s price will remain unchanged throughout the life of the option. Instead, it assumes that it will finish at the same price. Whether this is a realistic assumption or not, it is just meant to give us an idea about the rate of return from the option time premium alone and does not consider movements in the stock’s price. This clearly shows that covered call writers can make money on stocks without any movement in the stock’s price. That is definitely something that cannot be done with stock alone.

To be continued…..

Jan

27

Options 101 Part 78 Chapter Seven Covered Calls

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Up to this point, we have covered many topics on options and are now ready to put those concepts to use so you can understand and appreciate some basic option strategies. Before we get started though, it’s imperative to reiterate that all strategies are about tradeoffs. Chapter Three showed us by looking at a profit and loss diagrams, we can find the tradeoffs between any two strategies. Strategies are tools used to take advantage of particular opportunities much like hammers, saws, and screwdrivers for a carpenter. No option trader should tell you one strategy is superior to another any more than a carpenter should tell you that one tool is better than another. It depends on what you’re trying to accomplish. Each strategy presents a unique set of risks and rewards, and it is up to you to decide which is best for the opportunity you have uncovered.

There are several basic strategies, and it’s difficult to say which is the easiest to start with. Many books start with long calls and long puts since they represent rights. However, we are going to start with a strategy called the covered call since it represents a good starting point for most option traders. The reason is that it is one of many “stock-friendly” strategies, which means this strategy requires you to own stock. Further, covered calls are initiated by purchasing stock and often exited by selling stock, which also makes it easy for investors to understand. Since you probably already own stocks, the covered call represents an easy way to explore options.

However, covered calls can contain an unforeseen risk depending on subtle changes in the way the strategy is carried out. Covered calls can be a wonderful strategy if used properly, so it is critical that you understand the principles and risks described in this book and find out if it’s right for you before you attempt to make use of this popular strategy.

Covered Call Strategy
When you enter into a covered call, you buy the stock and then sell (or write) a call option against those shares. The shares of stock can be purchased at the same time the call is written or the shares may have been sitting in your account for some time. As long as you own shares, you can write calls against them.

The investor writes calls in a 1:1 ratio against the stock. For example, if you own 100 shares, you’d write one contract, 200 shares and you’d write two contracts, 300 shares and you’d write three contracts and so on. For every 100 shares of stock, you write one call option. Be careful that you are not writing an option that controls more than 100 shares. One of the biggest mistakes that investors make is to find option premiums that look relatively high and then sell them against 100 shares of their stock. Many times they find out the reason the option’s price looked so enticing is because it controlled 150 shares. (Naturally, if you owned 150 shares then you could certainly write such an option against them.) Just be sure that you own the same number of shares as the amount you are giving someone the right to buy.

We’ll find out later there may be times where you’d want to write fewer calls against your shares but you will never write more. For example, if you own 400 shares of stock, you may decide to write only three contracts (rather than four) but you would never write more for reasons we’ll talk about shortly.

For every call option you sell, you have the potential obligation to sell 100 shares of stock for the strike price. It is a potential obligation because it is up to the long call holder to decide if he wishes to exercise those calls and buy your shares. Just because you write a call does not in any way guarantee you will sell your shares; it just locks you into the obligation to sell your shares if the long position decides to buy. Of course, in exchange for accepting that obligation, you are paid a fee that is yours to keep regardless of what happens.

Why is it called a “covered” call? If you sell a call option without owning the shares of stock it is called a “naked” call, since you do not have the shares in your account to deliver. If you are assigned on a naked call and forced to sell 100 shares of stock, you must go into the open market and buy those shares and there is no telling what that price might be! Because of this, naked call-writing is considered to be among the riskiest of all option strategies since there is no limit as to how high a stock’s price can rise. This is why you never write contracts that represent a greater number of shares than what you own (such as writing 5 contracts against 400 shares). By doing so, you are never exposed to this potentially devastating upside risk.

However, by selling call options in proportion to the number of shares you own the upside risk is eliminated since you already own the shares. In other words, the upside risk of naked call writing is “covered” because you will always be able to deliver the shares at a known cost. You have already paid for those shares and that cost will never change.

The important point to understand now is that selling calls creates the potential obligation to sell your shares for the strike price. For example, if you buy 100 shares of ABC stock for $50 and then write a $55 call against them, you have the potential obligation to sell those shares for $55 no matter how high that stock may be trading. At some point though, every investor’s goal is to sell the shares, so this potential obligation is not a risk in the strategy. While it’s true that you may end up selling your shares far below the current market value, it is NOT a risk of the strategy since it still represents a profit. Selling below current market value at a profit is simply a lost opportunity and risk is never defined as missing out on some reward.

As long as you remain in the covered call position, you have limited upside potential since the most you will ever receive for your shares is the strike price. As with any option, you can get out of the contract by simply buying it back at some time but for now just remember that a covered call limits your upside potential.

The fact that you are capping your upside potential profit means the covered call strategy is designed for those investors who have a neutral to slightly bullish outlook on the stock. You should not write calls on stocks you feel will make explosive upward moves nor should you write calls on shares you think will fall in price. You should be reasonably confident that the stock price will fluctuate sideways through the life of the option (neutral outlook) or you should feel it may climb somewhat higher (slightly bullish).

Philosophy
The goal of the covered call writer is to collect many option premiums over a long period of time. Every time you write a call option against your shares you are effectively lowering your cost basis on those shares. This reduces your risk since you are reducing the amount of cash you have in the position. Covered call writers are not attempting to profit from rising stock prices; remember that the position is neutral to slightly bullish. It’s okay if the stock price rises (since higher stock prices will not generate a loss) but that is not the main goal of the strategy. If you are bullish on the stock you should just buy the stock (or long calls as we’ll find out in the next chapter) and just hang on. Covered call writers, on the other hand, have limited upside potential because they are obligated to sell their shares for a fixed price so the strategy is not designed to make money from rising stock prices. The goal is to generate your profits by writing calls over and over – collecting premiums – against those shares.

Covered Call Basics
Let’s start with the basics of covered calls by looking at an example using the AGIX quotes we have used earlier, which have been reproduced as Table 7-1:

Jan

26

Options 101 #77 Answers-Chapter 6

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Chapter Six Answers

1) If a bet is fairly valued then that means that you are expected to:
d) Break even over the long run
The fair value of any bet is the price where you are expected to break even over the long run. That is, after hundreds and hundreds of similar bets, you’d walk away no richer or no poorer.

2) If you pay more than fair value then you are expected to:
b) Lose over the long run
If you pay more than the fair value for a bet, you are expected to lose over the long run (after hundreds and hundreds of attempts). If a bet is priced above fair value, you can certainly win it over the short run but not over the long run.

3) You run a Black-Scholes calculation and find that the theoretical price of the call option is $3.50. What does this mean?
a) If you pay $3.50 for similar calls hundreds of times you’d just break even
The theoretical price of any investment (or any bet) is the same thing as the fair value. A call option that has a theoretical value of $3.50 means that if you were to pay $3.50 for hundreds or thousands of similar calls that you’d just break even over the long run. Bear in mind that the theoretical price of an option depends on your perspective of the future volatility. So while the theoretical value of an option does carry a distinct definition, it is impossible to really say what that value is in practice.

4) In order to successfully trade options you must be correct about the underlying stock’s direction and:
b) Speed
When trading options, you must not only get the direction of the underlying stock correctly but you must also determine how quickly it will move. It’s this second dimension of “speed” or “pace” that separates options from stocks. If you buy a stock, you will make money if it rises today, tomorrow, or next week. This is not true for an option. Long options generally need fast, aggressive moves in the underlying stock to be profitable.

5) Over time, volatility tends to move:
a) Sideways
Volatility tends to move sideways over time due to mean reversion. There is a long-run average for volatility so when it rises above this average it tends to fall and vice versa.

6) To find the true value of an option with the Black-Scholes Model, we need to know the:
c) Future volatility
In order to really know the true value of an option, we need to know the future volatility of the stock. That is, we need to know what the volatility will be over the life of the option. In practice, we substitute a forecasted volatility in for the future volatility. This forecast is usually some type of moving average of the past volatility.

7) If you are bullish and wish to trade options you should:
d) Either a or b depending on how quickly you think the stock will move
Long calls and short puts both make money as the stock rises so they are therefore bullish instruments. If you think the stock will rise sharply, you may wish to buy the call as that gives you unlimited upside potential but it comes at the expense of time decay. On the other hand, if you sell a put, the stock doesn’t need to rise for you to make money; it just cannot fall. The tradeoff is that the gain is limited to the amount of the premium received.

8) To reduce the “speed” component of an option, it is advisable to buy options:
a) With a delta of around 0.80 to 0.85
The higher the delta, the less time premium is present in the option. And it’s the time premium that creates the speed component. If you buy options with relatively high deltas, say 0.80 or higher, then you will not need the stock to move as aggressively for the simple reason that there is relatively little time value on the option. It’s advisable for new traders to buy options with deltas of 0.80 or higher for the fact they will behave more like the stock, which is what most people new to options are familiar trading.

9) Whether you feel an option is fairly valued or not depends on your:
c) Perception of the future volatility
As stated in Question 3, your perception of volatility is not a fact, so there’s no way to say for sure if an option is fairly valued or not. To say that an option is fairly valued means you must make a judgment call as to the volatility used in calculating that fair value. If that volatility seems reasonable, then you may feel the option is fairly valued. The fair value of an option depends on your perception of the future volatility.

10) If your call (put) option loses money even though the stock is rising (falling) quickly that is most likely due to:
d) Falling volatility
If the stock is moving quickly and the option is losing money, then this is likely due to falling volatility. If the stock were moving slowly, then the option may be losing to time decay. But the question states the stock is rising quickly so we can assume that volatility must be falling.

11) If you buy a put and the stock falls, you:
c) May or may not make money
Whether you make money or not depends on how quickly the stock’s price falls. If it falls sharply there is a good chance you’ll make money. But if it slowly and steadily falls then there’s a chance you won’t make money since the option will be gaining intrinsic value but losing value due to time decay. For long options, the speed at which the underlying stock moves is critical.

12) The fact that volatility measurements tend to move toward the long-term average is known as:
a) Mean reversion
Mean reversion just states that the data rise and fall toward their long-term average.

13) The time premium on an option can be thought of as the:
a) Point-spread on a bet
It’s the time premium on the option that creates the speed component. The reason is that you must recoup this time premium by expiration in order to be profitable. In a sense, the time premium acts as a point-spread on a bet since you must beat the spread before making money on the bet.

14) A low priced option:
d) Is not necessarily a good value
Just because an option is fairly inexpensive does not mean it’s a good value. To the contrary, it could be greatly overpriced. Whether an option is a good deal or not depends on the volatility assumption that went into pricing it. If that volatility assumption appears to be way out of line to the high side then the option is considered to be overpriced even though it is relatively cheap. When option traders speak of “cheap” or “expensive” they are referring to volatility and not the absolute price.

15) How many factors are needed in the Black-Scholes Model to determine the fair value of an option (including dividends)?
a) 6
The six factors are the stock price, exercise price, risk-free interest rate, time to expiration, dividends, and volatility.

16) What happens to the price of a call if interest rates rise assuming all other factors stay the same? Call prices will:
a) Rise
Rising interest rates will increase call option prices assuming all other factors stay the same. Remember though, this may not be what you experience in the real world. When interest rates rise, stock prices generally fall, which will also drag down options prices. But assuming all factors remain the same (of which stock prices would be included) then rising interest rates will increase call option prices.

17) What happens to the price of a put if dividends rise assuming all other factors stay the same? Put prices will:
a) Rise
As dividends rise, the price of the underlying stock will fall and that means put option prices will fall as well. As with Question 16, we must remember this assumes all other factors remain the same. In the real world, rising dividends will generally increase stock prices, which would decrease put prices.

18) What happens to the price of calls and puts if volatility increases?
a) Call and put prices rise
Rising volatility creates higher call and put prices. The reason is that higher volatility creates the potential for higher (or lower) stock prices, and that means call and put options have a greater chance of being profitable, so the market bids their prices higher. Remember that higher volatility would normally bring asset prices down but because options have asymmetrical payoffs their prices will rise with increased volatility.

19) Increasing the time to expiration has what effect on call and put prices?
a) Prices Increase
More time to expiration means that the stock has more time to either rise or fall, which is good for calls and puts. This means call and put prices will rise as the time to expiration increases.

20) One of the key differences between long and short options is that:
a) Long options need stock price movement to make money; short options do not
Option buyers must pay a time premium and this time premium must be recouped before a profit can be made. Long options therefore need the stock to move before a profit can be made. Short positions collect a premium up front, which is also the maximum profit they can make on the trade. Short positions do not need for the stock to move but, instead, just cannot have it move adversely.

To be continued…..

Jan

25

Options 101 #76 Questions-Chapter 6

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Some Final Thoughts
This chapter is not meant to teach you how to trade volatility, because that is an advanced subject upon which entire books could be written. This is an introduction designed to give you the basic concepts. It’s unfair to turn new traders loose into the options arena without letting them know about the volatility component of an option and how that component can adversely affect an option’s price.

I remember working for an active trader option team and one day answered the phone only to hear, “Give me the number to the SEC.” The client was noticeably upset so I asked what the problem was. The client proceeded to show me a call option he was ready to close out that would result in a loss even though the stock had risen in a short time. He concluded his dispute by saying, “I placed my bet, I was correct, and I demand to be compensated. This is fraud.”

I then had a very lengthy conversation with the client about the volatility component of options and, as you can tell from this chapter, is not an easy thing to talk out over the phone. But the client managed to understand the basic concept and said he wished he had been told that when he started trading options. So that’s why we’ve included this chapter. It is meant to alert you to what can happen if you are not aware of volatility or do not take it into account when buying or selling options.

When call option prices fall while stock prices are rising (or when put prices fall while the stock is falling), it is called a volatility trap. In trader’s lingo, we would say that anybody buying the AGIX $20 call for $4.80 and then wishing to sell it six days later when the stock was trading higher was caught in a volatility trap since he’d only receive $4.70 at that time.

How can you avoid volatility traps when starting out? You should buy in-the-money options. Chapter Two showed that in-the-money options are less risky. Remember that options are two-dimensional assets; you must correctly guess the direction and speed of the underlying stock. Shares of stock, on the other hand, are one-dimensional asset since you only need to determine if it is going to rise or fall. When stock traders become option traders they often buy at-the-money call options (since they are cheaper) as a substitute for the stock. Doing so subjects them to a two-dimensional asset when they are used to trading a one-dimensional asset, and that’s where the problems begin. When you are starting out, buy in-the-money calls with deltas in the 0.80 to 0.85 range and you will have an asset that behaves similar to the stock you’re used to trading. They will be more expensive but they are actually less risky. That’s a difficult concept to explain to new traders, but hopefully this chapter has convinced you that it’s true. You cannot beat the laws of probability when trading options but you can use those laws to put the odds on your side by selecting the right strategy and strike price. Understanding volatility is the key.

Key Concepts
1) Volatility can be considered a measure of how far a stock price typically drifts from its average.
2) Volatility is the key component to an option’s price.
3) Volatility is the only unknown variable for determining an option’s price.
4) The fair value of an option is the price at which you would break even over the long run if you were allowed to buy (sell) it many, many times at that price.
5) The price of an option is in no way related to its value. Very “cheap” options can be grossly overpriced and very “expensive” options can be a steal. It all depends on the volatility.
6) Volatility moves sideways over time.
7) To trade options successfully, you must take direction and volatility into account. If you wish to trade on option based on a directional outlook then use 0.80 to 0.85 deltas.

Chapter Six Questions

1) If a bet is fairly valued then that means that you are expected to:
a) Break even over the short run
b) Lose over the long run
c) Win over the long run
d) Break even over the long run

2) If you pay more than fair value then you are expected to:
a) Break even over the short run
b) Lose over the long run
c) Win over the long run
d) Break even over the long run

3) You run a Black-Scholes calculation and find that the theoretical price of the call option is $3.50. What does this mean?
a) If you pay $3.50 for similar calls hundreds of times you’ll just break even
b) If you pay $3.50 or less you will definitely make money
c) If you pay $3.50 or less you will definitely lose money
d) If you sell for $3.50 you will definitely make money

4) In order to successfully trade options you must be correct about the underlying stock’s direction and:
a) Earnings
b) Speed
c) Forward P/E ratios
d) Price to sales ratios

5) Over time, volatility tends to move:
a) Sideways
b) Up
c) Down
d) There is no discernable pattern

6) To find the true value of an option with the Black-Scholes Model, we need to know the:
a) Forecast volatility
b) Implied volatility
c) Future volatility
d) Historic volatility

7) If you are bullish and wish to trade options you should:
a) Buy calls
b) Sell puts
c) Sell calls
d) Either a or b depending on how quickly you think the stock will move

8) To reduce the “speed” component of an option, it is advisable to buy options:
a) With a delta around 0.80 to 0.85
b) With a delta near 0.50
c) With a delta near 0.25
d) With the lowest delta possible

9) Whether you feel an option is fairly valued or not depends on your:
a) Strike price
b) Time to expiration
c) Perception of the future volatility
d) Broker

10) If your call (put) option loses money even though the stock is rising (falling) quickly that is most likely due to:
a) Discrepancies in fair value
b) Arbitrageurs
c) Price manipulation
d) Falling volatility

11) If you buy a put and the stock falls, you:
a) Will at least break even
b) Will definitely lose money
c) May or may not make money
d) Will definitely make money

12) The fact that volatility measurements tend to move toward the long-term average is known as:
a) Mean reversion
b) Reverse conversion
c) Conversion
d) Put-call parity

13) The time premium on an option can be thought of as the:
a) Point-spread on a bet
b) Bid-ask spread
c) Fair value
d) Delta

14) A low priced option:
a) Is low risk since there’s little to lose
b) Is better to buy than a high-priced one
c) Puts the odds in your favor of making money
d) Is not necessarily a good value

15) How many factors are needed in the Black-Scholes Model to determine the fair value of an option (including dividends)?
a) 6
b) 5
c) 4
d) 3

16) What happens to the price of a call if interest rates rise assuming all other factors stay the same? Call prices will:
a) Rise
b) Fall
c) Stay the same
d) Cannot be determined

17) What happens to the price of a put if dividends rise assuming all other factors stay the same? Put prices will:
a) Rise
b) Fall
c) Stay the same
d) Cannot be determined

18) What happens to the price of calls and puts if volatility increases?
a) Call and put prices rise
b) Call and put prices fall
c) Call prices rise; put prices fall
d) Put prices rise; call prices fall

19) Increasing the time to expiration has what effect on call and put prices?
a) Prices Increase
b) Prices Decrease
c) Prices stay the same
d) Cannot be determined

20) One of the key differences between long and short options is that:
a) Long options need stock price movement to make money; short options do not
b) Long options do not need stock price movement to make money; short options do
c) There is no difference between the outlooks for long or short positions
d) Short calls need stock price movement but short puts do not

Answers will be presented next issue…

Jan

22

Options 101 #75

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How Option Prices Are Affected by the Model Factors
The Black-Scholes Model assumes we can fully determine the fair value of an option just by knowing the six factors that go into the model. Up to this point, we have touched on the way option prices behave based on changes in some of these factors. Despite the overlap, Table 6-26 lists all six Black-Scholes Model variables and shows how call and put prices respond to changes in these variables:

The most important thing you can learn from Table 6-26 is that option prices can move for reasons other than changes in the stock’s price. Let’s work through each of them just to be sure you have the concepts down.

Stock Price
Table 6-26 shows as the stock price increases, the price of a call will increase and the price of the put will decrease with all other factors constant. But after reading this chapter, you should know this is a theoretical statement and you should not be alarmed if your call option is not up even if the underlying stock is trading higher. The reason is that the other factors rarely stay constant. Even though the stock price rises, you could have a decrease in volatility. And if that decrease is big enough, the price of the call option will be down even though the stock is up.

Exercise (or Strike) Price
The exercise price is closely related to the stock price. In fact, they are really just two ways of looking at the same thing. When we were considering movements in the stock price above, we assumed the strike price (as well as all other factors) remained constant. Now, if we hold the stock price constant but change the strike price, we are effectively changing the relative value of the option. That is, we are making it more in-the-money or out-of-the-money. This is just another view of Pricing Principle #1 from Chapter Two. That principle stated that lower strike calls and higher strike puts must be more valuable with all other factors the same.

For example, if we lower the strike price of a call, effectively we are raising the stock price. We are moving the call option more in-the-money. Therefore, rising stock prices (or falling exercise prices) are beneficial for call option holders. Falling stock prices (or rising exercise prices) are good for put holders. Movements in the strike price are no different from movements in the stock’s price.

Interest Rates
How interest rates affect calls and puts are a little more difficult to understand. In Chapter Five, we showed that call options are a form of borrowing money by the following rearrangement of put-call parity:

C = S – Pv (E) + put

Once you look at this variation of put-call parity, it should be clear why call options increase with increases in the interest rate. Notice in the above equation the call price equals the stock price minus the present value of the exercise price. As interest rates rise, the present value of the exercise price falls and the right hand side of the equation gets bigger. That is, the price of call options increases. Although this is fairly easy to show mathematically, it is easier to remember if you understand it conceptually so let’s look at another line of reasoning.

Say interest rates are very high, perhaps 20%. You have $100,000 in the money-market that you would like to invest in stocks. You can either buy the stocks today or, for a fee, buy a call option which gives you control of the stock but allows you to defer payment. The choice should be easy; buy the call option so you can hang on to your money and continue to earn interest. Investors in the market follow this same line of reasoning and bid the calls higher as interest rates rise.

What about the puts? Puts give you the right to sell your stock, which represents a cash flow into the account, which is nice to have if interest rates are really high. So do you elect to buy puts to defer the sale? No, in fact, you may even sell the puts to generate cash into the account so it can earn the high rate of interest. The lack of put buyers (or the increase of put sellers) causes the price of puts to fall.

As with all the other factors, we must remember that these relationships assume that the other factors remain constant, which is rarely the case in the real world. So if interest rates rise suddenly, do not be surprised if your call options decrease in price rather than increase as we have said so far. This is due to the fact that stock prices fall when interest rates rise and falling stock prices correspond with falling call prices. But it should be evident that all factors did not stay the same in this case since we assumed interest rates rose and stock prices fell. However, if all factors remain constant and the only thing that changes is an interest rate hike, then we will see call prices rise and put prices fall.

Volatility
We have shown that increases in volatility cause increases in call and put prices. The reason had to do with the asymmetrical payoff structures of options. Because increased volatility can only help option prices then the market bids them higher.

Remember this is backwards from our normal view of risk. Riskier assets usually have their prices bid down, which is what we discovered in the Pricing Game in Chapter Two. But options are an exception to this principle since they have an asymmetrical payoff structure.

Time to Expiration
This factor is fairly straightforward. Pricing Principle #2 in Chapter Two stated the more time to expiration, the higher the prices of calls and puts. We said earlier an option could be viewed as a bet that the stock will be above the strike price (for calls) or below the strike price (for puts) by expiration. In other words, you are in effect betting the option will have intrinsic value. Because of this, the more time available, the more likely the stock will have intrinsic value.

Dividends
Last, we will consider the effect of dividends on calls and puts, which is fairly straightforward too. If a stock pays a dividend, the price of the stock is reduced by the amount of the dividend for the next trading session. The reason the price is reduced is because the company has paid out cash – one of its assets – so the company is now worth less than before it paid the dividend. If the stock price is down and all other factors stay the same, what will happen to the options? Call prices fall and put prices rise with all other factors the same.

Option prices can change for any of the six factors listed in the model, and this is what makes option trading more difficult to understand than stock trading. It is for this reason that you should be well aware of these six factors and how they affect option prices.

To be continued…..

Jan

21

Options 101 #74

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In order to make a successful trade, we must pick a strategy that properly aligns both beliefs – direction and volatility. Always remember that options are two-dimensional assets and we must be right on both counts. We must take into account our beliefs on the direction of the stock and the volatility of the options. In this case, our beliefs are:

• Direction = Bullish on the stock
• Volatility = Option volatility is too high (need to be the seller)

How can we create a bullish trade by selling an option? We need to sell puts. A long put is bearish since it makes money if the stock falls. A short put, being on the opposite side of the trade of a long put, is bullish. Most traders who are bullish are tempted to immediately reach for the long calls. It just seems to makes sense because of the unlimited gains afforded by long calls. If we were to buy calls, we could make unlimited gains but would be facing an unrealistically large point-spread.

A short put also makes money if the stock rises. But more important, short puts will also make money if the stock stands still. And there’s the big difference between long calls and short puts. A long call option needs the stock to move. But by selling puts, we can only make a limited gain; however, we do not need the stock to move. We don’t need to have the stock rise for us to make money; we just can’t have it fall. We have eliminated the speed component of the option.

So by selling a put, we are taking a bullish position and are not exposed to the large point spread. We have aligned both directional and volatility outlooks correctly. How would we have done if we had sold puts? Figure 6-23 is a reprint of the before and after quotes on AGIX (Figures 6-6 and 6-7) and you can see that we could have sold the $20 puts for $5.50 and bought them back for $3.90, which is a winning trade:

Notice that just because volatility was high, we cannot just arbitrarily sell calls or puts and necessarily make money. For example, if we had sold the $20 calls, Figure 6-23 shows we would have sold them for $4.40 and bought them back for $5.10 for a loss. Traders who sold these calls were correct for selling options because volatility was so high. However, they were wrong about the direction of the stock – the stock went up. And again, just because we believe the stock will rise, that doesn’t mean we can immediately jump to conclusions and buy calls. As we showed before, the traders that bought the $20 calls paid $4.80 and sold for $4.70. They were correct on the direction but wrong about the volatility. It is only the traders who were correct on direction and volatility who made the winning trade; it was the traders who sold puts.

Is the sale of the $20 puts the only winning trade in the Figure 6-23 matrix? No, the trader who bought the $15 calls could have paid $6.70 and sold them for $7.30. We could also have purchased the $17.50 calls for $5.60 and sold for $5.80. Why were the $15 and $17.50 calls profitable while the $20 call was not? Hopefully, you are starting to understand why. The $15 and $17.50 calls have less time premium in them because they are in-the-money. This means they have a smaller point-spread (breakeven point) and are not subjected to the “speed” component of the option like the at-the-money or out-of-the-money options. If you remember from Chapter Two, in-the-money options are less risky and now you clearly see why. They are not subjected to the volatility component in quite the same way as their riskier at-the-money or out-of-the-money counterparts and can make money even if volatility falls.

Regardless, please note the trade that produced the biggest profit was the one that made best use of direction and volatility – it was the sale of the $20 puts. The sale of any of the puts made money but not as much as the $20 puts since they had the highest time premium. Table 6-24 shows all of the long call and short put trades and their profits or losses:

Volatility is Relative
One of the most important concepts to learn as an option trader is that volatility is relative. If volatility is relative then so are option prices. This simply means you cannot look at an option that is priced low, say $5, and conclude that it must be a good value. In fact, we just found an example of one priced at $4.80 that was a horrible value – even though the price may appear to be relatively cheap. Conversely, we might find an option that is priced high, say $12, that turns out to be a steal. However, you will find countless people, including “professionals” who confuse these issues. For example, here is a sample of an email ad we received for an option training DVD:

You can see this professional got it wrong too. According to his “simple” rules, you only need to buy an option when it is undervalued and sell it when it is overvalued – just as you do for stocks. Let’s assume you run the Black-Scholes Model and find an option priced at $3 that is undervalued so you buy it. Later, it is trading for $1 but, according to the model, is overvalued so you sell it. You can see that paying $3 and selling for $1 is no way to make money even though you bought undervalued options and sold overvalued options. Undervalued and overvalued options are relative to your perceptions of future volatility. Value has nothing to do with “cheap” and “expensive” in absolute dollar terms.

Which Strike Should I Buy?
Table 6-24 shows that the in-the-money calls ($15 and $17.50 strikes) made profits while the $20 call did not. Once again, this is due to the fact the stock did not rise fast enough for the $20 call to make a profit. In other words, the time value on the $20 call was too high and therefore had more to decay with time. The in-the-money calls, however, had a much smaller time premium so were able to show a profit.

Even though in-the-money calls are less risky, that does not mean you shouldn’t buy the lowest strike call (or highest strike put) available. The reason is there may be many strikes with high deltas and we only need one that has a sufficiently high delta but not more. The goal is to find a good balance between intrinsic and time values.

As a general rule, if you are buying short-term options, say three months or less, you should look for options with deltas around the 0.80 to 0.85 level. In fact, this delta level is a good rule to always follow regardless of the time frame if you are using options as a stock substitute. However, if you are considering longer-term options, say up to a year, you may be able to get away with using slightly lower deltas. And if you are using options with more than a year’s time, you might decide to use an at-the-money option or even slightly out-of-the-money. The reason we mention these different levels is because investors invariably avoid in-the-money calls when they see the prices get expensive in terms of absolute dollars. It’s difficult for most traders to buy an option with a price of $20, $30, or higher even though it may be the right thing to do mathematically. So we’re not saying to never buy an at-the-money or out-of-the-money option. However, most traders stick with shorter-term options (usually because they’re cheaper) and buying deltas below 0.80 is often a huge mistake. For example, Table 6-25 shows option quotes for Dell Computer:

If we are bullish on Dell and want to buy a call option, we should look for one with a delta of around 0.80. This delta provides a nice balance between performance and price. For instance, we could buy the $27.50 call, which has a delta of 1.0, which is obviously equivalent to owning the stock (remember, long stock has a delta of one since it rises dollar-for-dollar with itself). However, that $27.50 comes with a price of $7.90 as shown by the last trade. We could therefore do better by purchasing the $30 strike because it also has a delta of 1.0 but only costs $6.40. If both calls provide a delta of 1.0, why pay the extra $1.50 for the $27.50 call? Remember, the key to finding the right strike is to find a good balance between delta and the cost so let’s keep looking at higher strikes.

The $32.50 call also has a delta of 1.0 and only costs $3.40. But the $35 call has a delta of 0.73 and costs $1.10; that’s the strike we want to trade. It has a sufficiently high delta (near the 0.80 mark we’re looking for) without paying the higher prices that come with the lower strikes. It will behave much like a long stock position yet cost a lot less and provide tremendous downside protection.

If your broker does not provide delta values there is a little trick you can use for times when you cannot look up the values on the other sites we mentioned. In Chapter Five, we said that the time value of the call (above the cost of carry) must equal the price of the put. If that’s true, then we can look at the put prices for one that is bidding a small amount, say 30 or 40 cents above the cost of carry and that should correspond to a sufficiently high delta for the corresponding call. If you are trading relatively short time periods, say three months or less, the cost-of-carry component will not be too great and you can just look for a put with a total value of 30 or 40 cents. In Figure 6-25, you can see that the $35 put was worth 40 cents and that is the same strike as the call we determined to buy by looking at deltas.

To be continued…..

Jan

20

Options 101 #73

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Time Decay?
Many traders believe the AGIX $20 call lost money simply because of time decay. In fact, most traders believe that any time you find an option whose value is less today than it was previously must be due to time decay (assuming the stock’s price is about the same). You must remember that there are two forces acting on the option’s price at all times – stock price and volatility. (Actually, there are other forces as shown in the Black-Scholes Model but they are relatively insignificant compared to these two.)

Find it hard to believe? Take a look at Figures 6-18, which shows the same set of eBay quotes taken seven days apart:

Notice the stock price is identical for both days. However, the asking price for the October $32.50 is higher on October 20 than on October 13! How can that happen? Even though seven days have passed, the perceived volatility of the future stock prices has increased. (You can see the stock was down $2.86 on the second day, which showed higher price changes than in recent history.) The amount of that volatility increase was more than enough to offset the loss from time decay. Remember, an option’s price can change for reasons other than time and stock price movements. But if you don’t understand the role of volatility, it’s easy to think that something is wrong with the quotes.

Let’s go back to our AGIX $20 call and see if time decay was the culprit in creating the loss. First, let’s define what we mean by time decay. Time decay means that time has been subtracted from the life of the option and therefore the option must be worth less money, assuming all other factors are the same. We can use the Black-Scholes Model to see if time decay was the culprit. Figure 6-19 shows that if we use 251% volatility then the price of the call is $4.80, which was the market price at the time we considered buying the $20 call:

The $20 call would not be in for a loss because the model shows us it would have been worth $5.71 and we paid $4.80. So the fact that time decayed by six days was not the culprit of the loss on the AGIX $20 call. You cannot just look at an option whose price is lower in the future and necessarily claim it’s due to time decay.

So if the $20 call should be worth $5.71, why was it bidding only $4.70? The only variable that we could possibly change is volatility. What is the volatility necessary to create a $4.70 bid price? Figure 6-22 shows that an implied volatility of about 200% (199.45%) creates a $4.70 call price. This shows the reason the $20 call lost money was not because of time decay but rather that the implied volatility fell from 251% to 200% in six days.

The Black-Scholes Model allowed us to see the volatilities the market was using to price the $20 call. Had we not used the model, all we’d have seen is the $4.80 call price and we’d have had to make our decision on which option to buy based on our belief about the direction of the stock. But as we’ve seen, there’s more to profiting on options than correctly guessing on the direction. We must also guess how quickly the stock will move. Had AGIX moved from $18.81 to $21.18 the next day, there’s no doubt the call would have been profitable. But it took six days to get there and that’s a different story. Although that may sound like a negligible amount of time, it’s a lot once you understand that the $4.80 price was extraordinarily high to begin with. And extraordinarily highly priced options have a lot of premium to decay. Their prices can fall rapidly with decreases in time and volatility.

Creating a Winning Trade
We’ve just demonstrated with a real-life example that option trading requires more than a directional belief about the underlying stock. In other words, just because you may be bullish does not mean buying calls is the right strategy to capitalize on that outlook. The reason is, as we previously learned, long option positions have a “point-spread” built into them in the form of a time premium. If that time premium is too high, we can lose on the option even though the stock price may rise.

In order to trade options successfully, you have to remember they are two-dimensional assets. If your only opinion is that you are bullish on the stock, you may be better off just buying the stock since it is a one-dimensional asset. But if you want to use options, having an opinion on the direction of the stock is certainly part of the puzzle but we also need to have an opinion on the volatility level. Using our football example, just because we may think the Patriots will win does not necessarily mean we should bet on them. We need to know what the point spread is before we take the bet. If we feel the point spread is too big, we would be better off betting against the Patriots even though we think they’ll win. In the same way, we cannot just believe that AGIX is moving higher and buy the call options until we understand the point spread facing us. That is, we must have an opinion on the volatility.

In this example, we were bullish on AGIX and, as we have discovered, it appears that volatility is too high. We believe volatility will be 55% over the next 30 days but the market is pricing the $20 call at 251%. In addition, volatility has never been remotely close to 251% in the past. Because we believe volatility is too high, the price must be too high (and the point spread is too big). That is, although we think the stock will rise, we’re not so sure it will rise past $18.81 + $4.80 = $23.61 at expiration. Remember, this is the “at expiration” breakeven point. You could certainly make money on this option even if the stock never reaches $23.61 – but the stock has got to move quickly.

Now, if the point spread is too high, do we want to be the buyer or seller of the bet? Obviously, we want to be the seller. In order to use options to make a bullish play on AGIX, in this example, we’ll need to be the seller of the option.

On the surface, many traders erroneously think that if the time premium is too high then we should simply sell options, whether calls or puts, but that’s not necessarily true. The options appear to be priced at astronomical volatility levels but it is possible there is good reason. Remember, there is some potentially powerful news circulating on the stock at this time. If we sell the call and the stock’s price jumps much higher, we could end up with devastating losses. So we don’t necessarily want to sell calls “just because” volatility is high. Also remember that selling calls is contrary to our directional outlook. In this example, we are bullish on AGIX but selling calls is a bearish strategy.

To be continued…..

Jan

19

Options 101 # 72

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It’s important to understand how to interpret this chart. Remember, this is not a price chart on AGIX; it’s a chart of the volatility. To create this chart, the computer takes the first 30 days, calculates the volatility number, and then plots that number as a single point on the chart. Next, it takes days 2 through 31, finds the volatility number, and then plots that number as a single point on the chart. This process continues for all 30-day groups in the data. When it’s done, all the dots are connected and you’re left with a fluctuating line as shown in Figure 6-14.

You can see the highest 30-day group had a volatility of about 70% and the lowest around 35%. The current level is about 55%. The million-dollar question now is which volatility should we expect over the next 30 days? In other words, which volatility should we use to determine the value of the AGIX $20 call?

Figure 6-14 shows us a yearly historic range but we need an estimate for the future – the next 30 days. Many traders use the current volatility level based on a simple theory the next 30 days should be about like the last 30 days. To understand this theory a little better, think of the weather. Our temperatures range from lows in the winter to highs in the summer. However, these temperatures are not random. We do not expect it to be 90 degrees and hot one day and then have snow on the ground the next. Instead, we observe that tomorrow’s weather is about the same as today’s. Weather changes slowly over time but any given small block of time has very similar temperatures. Using this theory, we should expect the next 30 days to have a volatility about like the last 30 days.

As Figure 6-14 shows, the current level is 55% and we may wish to use that as a future volatility estimate for the Black-Scholes Model. Although 55% is one estimate, it is not the only one we could use. Remember, volatility is the only true unknown in the Black-Scholes Model and now you see why – volatility does not stay constant. However, most option traders would agree the estimate you choose should be fairly representative of the average moves we observe in the chart.

Let’s assume we decide to use 55% for our volatility estimate and see what the Black-Scholes Model says about this $20 call option. We know the current stock price is $18.81, we’re interested in buying is the $20 strike, there are 29 days until expiration, and we’re using 55% as a future estimate of volatility. One of the nice features about the CBOEs Black-Scholes Model is that it will find the current risk-free interest rate based on T-bills with the same maturity as the option so this is not even a number you need to look up. At this time, the risk-free rate was 2.42%. Figure 6-15 shows the fair value of this call option is just over 70 cents:

As a reminder, this means if we were able to take this exact trade over and over hundreds of times, we would just break even by paying 70 cents – assuming our volatility assumption in the model is correct.

Despite the fact that we do not know what the future volatility will be, we do have reason to believe our estimate of 55% should be reasonably close to the truth. So now we have a benchmark for value just as we did with the Iraqi currency. The open market told us the currency was worth $680 while the asking price on eBay was $990 so we knew that was a price to avoid. In a similar way, we have good reason to believe that 70 cents is a reasonable price to pay for the $20 call but the market asking price is $4.80.

Clearly, there is a discrepancy between what we think the call is worth when compared to the market price. In other words, the price of the option appears to be far greater than the value to us. What is causing this discrepancy? There’s only one factor that we can change and that is volatility. Because the market must be using the same stock price, exercise price, time to expiration, dividends, and risk-free rate (at least reasonably close) this only means that the market’s volatility estimate is different from ours.

This is where an option pricing model, such as the Black-Scholes, can really help with trading. Our volatility estimate is different from the market’s estimate but how far off? If we had used 56% instead of 55% would we be closer in price? Or would we have to drastically increase it to, say 800%, in order to match the market’s estimate? This question is difficult to answer until you get a feel for how sensitive an option’s price is to changes in volatility. And that’s difficult to do since that depends on the time to expiration and strike price. That’s where a pricing model such as the Black-Scholes really helps.

We can find the volatility estimate the market is using in one of two ways. First, we could gradually increase the volatility number in Figure 6-15 from 55% until the call’s price equals $4.80 (we know to increase volatility since higher volatilities equate to higher option prices). Whatever volatility makes the price equal, $4.80 must be the one that the market is using to price the option.

Fortunately, there is an easier way. We can find out which volatility estimate the market is using by simply entering the $4.80 asking price into the “implied volatility” section in the lower right hand corner of the calculator, which is circled in Figure 6-16. (Make sure you also select the correct type of option from the drop-down menu. In this case, we need to select “call.”) After we hit the calculate bar below, the calculator shows the market is using a whopping volatility estimate of 251%!

Because the market is willing to pay $4.80, we mathematically backed into the volatility and found they are using 251% to value the option. As a check, you could type 251% into the “Volatility %” field on the left side of the calculator (where we previously typed 55%) and the call’s value would jump from 70 cents to $4.80. In other words, a volatility of 251% is required to make the option’s price equal to $4.80. It’s consequently called the implied volatility of the option since that is the volatility implied by the market just by the fact it is willing to pay $4.80 for the option.

Now, as option traders, we need to make a decision: Does this seem to be a reasonable estimate of volatility? After checking the volatility over the past year (or longer) we find it doesn’t seem to be in line with any of the volatilities we’ve seen in the past. Further, we know volatility reverts to the mean. This does not mean that it’s impossible to make money with this option but rather that the odds are stacked very much against us. It’s like paying $1.50 to make $1 at the flip of a coin. It is a trade we’re better off avoiding.

If you pay $4.80 for this option, you are probably overpaying. Sure, there’s a chance that the stock takes off like a rocket and you make money. After all, there is a tremendous amount of bullish news on the stock at this time. However, if you pay
$4.80, you are facing an enormous point-spread that is unlike any point spread we’ve ever seen in the stock. In our Super Bowl example, it would be like betting on the Patriots with a 30-point spread. Even if the volatility in the stock did rise to 251%, you can be reasonably certain that it will fall back to its average. If the volatility hits 251%, that’s like Mark McGwire hitting his 70th homerun; we should not expect it to maintain that level much less rise above it. Instead, we should expect it to fall. And if it falls, it will drag down the option’s price, which will cause you to lose even if the stock’s price rises.

That’s exactly what happened with the AGIX trade. Figure 6-17 shows the stock did rise from $18.81 to a high of more than $37, which certainly had a positive impact on the option’s price. However, during that same time, the volatility fell from a level of about 260% right back down to the long-run average of 55%, which is what we used to value the option. This fall in volatility had a negative impact on the option’s price. We ended up with a tug-of-war contest between the stock’s price rising and the volatility falling.

The falling volatility is what caused the loss on the AGIX $20 call even though the stock’s price went up. Remember, option prices (calls and puts) get cheaper as volatility falls.

It’s interesting to note the 30-day volatility did, in fact, rise to about 260% so the market was pretty good, in this instance, at guessing the future volatility. While it correctly guessed the volatility, it was not able to prevent the drastic mean reversion you see in Figure 6-17. (In Figure 6-17, we are using a 10-day moving average so you can see how quickly it fell since shorter-term volatilities are more sensitive to changes.)

The net result between these two forces was an overall loss at the time the quotes in Figure 6-7 were taken. Now, this does not mean the $20 call never became profitable. In this case, it did become profitable days later once the stock reached the higher price levels. The point we’re trying to make is that at the time the quotes in Figure 6-7 were taken, the stock price had risen but the option’s price had fallen. It’s the timing of the movements between stock price and volatility that determine whether or not the trade will be profitable. Unfortunately, that’s something we will never know until it’s time to exit the trade.

In this example, it’s also possible that AGIX may never have moved much higher than the $21.18 price in Figure 6-7 thus leaving the $20 call as an everlasting losing option. If AGIX never reached much higher than $21.18, the buyer of the $20 call would have paid $4.80 and never had a chance to sell it for a higher price. The decision to hold the option becomes a big dilemma for option traders. If you had purchased the $20 call for $4.80 and saw it trading for $4.70 with the stock significantly higher, would you continue to hold it? If so, every day you hold it with no movement in the stock leads to bigger losses due to time decay. Further, every day that volatility drops the losses are compounded. If the stock’s price doesn’t move, option traders have two potential forces that could drag down the price of their option – time decay and volatility. The decision to hold the option in hopes for profitability can become very costly.

To be continued…..

Jan

18

Options 101 #71

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When we value a football bet, there is no way to say for certain it is properly valued. It’s a question of the perceptions of the bettors. The casinos simply find out how many people wish to bet on each team and then create the necessary point-spread to balance the number of buyers.

Prior to 1973, this is exactly how the options market worked. Traders had to throw out bids and offers based on what they felt the trade was worth. Of course, this type of valuation means that traders tend to bid low and offer high, which creates very large bid-ask spreads. This makes the market very inefficient and never quite gets off the ground. Fortunately, that all changed in 1973 when Fisher Black and Myron Scholes created the Black-Scholes Option Pricing Model, which allows us to get a more scientific idea of what an option “bet” should be worth. It’s no surprise that this was the very year the Chicago Board Options Exchange (CBOE) was created since there was now an objective way to readily determine the fair price of a “bet” with an option.

As you get more advanced with your option trading, it is imperative that you use some type of option-pricing model. Option-pricing models allow traders to judge whether the price of an option reflects a good value. As we will show later, had we used the Black-Scholes Model, there would have been a big red flag flying above the $4.80 price of the $20 call option.

Let’s see how the Black-Scholes Model could have prevented us from taking this loss. We’ll rewind back to the beginning when we were looking at the AGIX $20 call for $4.80. Before we make this trade, we need to get a benchmark for value very much like we did for the eBay Iraqi currency. As traders or investors, we cannot just pay the asking price as if it’s the price of a lottery ticket. Lottery tickets have no point-spread to them. You either win or you lose (mostly lose). You cannot be correct on the numbers for a lottery game and still lose the bet. With options though, it’s different because the price we pay has a point- spread built into it and we need to understand what that spread is. In order to value this $20 call, we need to estimate the future volatility of the stock.

Volatility Moves Sideways
Before we show you how to estimate the future volatility, we need to take a short detour here and explain a very important characteristic about volatility. That is, volatility tends to move sideways over time. For example, Figure 6-10 shows an 18-year history of the Volatility Index, or VIX, which measures the volatility of the S&P 500 Index. Although the index has risen substantially over this time period, notice that the volatility chart just moves sideways.

This sideways characteristic of volatility is about the only constant in options trading and that’s why it’s so important to understand. When volatility rises, there’s a tendency for it to fall and vice versa. This shows that there is some long-term average that the volatility oscillates around. The tendency for volatility to fall toward the long-term average is called mean reversion. That is, volatility tends to revert to the mean (average). Mean reversion is nothing new and occurs in many types of events, not just options trading. In order to understand the mechanics of mean reversion let’s take a look at a well-known and rather intriguing mystery known as the Sports Illustrated Jinx.

The Sports Illustrated Jinx is a marvel well-known to professional athletes. The jinx states that if a professional athlete makes the cover of Sports Illustrated, they have just been jinxed and their performance is headed for a slump. There has been a very long (and quite convincing) history of this ever since Sports Illustrated was first published. The jinx became so commonly believed that in January 2002, Sports Illustrated wanted to publish a feature story about the jinx and asked St. Louis Rams quarterback Kurt Warner to pose on the front cover holding a black cat. But Warner refused so they shot the cover with the black cat by itself with the intriguing caption: “The Cover that No One Would Pose for. Is the SI Jinx for Real?”

Mathematician and author John Allen Paulos came up with a brilliant way to show that the Sports Illustrated Jinx is nothing but mean reversion at work and not an apparent slump as it appears. He suggests that the magazine choose the player with the worst record of the season and place his picture…on the back cover. Paulos is quite certain that you will see an increase in the player’s performance the following season. So whether you’re the best player on the front cover or the worst player on the back, we should expect both players’ averages to move toward the center. The bottom line is this: Any time an extreme event happens, whether good or bad, chances are that following events will be less extreme, not more.

Figure 6-10 shows that the VIX tends to bounce back and forth between 20% and 40% most of the time. When it moves significantly outside of this range, we should expect it to revert back to the average rather than to continue to rise or fall. That’s why the overall volatility trend moves sideways. We should not expect to see volatility rise month after month any more than we should expect Mark McGwire to continually outperform his record each season. Instead, we should expect extreme events to be followed by less extreme events.

Using Volatility
Now that you understand volatility, let’s see if there is a way we can use this sideways characteristic to gauge the value of an option. Let’s go back to the AGIX trade we discussed at the beginning of the chapter. Figure 6-6 showed us that the $20 call was priced at $4.80. But we also said that there can be significant differences between an option’s price and its value. How do we check the value? We must compare the current price with past volatilities. Before we buy this (or any) option, we need to check the past volatility of the underlying stock.
Most option brokers supply this information if you have an account with them. However, if they do not, you can find some basic information free of charge at www.ivolatility.com. Figure 6-13 shows what you will see on the front page:

If you type the option symbol in the box shown by the upper circle and then click on the chart in the lower circle, it will take you to the moving average of the volatility of that stock. As a general rule, you’ll want to match (at least closely) the volatility moving average to the expiration of the option. In this example, the AGIX $20 call had 29 days until expiration so we’d want to use a 30-day moving average, which is one of the standard time frames available from this website. Figure 6-14 shows the 30-day volatility moving average for AGIX over the previous year (9/16/2004 to 9/16/2004):

It’s important to understand how to interpret this chart. Remember, this is not a price chart on AGIX; it’s a chart of the volatility. To create this chart, the computer takes the first 30 days, calculates the volatility number, and then plots that number as a single point on the chart. Next, it takes days 2 through 31, finds the volatility number, and then plots that number as a single point on the chart. This process continues for all 30-day groups in the data. When it’s done, all the dots are connected and you’re left with a fluctuating line as shown in Figure 6-14.

You can see the highest 30-day group had a volatility of about 70% and the lowest around 35%. The current level is about 55%. The million-dollar question now is which volatility should we expect over the next 30 days? In other words, which volatility should we use to determine the value of the AGIX $20 call?

To be continued…..

Jan

15

Options 101 #70

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At the time of this auction, there were many similar auctions for this currency because of the radical changes taking place in Iraq. The country was getting lots of U.S. support to help its new government get under way. They also have the second-largest oil reserves in the world, so there is tremendous potential for their currency to rise against the dollar. If you buy a large block of its currency, you’d only need a small movement in the currency against the dollar and you could make a lot of money; at least, that’s the investment story the sellers of Iraqi currency are touting on eBay. Figure 6-8 shows this opportunity could have been yours for the low, low price of only $990.

We know the price is $990 but that really tells us nothing. Any asset can be priced too high no matter how good the story is that comes with it. The rarest works of art and most precious gems can be a horrible investment if too much is paid for them. As investors, we cannot just look at the $990 price tag on this eBay auction and think it is a good deal because of a good story. We need to somehow compare the price to the value.

That’s easy to figure out since there is an open market for currency. All we need to do is look at the exchange rate for Iraqi dinars and convert them to U.S. dollars. At the time of this auction (May 27, 2005), the exchange rate for U.S. dollars per Iraqi dinar was .00068, which means that one million Iraqi dinars were worth 1,000,000 * .00068 = $680. Now we have a benchmark for value since we know what the crowd is willing to pay. However, this auction dealer wants $990 for something that is worth $680 in the open market. Not only is this not a good deal but there’s a more insidious side to the trade than just being overpriced. If you pay $990 for the block of money and its value rises, you could still lose. For example, if the block of money rises from $680 to $900, it certainly went up substantially in value but you still lost money since you paid $990. This is exactly what happened with our AGIX $20 call. The price of the underlying stock rose, but our option was overpriced. The moral of the story is that if the price you pay is greater than the value, you can end up with a loss even if your directional outlook is correct. The legendary investor Warren Buffett said it beautifully: “Price is what you pay. Value is what you get.”

The price of an option is in no way related to its value.

Option Prices and Point Spreads
One of the best ways to understand option trading is to realize they can be viewed as a directional bet on the underlying stock. (This is not to say we are using options to bet on stocks. Instead, it’s a framework to help us understand what went wrong with the AGIX $20 call.) As with any bet, you put up some money in hopes of making a particular reward. There is some probability of winning along with a probability of losing. The amount you’re willing to wager on a bet can be thought of as the price of the bet. But, as we will show shortly, some prices reflect a good deal while others do not.

In order to better understand how some prices can be too high, imagine that it is 2004 and you are betting on the Super Bowl between the New England Patriots and Philadelphia Eagles. You do your homework and find that all of the analysts are predicting that New England will win. To the unwary, it sounds like betting is too easy; all you have to do is bet big on New England and you’ll make money. Unfortunately, you find that everybody wants to bet on New England and you cannot find anybody to take the other side of the bet. How can you entice someone to take the other side? There are several ways but one of the easiest is to offer a point spread. While nobody may be willing to bet on the Eagles in actual points (or “even up”), people will take the bet if you create a point spread. For instance, if you offer a seven-point spread on New England then anybody betting on that team must subtract seven points from the Patriots’ score before comparing it to the Eagles’ score in order to determine who wins the bet. If the Patriots win 21-14, there is exactly a seven-point spread and no money is won or lost. A bigger spread results in a win for the person betting on the Patriots while a smaller spread results in a win for the one betting on the Eagles.

If nobody accepts the bet with a seven-point spread, you can always increase it until you find a “buyer.” At some point, people will think the bet is fair and take the other side. Figure 6-9 shows the spreads at the Stardust and Mirage Casinos and you can see they were offering a seven-point spread, which is designated by the -7 under each of their names:

The spread acts as a way to even up the bet. It’s the way in which markets are created; otherwise everybody would bet on the favored team and there would be nobody left to take the other side of the bet. The spread is increased until we find an equal number of buyers and sellers. If the spread is too big, bettors will realize that they are better off betting against their team even though they think they will win. It’s only when the spread is just right that we end up with an equal amount of buyers and sellers on either side of the bet.

Figure 6-9 shows the final score was 24-21 in favor of New England. This means anybody who predicted New England would win betted correctly, but they still lost the bet. In other words, New England won but not by a big enough margin to win the bet.

Now let’s see how this football analogy relates to the options market. At the time the AGIX quotes were taken there were numerous articles about upcoming experiments for one of its drugs to reduce the amount of fatty plaque that causes clogged arteries. If the experiment is positive, the stock’s price could jump significantly.

Now think about this. If everybody believes that AGIX will rise, then everybody would want to buy call options (just as if everybody thinks the Patriots will win then everybody wants to bet on them). And if everybody wants to buy calls then there is a problem. Who is going to sell those calls? The answer is that nobody will. That is, nobody will sell them unless you offer a point spread on the “bet.” And that’s exactly what has happened with the AGIX $20 call.

Figure 6-6 showed that the $20 call was asking $4.80. In essence, anybody buying this call is really betting that the stock’s price will be above $20 + $4.80 = $24.80 by expiration since that’s the breakeven point on the option. The $4.80 time premium of the option acts in the same way a point-spread does for a football bet. It’s only because of this $4.80 “point-spread” that a market between buyers and sellers could be created. If the time premium was higher than $4.80, then the point spread would be too big and we’d have too many people wanting to sell the bet and the price would fall. If the premium is less than $4.80, then the point-spread is too small and traders would believe the $20 call is a good deal. We’ll end up with too many people wanting to buy the call and the price will rise. A price of exactly $4.80 is what is required to balance the number of buyers and sellers at that point in time.

Notice that, at expiration, if the stock rises from $18.81 to $24.80 or less, any trader who paid $4.80 for the $20 call loses the bet – even though the stock’s price rose. This is exactly what happened to those who bet on the Patriots with a seven-point spread. Even though they were betting on the correct team, they still lost the bet since they did not win by a big enough spread. And this is exactly what happened to the traders who bought the $20 call on September 16 and tried to sell it six days later. Although traders buying the call were correct on the direction, they accepted too big of a point-spread on the bet. In short, the price of the call was much higher than the value.

To be continued…..

Jan

14

Options 101 #69

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The only variable we’re not sure of is volatility and that’s why it’s the most important variable in the model. If it’s an unknown variable, then how did we look up volatility numbers for Google and McDonald’s earlier? When we looked those numbers up they were historic numbers; they had already occurred in the past. When the Black-Scholes Model asks for volatility, it really needs to know the future volatility of the stock and not the historic volatility.

To understand why, go back to our two-price stock model where the stock could move up or down $5. If this is how the stock has behaved in the past then we would value the $50 call at $2.50. However, suppose we have reason to believe the stock will now move up or down $10 in the future. Now the $50 call is worth $5 and not $2.50. It’s the future volatility of the stock that determines the price of an option and, unfortunately, that is something we will not know until expiration.

In order to truly know the value of an option we must know the future volatility of the underlying stock. And that is something that can never be known for sure until expiration.

Using the Black-Scholes Model
Let’s take a look at how to use a Black-Scholes Model. There are many available online, but one of the best can be found at the CBOEs website www.cboe.com:

Let’s assume we are looking at a stock trading for $50. We’d simply type “50” in the “Price” field on the left side of the calculator. If we wish to evaluate a $50 strike, we’d type 50 into the “Strike” field. We’ll also assume that there are 365 days to expiration and that interest rates are 2%, which we type into their respective fields. Last, we’re going to assume that the future volatility of the stock will be 17.62% over the course of the year (you’ll find out why this specific number was chosen shortly). What is the $50 call worth under these assumptions? All you have to do is click the “calculate” button in the middle of the screen and the call and put prices show up on the right by the “Option Value” field (circled).

It’s showing us the call should be $3.99 and the put should be worth $3. The reason 17.62% was chosen as the volatility is because that’s the volatility that makes the put worth exactly $3, which fits an example we worked by hand in Chapter Five. If you recall in that chapter, we were trying to figure out what a market maker should charge for a one-year, $50 call with the stock at $50. We also assumed he paid $3 for the put and interest rates were 2%. From put-call parity, we calculated that the market maker should charge $3.98 for the call, and the Black-Scholes Model in Figure 6-2 is coming up with $3.99. So we’re off by a penny, but that is due to differences in the interest compounding assumptions and number of days assumed in a year.

Although the Black-Scholes Model makes use of some very complex mathematics, the essence behind the calculations is similar to what we worked through when trying to figure out how much the market maker should charge for a call option.

Why do you suppose the call in Figure 6-5 is roughly $1 higher than the put? Hopefully you remember from put-call parity that it’s due to the cost-of-carry on the stock. If interest rates are 2%, it will cost $50 * .02 = $1 in lost interest to buy and hold the stock for one year. In other words, if you pay $50 for stock and hold it for a year, you could have had $51 at the end of the year if you had left the money in a risk-free account instead. So there is a $1 cost of carry on a $50 stock over a year if interest rates are 2%. That’s why the call is priced $1 higher than the put. The Black-Scholes Model is a complex form of put-call parity with volatility as the key ingredient.

Why You Need to Understand Volatility
This chapter is by no means meant to be a comprehensive lesson on volatility. However, most beginning option books do not even mention it, and that’s a huge disservice to new traders and investors. If you don’t understand the role of volatility, you can end up with unpleasant surprises as we will now demonstrate.

Many option traders believe option trading is a relatively easy task and that you buy calls when you think the stock is going up and buy puts when you think it’s going to fall. After all, that’s all that’s needed to trade stocks. When most traders make the switch to options, they apply this same directional procedure to the options market. However, this approach ignores the time value of calls and puts in terms of volatility and unexpected, almost paradoxical, losses can occur as the following real-life example shows.

On September 16, 2004, Atherogenix (AGIX) was trading for $18.81 as shown by the quotes in Figure 6-6. At the time, there was tremendous bullish news on the stock regarding a new heart medication. Most option traders who were bullish might have been tempted to buy the $20 call since it was the next-highest strike from the (then) current stock price. Figure 6-6 shows the $20 call (circled) would cost $4.80, or $480 per contract.

Direction Versus Speed
What happened? How did this call option lose money even though the stock’s price went up? Loosely speaking, the reason is because options are two-dimensional assets. That is, option traders must not only guess the direction of the stock correctly but they must also guess how quickly the stock’s price will get there – the speed.

Stock traders, on the other hand, only need to correctly guess the direction; they are dealing with a one-dimensional asset. It doesn’t matter how long it takes for the stock to move, just as long as it moves in the right direction.

As an analogy, you car moves in one dimension – horizontally. An airplane, on the other hand, can move in two-dimensions – horizontally and vertically. It is this second dimension that makes flying an airplane so much more difficult than driving a car. Just because you may have driven a car accident-free for 20 years does not mean you should just jump into an airplane and start flying. There is a second dimension you’re not used to dealing with. Likewise, just because you may have been trading stocks successfully for 20 years does not mean you should just jump into the options market and start trading options based on direction. That’s an equally bad idea.

In this example, the $20 call option trader got the stock direction right but not the speed; it took too long for the stock to get there. If the stock had moved to $21.18 in a shorter time, say a day or two (rather than six), the $20 call would certainly have made money. It is this second dimension of speed that makes options trading so much more difficult than stock trading. Notice that a stock trader would have made money by purchasing the stock for $18.81 and selling at $21.18. The speed at which the stock rises doesn’t matter. So while both traders guessed the stock direction correctly, only the stock trader made money.

This example shows that call options are not necessarily a direct substitute for stock. If you think a stock is moving higher, you cannot just buy a call in place of the stock and expect to make money if you are correct. Yet most option traders mistakenly apply this one-dimensional stock trading technique to options and, consequently, end up losing money. What is responsible for this speed component? It’s the time premium of the option. If the time premium is relatively high, then the breakeven price is pushed too high and the option may lose money even though the underlying stock moves favorably. In order to prevent that from happening, option traders must learn to separate the price of an option from the value.

To be continued…..

Jan

13

Options 101 #68

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We can even use computer simulation to see if we’re right. Figure 6-2 shows a computer model with the number of tosses on the horizontal axis and our total profit or loss on the vertical axis:

You can see that after 500 tosses, we’re about back at breakeven. However, prior to that, we can certainly end up winning or losing due to chance. But in the long run, we’d expect to just break even. The “zero” horizontal mark in Figure 6-2 acts like a magnet for a fairly valued bet in that the profit and loss line doesn’t get too far from it. The profit or loss line can stray from zero but it cannot just move away from it indefinitely. The profit and loss line just tends to oscillate around zero.

Let’s use this same formula to see what it says about paying $1.50 for the $1 reward:

(0.50) * +$1.00
+ (0.50) *-$1.50
Expected value = -25 cents

The formula shows that we are expected to lose 25 cents per flip. Paying $1.50 for this bet is therefore too high a price, since we would expect to end up with certain losses over time. Figure 6-3 shows that a computer simulation agrees with the formula:

In fact, mathematically, after 500 tosses we would expect to end up at 500 tosses * -.25 cents = -$100 and that’s roughly where the computer simulation ended. Curiously enough, notice that even though we’re paying above fair value it’s still possible for us to end up on the winning side in the short run. Figure 6-3 shows that we ended up on the winning side even after 100 flips. But that is just due to some short-term good luck on our side. We had significant winnings to cover our losses after 100 flips. But if we stay in the game long enough, the profit and loss line does not tend to get pulled toward zero. Instead, it moves into a definite downward path and never returns. Once again, this shows that $1.50 is too high of a price to bet on this coin flipping game.

Let’s see what the formula has to say about wagering 50 cents for the $1 reward:

(0.50) * +$1.00
+ (0.50) * -$0.50
Expected value = +25 cents

Wagering only 50 cents to win $1.00 at the flip of a coin is a good deal for us, as we now expect to win about 25 cents per flip. Figure 6-4 shows a computer simulation of this arrangement:

Again, we would expect to have 500 tosses * +25 cents = $100 profit after 500 flips and that’s about where this computer simulation ends. Notice too, however, the chart shows we actually lost money after 75 flips even though the odds were on our side. That’s because the profit and loss line dips below zero up until the 75th flip mark. At that point, we head into uninterrupted profits. This profit and loss line is not pulled toward zero in the long run. Although we could certainly lose in the short run, we will end up on the winning side after numerous flips, which is confirmed in Figure 6-4.

Only when the price of the bet is $1.00 can we say that it is “fair” for both parties. As a reminder, just because the bet is fair does not mean you cannot end up on the winning or losing side. The fair price for both just means that, over the long run, neither side is expected to end up on the winning or losing side.

Fair Value Depends on Perspective
In the coin toss example, we calculated that $1.00 was the fair value of the bet. However, that result is due to our assumption that the chance of winning (and losing) is 50%. Obviously, if we used different probabilities, we would get different results. This means the fair value of any bet depends on our perspective; it depends on our views of the probability of winning.

For example, let’s assume that somebody offers to wager $1.50 for this bet. There are two ways we could look at it. First, we could assume there is a 50% chance of winning and losing and assume that is too high of a price since it results in an expected loss of 25 cents per flip:

(0.50) * +$1.00
+ (0.50) * -$1.50
Expected value = -25 cents

However, we could also look at this bet another way. We could assume that it’s priced fairly since nobody should intentionally pay more than what they think is fair. If someone offers to pay $1.50, we could say that the gambler must think it is a fair price to pay. In order for that to be true, the gambler would have to think his chances of winning are 60% since that results in a fairly valued bet:

(0.60) * +$1.00
+ (0.40) *-$1.50
Expected value = 0

If a gambler were willing to pay $1.50 for this bet, we would say he is implying that his chances of winning are 60%. In other words, just by the fact he is willing to pay $1.50 for such a bet we can back into it mathematically and assume he believes his chances of winning are 60%; otherwise he would not bid so high.

This shows there are two ways of looking at any bet. First, if we believe there is only a 50% chance of winning then paying $1.50 is too high a price. Second, we can assume the $1.50 is a fair price and adjust the probabilities to make the expected value equal to zero. We can back into this figure algebraically and, in this case, we’d say the gambler willing to pay $1.50 for this bet is implying that there is a 60% chance of winning the $1.00 prize and a 40% chance of losing the $1.50 wager.

Now, as gamblers, it’s up to us to decide which viewpoint is more realistic. Should we assume the chances of winning are 50% and be willing to pay only $1.00? Or is 60% a better assessment? Notice that if we assume 50% is the better guess we will be outbid by another gambler if he feels 60% is the more realistic probability. We would only be willing to bid up to $1 for the bet while he would be willing to pay up to $1.50. It is critical that we are confident in our assessments. If 60% sounds like too high of a probability, we’re probably better off forgoing the bet and letting someone else make it. It’s better to miss out on some reward rather than lose our money.

Whether we should use 50%, 60% (or something else) to value this coin flip is an important question. It’s even more important when valuing options. However, few option traders ever check to see how the price of an option compares to their assessment of value. Failure to do so is the leading reason that option traders lose with options. In order to make that assessment, option traders need to use the Black-Scholes Model.

The Black-Scholes Option Pricing Model
We briefly mentioned the Black-Scholes Model in Chapter Five. There are many mathematical pricing models that can tell us what the price of an option “should be.” Naturally, there will be minor variations in the answers depending on the assumptions in the model. The most famous is the Black-Scholes Option Pricing Model named after Fischer Black and Myron Scholes. Its development was no small feat, as the model relies on complex mathematics and arbitrage pricing relationships to determine what the price of an option should be and is considered to be one of the biggest breakthroughs in the modern financial era. In fact, the 1997 Nobel Prize in Economics was awarded to Myron Scholes for its development (unfortunately, Fischer Black died in 1995 and the Nobel prize is not awarded posthumously).

According to the Black-Scholes Model, there are six factors needed to determine the price of a call and put option:

• Stock Price
• Exercise Price
• Risk-Free Interest Rate
• Time to Expiration
• Dividends
• Volatility

Notice the last factor, volatility. Of these six inputs, volatility is the most important for the fact that it’s the only true unknown factor. For example, assume the risk-free interest rate is 5% and hundreds of traders are trying to value a 30-day, $100 call option on a stock trading for $95. We’ll also assume the stock pays no dividends over the life of the option. Notice all of the factors are automatically determined except volatility:

• Stock Price = $95
• Exercise Price = $100
• Risk-Free Interest Rate = 5%
• Time to Expiration = 30 days
• Dividends = 0
• Volatility = ?

To be continued…..

Jan

12

Options 101 # 67

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A Simple Pricing Model
The size of the jumps – the volatility – in a stock’s price is the key to determining what an option is worth. In order to gain a better understanding of how volatility affects an options price, let’s make a very simple model and assume that a stock is trading for $50 and that it can only rise or fall by $5 at expiration with equal probability. (To make the calculations simple, we’ll assume there is no cost of carry; that is, interest rates are zero.)

This means that only two final prices are possible, $45 and $55. What is the $50 call option worth? We can figure that out intuitively. Half the time it will be worth $5 (the call has $5 intrinsic value) when the stock ends at $55, and half the time it would be worth nothing when it ends at $45 (the $50 call expires worthless).

Now let’s consider some prices to pay for the call. If you pay $5 for the $50 call then half the time you’ll break even and half the time you’ll lose $5. This means you can’t win but could certainly lose, so $5 is too much to pay for the call. What if you paid $1? In this case, you’d make a $4 profit half the time and lose $1 half the time, which means you’ll make money for sure over the long run. This price is certainly a good deal for you, but that also means you’ll likely get outbid by another trader so it will be too low a price in an actual market.

It turns out that $2.50 is the price you should be willing to pay. If you do, you’ll win $2.50 half the time and lose $2.50 half the time, thus breaking even in the long run. This is called the fair value of the option. The fair value of an option is the price at which you will neither gain nor lose over the long run. It’s very important to understand that when we talk about the fair value of an option, we’re talking about the price where you would break even if you were allowed to play this exact option hundreds and hundreds of times. In this example, if you were able to buy this call option over and over for $2.50 you would just break even after hundreds of trades. Obviously, in the real world, you get one shot at any particular option assuming all other variables constant. But we still must look at long-run averages to determine the fair price, or fair value, of an option.

We just stepped through an intuitive way of finding the fair value by picking call prices out of the air and seeing how our profit would perform in the long run. We can take a short cut and figure the fair value out mathematically by simply multiplying each probability by the payout and then adding them all together. In this example, half the time the option is worth $5 and half the time it is worth zero so:

(0.50 * $5) + (0.50 * 0) = + $2.50

In mathematical terms, this is called the expected value and shows what the call option is expected to be worth in the long run. If we are expected to make a profit of $2.50 per trade in the long run then it also means this should be the price where it should be trading in the open market.

Here’s why the market will end up pricing it at $2.50. Let’s say you bid $1 for it. You would make $1.50 profit per trade in the long run (if the option is worth $2.50 and you pay $1, you’d expect to make the difference as a profit). We can show this another way. Half the time the option is worth $5 at expiration, which nets a $4 profit since you paid $1. Half the time the option is worthless and you’d lose your dollar. Mathematically, your expected outcome in the long run is:

(0.50 * $4) + (0.50 * -1) = + $1.50

So one dollar is too low of a bid since it results in a positive expected value of $1.50 for the option. Sure, you could lose on this option no matter how low of a price you pay. However, if there is a positive expected value then the markets will bid the price higher.

Let’s assume another investor bids $2. We would expect him to make a long-run profit of 50 cents per trade, which again is the difference between the $2.50 expected value and the $2 price. Mathematically, we can show that the expected value is:

(0.50 * $3) + (0.50 * -2) = + $0.50

Once again, there is free money being left on the table over the long run, so other traders will compete for this call option in the open market. This action continues until we reach a price of $2.50. If the price is $2.50 then the expected value is:

(0.50 * $2.50) + (0.50 * -2.50) = $0

At a price of $2.50, the call has a long-run expected value of zero; in other words, it is expected to just break even. So if the price is below $2.50, traders will bid the price up. If the price gets above $2.50, traders will sell the option, which puts downward pressure on its price. The net effect is that the option will be trading for $2.50 in the open market.

We’ve just shown that if a stock is $50 and can only rise to $55 or fall to $45 then a $50 call is worth $2.50 (assuming zero interest rates). Remember that we’re trying to show that higher volatility equates to higher option prices. In this example, the $50 stock could either move up or down $5, which is a 10% move in either direction. Now let’s change the size of the jumps to 20%, or plus or minus $10 and see what happens to the option’s price:

(0.50 * $10) + (0.50 * 0) = + $5.00

If the $50 stock can now move to $40 or $60 at expiration then the $50 call is worth $5 for the same reasons we just covered. If traders bid less than $5, there will be a positive expected value. If they bid higher, a negative expected value occurs. Only when the option’s price is $5 do we get a long-run breakeven price on the option. The most important point to understand is that even though you could certainly lose on either option, the one with the 20% price jumps has more value than the one with 10% jumps. That is, higher volatility leads to higher option prices. Fair value and the concept of the “long run” are very important concepts for options traders so let’s go further into detail.

Fair Value: How Much is a Bet Worth?
Let’s say we are offered the chance to play the following game indefinitely: A coin is flipped and we win $1 if it lands “heads” but lose our bet amount if it lands “tails.” How much should we be willing to wager on this game? The value of any bet is determined by two things: 1) The reward and 2) The probability of winning that reward. As the reward or probability of winning increases, so does the value of the bet. In this problem, we know that the reward is one dollar, so all we need to determine is the probability of winning. This is a critical step in understanding option pricing so it is worth repeating: The first step in determining what we should pay for any bet is to determine the probability of winning.

We can figure this out in a way that’s similar to our simple two-step option pricing model. We know there is a 50% chance of winning $1 and a 50% chance of losing X-dollars. We also know that the expected value should be zero:

(0.50) * +$1.00
+ (0.50) * -$X
Expected value = $0

We can solve this for X and find that it equals $1. If we substitute $1 for X, the calculation is saying there is a 50% chance of winning $1.00, which means it has a value to us of 0.50 * +$1.00 = 50 cents. But we also have a 50% chance of losing $1.00, which has a value of 0.50 * -$1.00, which equals -50 cents. The positive and negative 50 cents cancel out and we’re expected to walk away with nothing after hundreds of flips.

The reason we have to solve for X when we didn’t do that for the two-step call option is because options must always be paid for. When we bet, as with the coin example, no money changes hands prior to the bet, and that changes the way we must calculate things. However, the principle of the expected value is exactly the same.

We can even use computer simulation to see if we’re right. Figure 6-2 shows a computer model with the number of tosses on the horizontal axis and our total profit or loss on the vertical axis:

To be continued…..

Jan

11

Options 101 # 66 Chapter Six An Introduction to Volatility

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In Chapter Two, we talked briefly about volatility and how it affects an option’s price. It was there we found out that the uncertainty of stock prices – the volatility – is what gives an option its value. The higher the volatility of the stock, the higher the option’s price. However, the definition alone is not enough to trade options successfully. New and experienced traders must understand the role it plays in determining the fair value of the option as well as how it is possible to lose with options even though the underlying stock moves in their favor.

The Frog and the Roo
To understand the role of volatility and option prices, imagine that you are at a carnival with a very unusual game – a frog jumping game. A frog starts in the middle of a floor and can only jump left or right. The frog moves randomly, jumping right or left with equal probability. At the end of one minute, the frog’s final destination is marked and you are paid $1 for every foot the frog is to the right of the starting point. If the frog happens to land anywhere to the left of the starting point, you win nothing:

How much would you pay to play this game? There is no right or wrong answer but think about it for a moment and pick a number that you think sounds reasonable. Now let’s change the mechanics of the game a bit. Imagine there is another game that is played with the same set of rules except this one uses a kangaroo:

How much would you pay to play this game now? As before, there is no right or wrong answer but think again for a moment and come up with your best estimate as to what this game is worth to you. It should be obvious that no matter which price you chose for the frog you should be willing to pay a higher price to have it replaced by a kangaroo. Why? Because the kangaroo has the ability to jump further, and that means you could win far more money, so the game is worth more to you. Notice that while both games offer potentially different rewards, neither has a mirror-image downside risk. In other words, you do not lose one dollar for every foot to the left of the starting point — once you place your bet that’s the most you can lose. So the only thing that matters to you is the upside potential. The game with the most upside is the one that is worth the most. It is the asymmetrical payoffs of these games that makes the kangaroo game more valuable.

In order to understand how volatility affects options prices, just replace the frog and kangaroo with at-the-money calls on two different stocks. One stock hardly moves like a big blue-chip stock such as General Electric (GE). The other bounces all over the board like Google (GOOG). Which call is more valuable to you? It’s the one that has the highest ability to move; in other words, it is the stock with the highest volatility. If you own a call option, you’re not as concerned with the downside risk as you are when holding a stock. If you own a stock, you can make dollar-for-dollar on the upside but also lose dollar-for-dollar on the downside. Put-call parity showed us that when you buy a call option, you are doing the same thing as someone who buys stock and buys a put option. In other words, call options provide downside protection so we are not concerned with the downside in the same way as when you own stock. Likewise, if you own a put option, you are doing the same thing as someone who shorts stock and also buys a call to protect them from the upside risk. Therefore, when you own an option, your maximum loss is limited. What determines the value of the call (or put) is the likeliness for the stock to make large moves – the volatility.

We can mathematically measure the volatility of a stock. The calculation is quite easy, although tedious, but is not really necessary to understand for our purposes. Just be aware that we can measure how far a stock price typically moves from its average. Volatility is typically measured in percents; the bigger the percentage, the more volatile the stock. A high-volatility stock is one that exhibits large price swings throughout the day or over time. Conversely, low-volatility stocks are those whose prices do not move much. The volatility range is not limited to 0 and 100 like many might suspect when dealing in percentages. Most stocks will probably fall in the 15% to 30% categories while 50% and higher would probably constitute a relatively-high-volatility stock. However, ranges can extend into the thousands during unusual circumstances.

One of the exercises in Chapter Two asked you to look up at-the-money quotes for Google and McDonald’s and see which is more expensive and then asked why. If you did that exercise, you found that the options on Google were far more expensive than for McDonald’s. From the brief discussion on volatility in that chapter, you should have realized that Google options are more expensive because the stock is more volatile. Now let’s see if we can gain a better understanding of what we meant. Take a look at Figure 6-1, which shows historic price charts for Google and McDonald’s over the same six-month time frame:
Think of the pictures as roller coasters. You can see the Google is a much “wilder ride” since there are bigger drops between the peaks and valleys. McDonald’s, on the other hand, had a relatively steady climb and doesn’t exhibit price swings like Google. Another way we can tell that Google is more volatile than McDonald’s over this time period is by the heights of the individual bars. The heights of those bars are determined by the high and low stock prices during the day. It is evident that the bars are much taller for Google than for McDonald’s, on average, and that means Google had much larger price swings during the day. So whether you look at the charts intraday or across time, Google had bigger price fluctuations than McDonald’s and that means we’d expect it to have a higher volatility number. Granted, these two charts are on different scales but they still give a good visual representation of the concept of volatility. If we were to look up actual volatility numbers during this time frame, we’d find that Google had 40% volatility while McDonald’s had 20%, which confirms what we just visually interpreted.

It’s important to understand that high volatility does not necessarily mean better performance. Higher volatility just means that there are larger price fluctuations over the time period; it says nothing about the performance of the stock. In fact, in Figure 6-1, you can see that Google had a low around $360 and a high of about $490 over the time period, or a 36% increase. McDonald’s had a low and high of $34 and $45 respectively, or 32%. So the performances are similar even though the volatilities are vastly different. The higher volatility for Google just means that the movements across the chart exhibited bigger “jumps” than were realized for McDonald’s.

In the same way, the kangaroo game is more volatile than the frog game. This simply means that the sizes of the jumps are much bigger for the kangaroo so there is more potential for upside gains. But this doesn’t necessarily mean that the kangaroo will always win. It is certainly possible for the frog to win. High volatility just means there are bigger fluctuations during the day and across time; it says nothing about performance.

A Simple Pricing Model
The size of the jumps – the volatility – in a stock’s price is the key to determining what an option is worth. In order to gain a better understanding of how volatility affects an options price, let’s make a very simple model and assume that a stock is trading for $50 and that it can only rise or fall by $5 at expiration with equal probability. (To make the calculations simple, we’ll assume there is no cost of carry; that is, interest rates are zero.)

This means that only two final prices are possible, $45 and $55. What is the $50 call option worth? We can figure that out intuitively. Half the time it will be worth $5 (the call has $5 intrinsic value) when the stock ends at $55, and half the time it would be worth nothing when it ends at $45 (the $50 call expires worthless).

Now let’s consider some prices to pay for the call. If you pay $5 for the $50 call then half the time you’ll break even and half the time you’ll lose $5. This means you can’t win but could certainly lose, so $5 is too much to pay for the call. What if you paid $1? In this case, you’d make a $4 profit half the time and lose $1 half the time, which means you’ll make money for sure over the long run. This price is certainly a good deal for you, but that also means you’ll likely get outbid by another trader so it will be too low a price in an actual market.

To be continued…..

Jan

8

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.

For more information about the fantastic world of stock options, contact Options University (www.optionsuniversity.com) for a listing of online courses, webinars and seminars.

Jan

7

The Importance of Keeping Score

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The basic premise of trading is that by cutting losses as quickly as possible and letting profits run will allow the trader to come out ahead over the long term. Having losing positions will happen, no matter how well they were set up. It’s a fact of life. A trader must constantly keep in mind that if the margin on losing trades is on average less than the average profit margins on successful trades the trader will help keep the perspective needed to go the distance.

When trading options, traders should be constantly aware of: 1) the percentage of profitable trades they expect to generate, as well as the profit margin of the average profitable trade compared to the average losing trade; 2) how many estimated trades will be made over a specific period. With these two statistics, an option trader can get a sense for the estimated profit potential for trading options over a period of time. This estimation can serve as an important, measurable goal and help to psychologically set expectations.

For example, let’s be conservative and say that 50% of your trades would be winners with an average net profit margin (profits less transaction costs) of 14% and losing trades to have an average net loss of 8%; the trader can expect a net return before taxes of 6% on 50 % of the total amount spent on total trades. If the trader anticipates making 5 trades per month at an average premium of $ 1,000, then the trader can expect to make about $150 net profit per month (2 winning trades =$2,500x.06= $150). Of course this depends on how long positions are held. Annually, this would translate into $1,800 on an account of let’s say $5,000 ( in this example, the trader would have an account of $5,000 but only use an average of &1,000 as a maximum for each trade). This translates into an annual return of 36% on the account capital. If you have a system with a 75% win-loss ratio, then your estimated monthly return would be $225 with an annual net of $2700 for a return of 54% on the account capital of $5000. The variables are: win-loss ratio, premium capital to be used, and profit and loss margins. (In the above example if you used $50,000 in premium capital and traded 10 contracts with the same other variables, profits would be 10 times greater or $27,000. But don’t quit your day job just yet.

Of course, the example is a simplification but the concept can be used to help set option trading goals to shoot for. Moreover, after each trade is completed, the trader should track the at least: win-loss ratio, profit and loss dollars and percent for each trade and cumulative trades. Creating benchmarks and using metrics to track variations on a trade-by-trade basis is essential to help the option trader measure the performance of the system; moreover, the trader must assess how closely trading parameters and procedures are followed for each trade.

The idea is to track the option trading system’s performance and not the trader’s. It’s like using a mathematical function; plug in the numbers and look for a consistent result. If the trader alters the parameters and procedures, we only measure the trader.

The idea is to identify high probability trades and use consistent option trading procedures. If the trader’s system is good, it will produce a win-loss ratio of over 50%. Some successful traders who have learned to identify high probability trades and execute a trade with consistent discipline have win-loss ratios above 70%.

Jan

6

Collar it

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“Put a collar on that damn thing!”, yelled my neighbor after my prized Pug escaped to ravage his in-heat mutt. He was right. The Pug had cost me over $1500 and the last thing I wanted was for Louie to run away. Put a collar on it. When you don’t want something to get away from you, put a collar on it. Take the situation of protecting unrealized profits on stock gains; you canput a collar on that, too .
Stock options are so flexible, I don’t know why an investor would want to trade anything else. Among other things, stock options work for up markets, down markets, sideways markets and for collaring profits. Yes, collaring profits. What does that mean?
A stock option trader who understands the multiple uses of stock options will use a “collar” to lock in accumulated gains from stock positions. A collar demonstrates that just one stock option position can do several things: make a profit even if the market doesn’t move up, can make money if the market moves down and can allow a trader to hedge for little or no cost. How does it work:
If an option trader has been holding an underlying stock that has accumulated gains and the trader is concerned about losing those unrealized gains (eg. the trader feels that the market will enter a correction phase or the company may experience some bad news), the option trader can establish a “collar”. This is done by opening a single position whereby the option trader will write an out-of – the-money covered call on the shares (each contract is 100 shares), and a simul-taneous long position in out-of-the-money puts. Both selling and buying are referred to as a combination having the same number of contracts and are established using the same expiration month.
The selling of the covered call provides a premium which will offset the cost of the long put postion and many times provide a credit. If the underlying stock goes down, losses in accumulated profits are largely offset by the long put position. If the stock goes up but does not go into the money, the position may provide additional profits on the premium and if the stock goes into the money and is called away, the stock option trader makes the additional profits over and above the original accumulated profits. Yes, if the stock is called away the stock option trader will lose the potential additional profits if the underlying stock were still held, but the collar is used when the feeling is that there is an iminent possiblilty of the stock losing value. The combination may be closed out as a unit just as it was established as a unit. To do this, the investor enters a combination order to buy a call with the same contract and sell a put with the same contract terms, paying a net debit or receiving a net cash credit as determined by current option prices in the marketplace.

Jan

5

The Big picture when Trading Stock Options

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You’ve done all the due diligence. You’ve checked the charts and studied the fundamental issues of the underlying stock. The March out of the money- option looks like a good time interval and strike price to move into the money and hit your target price. You feel that it looks like a good trade and you have three of your four technical indicators supporting your decision. You’re just waiting for the price to move through the 20 day simple moving average. As, you watch the price move up to touch the SMA line, you call your broker and place a market order for five March 50 strike price contracts along with a stop loss. You get a confirmation and you sit back to watch the action. Your heart is beating faster and you move closer to the screen. “Come on, babies, show me the money”, you murmur to yourself.

You’ve told yourself that keeping glued to the CRT is something you want to avoid but for some reason you get hypnotized by the promise of seeing the price move in your favor. Finally, the option price starts moving up slowly. You feel excitement and a sense of anticipation. You did exactly what your options trading system procedures called for and a surge of confidence brings a smile to your face. You decide to tear yourself away from the screen and go for a walk to enjoy the feeling and relieve the tension.

When you return to the computer, you gasp in horror as you see that the price has retraced and is nearing your stop loss. You quickly check the news and the charts for some indication of what’s happening. Nothing. As a matter of fact, you notice that the RSI (relative strength indicator) has moved down. Maybe this is the testing before it really takes off. “But what if I get stopped out before it makes the move back up?” you ask yourself. You quickly call your broker and ask him to move your stop loss lower to give your position some room to breathe.

Within several hours, the price of the underlying stock is starting to move up and you watch with hopeful anticipation for the options to follow suit. But as you watch in horror, the option prices not only blow past your original stop loss but also scoot right past your adjusted stop. Before the first day is over, yo’re out of the game and lost all the option premiums. You’re angry and confused. All the study and preparation for what? You should have listened to others and stayed away from options trading. No more options trading for you!

This scenario is too typical and is what separates successful traders from the majority of stock option trader “wannabees”. Listen, losing is part of trading. As a matter of fact, a trader who has a win-loss ratio over 60% is probably making good profits over the long term. The idea is that if you cut your losing trades quickly and without second guessing yourself, and let your winners run, you will do well.

The key to becoming a successful trader is being able to “stay in the game”.
Simply put, staying in the game is a matter of setting up a strict policy regarding the amount of trading capital allowed for each trade and religiously “punching out” when a stop loss is hit. Most successful traders limit their trading capital to about 5-8% of the trading account on any trade. If they draw down the account below 30%, most traders will stop trading and go back to redesigning their trading system or adjusting their heads. Simple rules to trade by, but most new traders don’t go into options trading with these sorts of constraints in place.

Losing is part of winning. Nobody wins ‘em all, and any trader with a win-loss ratio over chance (50%) is usually doing well because the average losing trades lose much less than the average winner gains. For example, if average losers have an 8% loss and the average winner gains 18%, multiply that average margin difference (in this case, 10%) by the number of contracts traded over time and that is what it’s all about. It’s not about hitting home runs, but hitting for average.

Jan

4

# 77 Iron Butterfly

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No, I’m not talking about the 1960’s psychedelic rock band. I’m talking about a modification of the popular option spread-the Butterfly.

The Iron Butterfly Spread belongs to the family of complex stock option spread strategies like the Condor Spread, Butterfly Spread and Iron Condor Spread. Each of them has their own strengths and weaknesses.

The Iron Butterfly is normally used when an option trader expects the price of the underlying asset to change very little over the life of the option. One way that the Iron Butterfly Spread differs from the Butterfly Spread is that the Iron Butterfly Spread initially results in a net credit whereas executing a Butterfly Spread results in a net debit. There is also a variation in the middle or body portion of the spread.

In the more common Butterfly spread, the body (situated at the mid-strike price) is normally either two sold calls or puts. In the case of an Iron Butterfly, the body is made up of one call and one put. This strategy helps to limits the amount of risk and reward for the option spread because of the offsetting long and short positions. If the price falls dramatically and the investor holds a short straddle at the center strike price, the position is protected because of the lower long put option. Conversely, when the price of the stock rises, the investor is protected by the upper long call option.

In effect, the Iron Butterfly Spread actually consists of a Bear Call Spread (purchase an At-The-Money or Out-of-The-Money call option and simultaneously writing (selling) an In-The-Money or At-The-Money call option on the same underlying and same expiration month.) and a Bull Put Spread.

Iron Butterfly:
Buy OTM Put + Sell ATM Call + Sell ATM Put+ Buy OTM Call

Current IBM: $104
B/S C/P SP Premium $
B (1) P 100 .50 ($50)
S (1) C 105 3.35 $435
S(1) P 105 3.10 $310
B (1) C 110 .50 ($50)
Credit $645

Iron Butterfly Math
Breakeven:
Lower : Short Put Strike – Net Credit = $105 – $4.45 = $100.55
Upper: Short Call Strike + Net Credit = $105 + $4.45= $109.45

Maximum Risk: Difference in strikes-Net Credit= $5-$4.45= .55 or $55
Maximum Profit: If IBM price expires at 105= $445
Estimated Commissions $20
Net before tax= $425
Less cap gains Taxes: $ 148.75
Net after tax: $276.25
Max Return: Net Credit ÷ Maximum risk= $276.25/$55= approx 500%

Keep in mind that maximum profit happens if at expiration the price of the stock is ATM for the middle strike price.

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