Dec
31
If you want to make money as a trader, you need movement and you need it now. The more the merrier. Most people associate volatility with their high school football coach. Others view it as something to be avoided. And a few-mainly option and commodity traders- see volatility as opportunity.
Volatility is the measure of variance around the mean price. If a stock has low volatility, its band of price movement is limited. On the other hand, a stock with a wide band of price movement is considered volatile. Most investors want to have the value of their investments increase over time. But traders want price to move rapidly and with variation. If a trader can predict the proper direction of movement within a certain time frame, they can make many trades with small profits which will compound over time. Traders want movement and they want it now! To do that, they need investment vehicles with volatility and options can certainly fill the bill.
Types of volatility
There are two types of volatility: implied and historical.
Implied volatility is what the market expects for a stock’s price movement. If implied volatility is high, the market expects the stock price movement to be choppy. Of course, low implied volatility suggests smoother stock price movements within a limited price range.
Implied volatility is, indeed, the same as option value. However, implied volatility can be different for different positions on the same stock. Typically, when volatility on a stock is on the rise, the market is focusing on the stock and something out of the ordinary is happening. If a stock is breaking out, and is not accompanied by volatility, the breakout will probably not be sustained. If volatility builds up along with other technical indicators, a break-out can be significant.
Historical volatility measures the stock price changes in the market and translates this into a statistical measure of variance. We won’t concern ourselves with the math but the result is presented as an annualized percentage. This percentage provides an idea of how far the stock price can vary from its average price. For instance, if a stock has an average price of $40 with a volatility of 50% this means that price could vary between $20 and $60.
An option price is affected by several components: the strike price, days to expiration, current stock price, dividends paid (within the option period), interest rates and implied volatility. Each stock has many options and each will be different mainly due to implied volatility. In general, out-of-the- money (OTM) options have a higher implied volatility because of more risk than at or in-the-money options. Moreover, puts and calls for the same period usually doesn’t have the same implied volatility.
A good option trading strategy using volatility
Covered Call writing is when an owner of the underlying stock sells (writes) an out of the money call. This is a popular strategy and is considered a conservative option trade. According to Ravi Kant Jain in his article “Putting volatility to Work”, a trader should start with a mildly bullish stock. If a trader picks a very bullish stock, it could be akin to shooting oneself in the foot as the trader will lose the potential gains of owning the stock unencumbered by having it called away if n option is exercised. Historical volatility is the next thing to consider. If the historical volatility is high, this demonstrates that the stock moves a lot. That’s good. This means that the stock has a good chance of moving below the strike price as well as above it. Jain recommends that the best candidate is a stock with the biggest difference between implied (option premium) and historical volatility.
Dec
30
Anything that still produces excellent investment results after 400 years must have something to it. Four hundred years ago, Japanese rice traders developed a system to track trading sentiment. Call it the first technical trading system in history. The theory is that as sentiment goes, so goes prices. If market feels that demand for a stock, rice, option, etc, is strong, it will be demonstrated in how price moves over a period of time. If price and buying patterns change, sentiment can also be changing. For example, if a stock price opens at one price and closes at a higher price without going below the opening price for the whole day, demand is strong (Fig 1). If price opens and spikes up but ends the day lower than at the opening, demand may be waning (Fig. 2). If the stock opens then spikes up, spikes down and closes at the opening price, it indicates total confusion as bulls and bears are indecisive. This usually signals a trend reversal (Fig.3). Candlestick figures which show opening, high and low and closing are called Japanese Candlesticks. The color makes it easy to see if a stock is moving up or down. Usually, “up” is green (or clear) and “down” is red (or black). Over the centuries, distinctive patterns have demonstrated a high degree of success in predicting a change in sentiment and resulting price direction.
Fig. 1 Increasing value candlestick Fig 2. Decreasing value
There are over fifty candlestick patters but about thirteen are most common to traders. Most option traders use a candlestick as a primary indicator which points out potential opportunities. Further analysis needs to be done to confirm the sentiment indicator of the candlestick. For example, if a Doji is spotted, the trader will then focus on the stock and do further analysis in accordance with the particular trading system.
The example below demonstrates how one trading system can be employed to confirm a Doji candlestick pattern.
Fig. 4
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Once the Doji appears, further analysis depends on the system. In this case, the trader would look at RSI (relative strength indicator) to see if the stock is over sold or over bought. In this case, the RSI shows the stock in an oversold situation. The trader than checks the 20 day simple moving average (green line). It shows the prices moving back up toward the sma. Next, the trader might want to check to see if the current price levels are abnormal for the stock. One does this by using Bollinger Bands, (upper and lower orange bands. |
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TheBlack line is the median. The prices are well outside the boundry lines. Every indicator in this system seems to confirm the reversal that the Doji indicated. Analysis, fundamentals on issues should be checked to make sure there are no company or industry issues. |
Candlesticks make a good preliminary indicator for a possible option trade but it should be backed up with other indicators and at least three out of four indicators should technically confirm the venerable candlestick. The Doji is only one of many useful candlestick patterns and a trader is well advised to learn about them. Four hundred years speaks volumes.
Dec
29
It’s not surprising. It used to be all the talk amongst the financial egghead group. But now, the dawdling masses are catching on. Not many stock or option investors know about the investment theory that won a Nobel Prize in 1991. Nor do they know about a landmark study that showed that over 90% of the returns on an investment portfolio comes from how- not what- you own in your portfolio.
That’s right. Not the hot picks, top rated or whatever system stock picker gurus use. While most “lay” stock and option investors watch the flash- bang of Wall Street marketing, the buttoned down mathematicians and portfolio managers quietly put the new theory to use. There’s probably a good reason why most investors don’t know about this remarkable study and the importance of Modern Portfolio Theory (MPT). You see, there is a huge industry dedicated to telling you how to invest and what to buy.
MPT is a major tool for professional investment managers and this fact might also be another factor that keeps it mostly invisible to the average retail customer. Up until recently, the sophisticated Nobel Prize winning strategy needed somebody with an MBA or PHD to implement the strategy. But now the tools needed are accessible and easy to use for almost any non-egghead stock or options investor.
Modern Portfolio Theory for dummies
In a nut shell, MPT says that to minimize investment risk and optimize portfolio returns, close attention needs to be paid to the proper balance of asset classes within a portfolio. This is not to be confused with asset diversification. Asset class means types of investments with varying correlations. For example, you don’t want too many investments that move together in sync. That’s O.K when the market is going up and positions are long. But if things turn dicey, closely correlated investments all go down together; eggs in the same basket sort of thing. Investment asset diversification only pretends to give that sort of protection. Having different asset classes with varying correlations in a portfolio does. The important thing is that varying correlation promotes lower overall risk which helps allows an investor to add some kick to the portfolio and boost total returns.
More kick in your portfolio
Listen to this: a study done by the Chicago Mercantile Exchange demonstrated that a portfolio with as much as 20% of investment assets in futures and options yielded up to 50% more than a portfolio limited to low and moderate risk investments.
Options are perfect for the 10-20% of a portfolio balanced for risk reduction. Options offer high leverage so the 10-20% of a portfolio can represent a much larger percentage of assets held. For example, if you have a portfolio with $200,000 in assets, if 10% of the portfolio is in options, the $20,000 alone could provide up to an additional $200,000 or more in rights to stock assets on top of the value of the balance of the portfolio. In this case, 90% of the portfolio would be invested in stocks, bonds and mutual funds and $200,000 in rights to stock through options for a total of $380,000 from which to obtain returns.
Used together with Modern Portfolio Theory, using the flexibility and leverage of options makes for a potent strategy. Consider the important fact that even a slight increase in portfolio returns can make a big difference over time. More investors should take a look at ways to optimize return and reduce risk. MPT and options is a strategy worth investigating.
Dec
28
Do the numbers tell it all? When you read something about a company, do you really believe it? How do you make a decision about what makes a good investment opportunity? For most traders, technical analysis takes center stage and some times the fundamentals are pushed to the back or forgotten all together. But there are some important fundamental factors that an option trader should always keep in mind.
1) Every trader or investor should know what is happening within the company and the industry to confirm why the stock or option is behaving as it is or if there are any possible events which could affect the stock or option price. Going to the company website and contacting the Investor Relations department is a good idea before entering into a trade. Its a little time consuming but this step may save you from any surprises and help to confirm your analysis. Of course, consider the source.
2) Investors and traders need to know when a target company comes out with financials such as earnings estimates, quarterly and annual reports and files SEC documents. The SEC regulations are designed to provide investors and traders with transparency. However, if a trader or investor isn’t aware of SEC filings by a company, the trader-investor may overlook important information that is revealed in the required documents. A company could say “it was there for the entire world to see”. It’s caveat emptor, baby.
3) Option traders should be aware of “Triple Witching” dates. This scary sounding day is indeed something to avoid and it happens on every third Friday of expiration months. “Quadruple Witching” day happens when several types of options and other derivatives expire on the same day. This happens on the third Friday in March, June, September and December. Triple or quadruple witching days see volumes and volatility increase, which is largely due to investors “rolling” existing options positions to new expiration months and exercising option contract rights. With the advent of single stock futures (SSF) and improved technology, many feel that the Triple and Quadruple Witching days are no longer quite the chaos they were in the past. However, it’s a good idea for the options trader to be aware of when the witches come out to play.
4) Decide if the stock and its options are overpriced. Look at the last 12 months price range for the stocks and see what the options have been doing in various expiration months. If the price is currently near the top end, consider buying on pullbacks.
5) Check the volatility of the stock. If it is above normal for the stock, there could be some information out there that’s not readily apparent.
6) Check and see if insiders are buying or selling the company stock or exercising or selling options.
7) Review the Annual Report called the 10K or Quarterly Report (10Q) and particularly to the section usually titled “ Management Discussion and Analysis” (usually in the front of the report). This will give a good synopsis of what the company management team feels about the state of the company and what future prospects are.
Check the company Income Statement and Balance sheets. The Income Statement (also called the Operating Statement) shows the profitability and expenses of the company operations and the Balance Sheet shows the financial strength of the company. If you don’t know how to read financial statements, there are plenty of free sources to teach you.
9) Check out the competition in the Industry. How does the target company compare to its competitors? How does the company Price-Earnings ratio compare with that of the industry. The same holds for EBIT (Earnings before Interest and Taxies) profit percentage.
These suggestions should be part of an option trader trading due diligence and incorporated into a checklist from to be checked-off before entering into any trade. Trading strictly on the technicals could miss factors not fully discounted into price. Do both Technical and Fundamental analysis and then make your opinion.
Dec
27
“Oh, my God, the sky is falling in! It could mean the end of the United States as we know it. The strong U.S. dollar-representative of the strongest economy on earth-is crumbling and with it the future”. The alarmists and conspiracy theorists are jumping for joy. “We told you so. And yes, we’re smarter that the lot of you,” they say under their collective breath. Pure, unadulterated hogwash.
The “chicken little” run for the hills thinking offers investors a real opportunity. You see, the U.S. dollar is just making the long sought after correction needed to make U.S. exports much more competitive. From 1995 to 2002, the U.S dollar rose over 35% in relation to other floating currencies, namely the Euro and Canadian dollar. Since 2003, the U.S. dollar has fallen back 35% from what most economists felt was an overvalued U.S. dollar.
While there are problems with the U.S. Federal Budget Deficit and trade deficits, they pose not imminent crisis. No doubt better fiscal policies need to be enacted in Washington but the real pain in a falling dollar lies with our trading partners who hold huge reserve of U.S. dollars. They don’t want to see a large devaluation and they don’t want the dollar to become too competitive either. That’s the real truth. And that is the reason that our trading partners will keep buying U.S. treasuries while more responsible heads try to sober-up the drunken sailor. So, shun the panic and look for the opportunities.
Most of the U.S trading partners in Asia and Latin America have more or less pegged their currencies to the U.S dollar. This means that most of the current devaluation is not exported as price increases to the U.S. As a matter of fact, export opportunities for the U.S. are increasing with each down tick of the dollar against the “floating currency countries”-more specifically Europe. Stocks of U.S. companies who produce and export things such as transportation equipment, computer and electrical products, chemicals and industrial machinery will greatly benefit from a falling dollar. These in-dustries provide 70%-80% of U.S. exports to Europe and Canada. These same industries provide 68% of U.S. exports to China who has recently revalued their currency. As U.S. exports go up, profits go up, employment goes up and tax revenue to help balance the federal deficit go up. On the other hand, in exchange for the benefits of a lower dollar, U.S. travelers going abroad-particularly to Europe and Japan- will find it more expensive overseas. Sounds like a good trade-off.
A good strategy for stock option traders would be to locate solid U.S. ex-porters in the industrial sectors mentioned and consider buying long term out-of-the-money call options or bullish spreads. To many “in the know”, a weaker dollar-even though it sounds bad-is mostly a good thing. The only danger is if trading partners and foreign investors lose confidence in the dollar and flood the currency market with a tidal wave of dollars which could have a disastrous effect but not only the U.S would be hurt but also the World as foreign dollar reserves plunge in value. Moreover, the U.S. dollar is the world’s trading currency. To replace it would require much more crisis management and political investment that it would cause tremendous disruptions. To let the dollar crash would be a foolish mistake.
Traders love it when panic and emotion cloud the thinking of the market place and create real opportunities. Trust in the basic fact that most investors will do what is best for them when they understand what they must do to protect their own interests. This means that there won’t be a run on the dollar. When other investors wake up and act logically and without fear, the window of maximum opportunity usually has already slammed shut.
Dec
26
When you first realize it hits like a ton of bricks. So simple yet so true. About 80% of stocks follow the trend. We all know the “the trend is our friend”. Can you smell a contrarian in the wood pile? Well, if 80% of stocks move with the trend that must mean that only about 20% of stocks or options will move against the trend on a normal day. There must be a way to use those favorable odds. And with options, there is.
An option trader can take advantage of this knowledge and use it to make a profit against the market trend. The trader can write (sell) an out-of-the-money put. This is also called a “naked put” because the writer does not own the underlying stock (it doesn’t mean the option must have been written in a state of undress). If the price of the stock goes up-as is expected-the trader who writes (sells) a put will keeps the writing premium just as long as the price does not go down below the strike price and into-the-money. Given that 80% of stocks move with the trend, the probability of the stock moving against the trend and the writer can be very small. However, to make this sort of trade, the trader needs to have a good understanding of what the short and long term trends are and if there is any possible news (earnings reports, adverse news, etc) that might send the stock reeling backward. This is one of the more risky strategies because if the put goes in-the-money and the option is called, the writer must purchase the underlying stock to place with the option buyer.
A much safer way for an option trader to make money going against the trend is to write a covered call. If the underlying stock is owned by the trader (thus, the put is “covered” in case it is called away), the option call writer is hoping that some other trader believes that the underlying stock will go up in value as will the derivative option. But if the owner knows his stock very well and believes that its usually docile behavior will keep it away from reaching a certain strike price, the call writer will make money when the option expires if it doesn’t get into-the-money and get called away. For example, if the long term trend is up but the shorter term trend is in a correction phase, the trader can write the covered call with an expiration date that will fall within a time frame that should see the correction move back toward the long term trend. Using the promise of a substantial move upwards into the money, the call writer hopes to lure in a trader who doesn’t understand the stock as well as he. Once the option expires, the call writer keeps the premium and if things still look good, (not much upside movement) he prepares to do it again, and again and again. Given that there are option expiration dates for almost every month, the return can be quite impressive over the long term. If a covered call writer is unlucky and his stock gets called away, well he gets to keep the profits and the premium. The only thing he might lose is the opportunity cost of a large move in the underlying stock.
Dec
24
When you learn about options-really learn- you’ll understand why they have become so popular. Don’t let the word derivative scare you. Read on and find out whey options are the way to go. Most importantly, options provide investors with the flexibility to choose from a wide range of strategies. In this short article, we’ll discuss some of the more basic and easy to understand ways to employ stock options.
Long Call
The most basic and easiest to understand is the long call. This is when an option is purchased with the idea that within a certain period of time the value of the option will increase and profits can be made with a much smaller investment than would be needed to purchase the underlying stock. For example, if the underlying stock is currently trading at $30 and you expect the stock to go up to $40, a trader can purchase long call options with a strike price of $ 31 that would expire in some future month. If the option moves past the strike price ($31) the stock option owner can either exercise the option and acquire the underlying stock or hold the option and take advantage of the option premium appreciation.
Long Put
Traders who believe that the future price of a stock may go down in value within a certain period of time can buy the right to sell the stock at a certain price. As in all options, the option holder has the right to sell the stock but not the obligation.
If the market price goes down as anticipated within the time period of the option the premium price will increase and the trader can profit from the difference of the purchase premium and the current premium price. If the price does not increase, the trader can let the contract expire or sell it to someone else.
Short Call ( aka “ Naked call)
When a trader sells (writes) an option, he can either own the underlying stock- which case it is called “covered” writing and or in the case of a “naked” writer, an option is written without actually owning the stock. In the case of writing a naked call, if the market price of the underlying stock decreases, the short call writer will profit by the amount of premium change. If the price of the under lying stock increases, above the strike price of the option contract then the short call will suffer a loss. The short call writer is betting that the stock will not go up. If the short call is exercised then the writer is obligated to buy the underlying stock and honor the option contract specifications. This is perhaps one of the riskiest strategies because of the potential of having to purchase the stock in the open market and then transfer the stock to the short call option holder.
Short Put
If a trader believes that the future price of a stock will increase, they can sell (write) the right to sell the stock at a certain price. If the stock price goes up, the short put position makes a profit on the premium. Conversely, if the price goes down below the strike price, the put writer (same thing as short put) loses money.
To summarize, to be long is to purchase a call or a put. To be short is to sell (or write) a call of put believing that the price will not move in the direction of the call or put. Shorting is a contrarian strategy with a high probability of being correct if going against the prevailing trend as 70% to 80% of stocks move in sync with the strong underlying market trend.
Dec
23
You can’t believe it’s happening. The stock is starting to move up but the option premium is falling. That’s not supposed to happen, or is it? Stock options are quirky when it comes to time left in the option period. It’s really different than investing in stocks. One of the vital concepts that stock option traders learn about and need to understand is the time value of an option. They learn that as an option contract approaches its expiration date, it loses value because there is less time for the option to move as forecast. The Chicago Mercantile Exchange once did a study that demonstrated that over 80% of all options expire worthless. Does that mean that 80% of option traders lose money? Not really; and in certain cases, expired options are far from worthless. To an option seller, expiring options are all about profits. An option seller under-stands how to make a profit with stock options- even if the market doesn’t move!
When buying an option, the time value works against the buyer as the chart below depicts. The closer to expiration, the more the time value of an option decays until reaching zero at expiration.
The premium value of an option is composed of intrinsic value and time value. Intrinsic value is the in-the-money portion of the option premium. For example, if you buy a call stock option at a strike price of $25 with the underlying stock’s market price at $35, then the intrinsic value of the call option is $10 (in-the-money). If the option contract premium is $12 per share, the additional price component ($2) is the time value-the more time left before expiration date, the higher the time value.
An option seller (also known as the “writer”) wants the option he/she has sold to expire worthless so the premium paid to the writer for the option can be kept. In-the-money or out-of-the money options can be written. If a writer of an option already owns the underlying stock, this strategy is called writing a “covered option”. If the writer doesn’t own the underlying stock, the strategy is called writing a “naked option”. Using this strategy debunks the idea that expiring options are worthless. In fact, option writing is an excellent strategy when you believe the underlying stock is going to move in one direction (or not at all) and you write an option for potential movement in a contrary direction. It’s important to understand that 70% to 80% of stocks move with the trend. For example, if you are bullish, you would sell (write) an out-of- the-money put option. As long as the underlying stock doesn’t go down and into-the-money (hits its strike price) before expiration, you keep the premium paid for the put option. The risk of writing the covered position is having the stock called away if it is in-the-money and the un-covered position is that you might have to purchase the underlying stock if it moves into the money and is called away. In reality, writing a covered option is considered a conservative strategy. Writing uncovered is more risky.
Another nice thing about selling (writing) an option is you don’t have to worry about when to get out. You make money just by not moving into the money. You don’t even have to be correct about the magnitude or direction of movement; just as long as the option doesn’t get into the money. Remember, 80% of options expire worthless. The odds are definitely in your favor if you are going against the trend but that in no way relieves the responsibility of doing the due diligence. The trader needs to not only look at the technicals-particularly Relative Strength Index (RSI) but also fund-amental issues like any potential situations that could cause the stock to reverse direction.
Selling out-of-the-money options can be much less stressful because it only requires an analysis of identifying the high probability of little or no significant movement. The profits are fixed and there is none of the usual conundrum of when to exit a trade. Just ride the time decay curve to the end and ring it up. If you do it successfully enough times, you’ll be a happy camper and probably become a died-in-the-wool contrarian.
Dec
22
This is what it’s like to be an option trader. You’ve done all the due diligence. You’ve checked the stock and option charts and studied the fundamental issues of the underlying stock. The March out of the money- option looks like a good time interval and strike price to move into-the- money and hit your target price. You decide that it looks like a good option trade and you have three of your four technical indicators supporting your decision. You’re just waiting for the stock price to move through the 20 day simple moving average (SMA). As, you watch the stock price move up to touch the SMA line, you call your stock broker and place a market order for five March 50 strike price call option contracts along with a 7% trailing stop loss. You get a confirmation and you sit back to watch the action. Your heart is beating faster and you move closer to the screen. “Come on, babies, show me the money”, you murmur to yourself.
You’ve told yourself that keeping glued to the scream is something you want to avoid but for some reason you get hypnotized by the promise of seeing the stock and its option price move in your favor. Finally, the option price starts moving up slowly. You feel excitement and a sense of anticipation. You did exactly what your options trading system procedures called for and a surge of confidence brings a smile to your face. You decide to tear yourself away from the screen and go for a walk to enjoy the feeling and relieve the tension.
When you return to the computer, you gasp in horror as you see that the option price has retraced and is nearing your stop-loss. You quickly check the news and the charts for some indication of what’s happening. Nothing. As a matter of fact, you notice that the RSI (relative strength indicator) has moved down. Maybe this is the testing before it really takes off. “But what if I get stopped out before it makes the move back up?” you ask yourself. You quickly call your broker and ask him to move your stop-loss lower to give your position some room to breathe. You know you shouldn’t have done it but you did it anyway.
Within several hours, the price of the underlying stock is starting to move up and you watch with hopeful anticipation for the options to follow suit. But as you watch in horror, the option prices not only blow past your original stop- loss but also scoot right past your adjusted stop. Before the first day is over, you’re out of the game and score some red on the trade. You’re angry and confused. All the study and preparation for what? You should have listened to others and stayed away from options trading. No more options trading for you!
This scenario is too typical and is what separates successful traders from the majority of stock option trader “wannabees”. Listen, losing is part of trading. As a matter of fact, a trader who has an option win-loss ratio over 60% is probably making good profits over the long term. The idea is that if you cut your losing option trades quickly and without second guessing yourself, and let your winners run, you will do well.
The key to becoming a successful options trader is being able to “stay in the game”. Simply put, staying in the game is a matter of setting up a strict policy regarding the amount of trading capital allowed for each trade and religiously “punching out” when a stop loss is hit. Most successful option traders limit their trading capital to about 5-8% of the option trading account on any one trade. If they draw down the option trading account below 30%, most option traders will stop trading and go back to redesigning their trading system or adjusting their heads. Simple rules to trade by, but most new traders don’t go into options trading with these sorts of con-straints in place. And even if they do, many let the emotions take over and will violate their own option trading system to save their egos or try to salvage money they shouldn’t be trading.
In options trading, losing is part of winning. Nobody wins ‘em all, and any trader with a win-loss ratio over chance (50%) is usually doing well because the average losing option trades lose much less than the average winner. For example, if average losers have an 8% loss and the average winner gains 18%, multiply that average margin difference (in this case, 10%) by the number of contracts traded over time and that is what it’s all about. It’s not about hitting home runs, but hitting for average.
Dec
21
If you don’t know much about stock options, wait until you read this! Most investors think that the only way to profit from investing is when the price increases (long position) or when price decreases (short position). However; with stock options, an investor can make money when there is no or little movement in a stock market or individual stock price. Consider the simple strategy of writing a covered call. (The term “covered” means that you own the underlying stock of the derivative stock option).
Writing an out-of-the- money call option
One of the many inviting strategies that can be used when there is little price movement in an underlying stock is to “pledge” the rights of your ownership to others. Some investors in the vast universe of stock option investors might believe that the stock you own may experience an increase in price within a certain time period. In order to position themselves to take advantage of their analysis, they look to purchase a call option(s) contract on the stock.
An option contract is composed of the temporary ownership of the rights to an underlying stock issue. To do this, they pay a premium for each share of stock. For example, a call option for a certain month may cost $2. This means that to borrow the rights for the underlying stock, an investor will pay $2 per share for 100 shares per contract; one contract would cost $200 plus transaction costs. If a stock has a current price of $32, 100 shares would cost about $3200 to purchase. On the other hand, to have the rights for 100 shares of the same stock would cost only $200 for a specific period of time. The cost of the premium depends upon if the option is in- the-money (ITM), out-of-the-money (OTM) and length of time left on the option. Of course, demand for the option is the major determinant.
The owner of a stock can “write” an out-of-the-money covered call whereby he/she pledges the rights to the stock in exchange of a premium payment. In the example above, the owner of the stock would receive the $200 premium for the rights to 100 shares if the stock for the specified time period. If the stock moves from OTM to ITM, the holder of the option may call away the stock and the writer of the call option must pass ownership of the stock to the option holder for the current market price of the stock. However, if the stock option does not move into-the-money, the option can’t be exercised; the premium and the stock stay with the call option writer.
Covered call writers can repeat the process many times over with the same stock and still maintain. For example, if the owner of the stock had paid $3000 for 100 shares of XYZ and then writes 3 covered call contracts per year at the same premium price of $2 per share, the writer of the call options would realize an annual return of 20% including any appreciation which didn’t trigger a call away of the underlying stock. However, the risk of writing covered calls is that if the stock appreciates and the underlying stock is called away, the owner would then lose the opportunity of taking advantage of the underlying stock appreciation.
Writing an in-the-money call
Here is another interesting way to take advantage of the tremendous flexibility of stock options. Instead of paying a broker to sell a stock position, why not make a profit by writing an in-the-money call.
Example:
Suppose the owner of 500 shares of Home Depot (HD) wants to sell the shares… Instead of calling his/her broker and telling the broker to sell the shares, the owner can write an in-the-money call. Keep in mind that ITM calls have higher premiums because of intrinsic and time value.
The owner of the shares discovers that an in-the-money call of the stock costs a premium of $9 per share for an HD-EG-E (May contract month with a strike price of $ 35, which is in the money because the current price of HD is $39.25). For the five contracts (500 shares), the owner would get a premium of $4500 less commissions for writing ITM options for the 500 shares he/she owns. The stock price is currently $39.25 and the calls will probably be exercised and the 500 shares will have to be assigned for the strike price of $35, and, therefore, the owner will lose $4.25 per share ($39.25-$35) for a loss of $2125. But the difference between the premiums ($4500) for the ITM covered calls and the projected loss of $2125 still gives the owner a net profit of $2375 and would give the owner a 12.1% return just on the sale of the underlying stock instead of selling at the current market price of $39.25 and paying commissions to sell the stock. What makes this covered call attractive is the time value of the option.
Dec
20
Do you hold yourself accountable for your performance? Does your ego keep you from acknowledging the truth? The basic premise of a successful investing strategy-particularly for short-term investing (trading) – is that by cutting losses as quickly as possible and letting profits run, over time, there will be a pre-ponderance of profits over losses.. Having losing positions will happen, no matter how well the system or the trader. It’s a fact of life. To help keep perspective, a trader must constantly keep in mind that the “name of the game” is to have higher margin winning trades than minimized losses on the losing trades. Losses will happen. Even a 50% win-loss ratio can be a winner over the long term!
When trading options, traders should be constantly aware of: 1) the percentage of profitable option trades they expect to generate, as well as the profit margin of the average profitable option trade compared to the average losing option trade; 2) how many estimated option trades will be made over a specific period. With these two statistics, an option trader can get a sense for the estimated profit potential for trading options over a specified period of time. This estimation can serve as an important, measurable goal and used to help set-up psychologically expectations.
For example, let’s be conservative and say that 50% of your option trades would be winners with an average net profit margin (profits less transaction costs) of 14% and losing option trades to have an average net loss of 8%; the trader can expect a net return before taxes of 6% on 50 % of the total amount invested in total trades. If the trader anticipates making 5 trades per month at an average premium of $1,000, then the trader can expect to make about $150 net profit per month (2 winning trades = $2,500 x .06 = $150). Of course this depends on how long positions are held. Annually, this would translate into $1,800 on an account of let’s say $5,000 (in this example, the trader would have an account of $5,000 but only use an average of $1,000 as a maximum for each trade). This translates into an annual return of 36% on the account capital. If you have a system with a 75% win-loss ratio, then your estimated monthly return would be $225 with an annual net of $2700 for a return of 54% on the account capital of $5000. The variables are: win-loss ratio, premium capital to be used, and profit and loss margins. (In the above example if you used $50,000 in premium capital and traded 10 contracts with the same other variables, profits would be 10 times greater or $27,000. But don’t quit your day job just yet.
Of course, the above example is a simplification of the option trading premise but the concept can be used to help set option trading goals to shoot for. Moreover, after each option trade is completed, the trader should track- at least: win-loss ratio, profit and loss dollars and percent for each trade and cumulative trades. Creating benchmarks and using metrics to track variations on a trade-by-trade basis is essential to help the option trader measure the performance of the system; moreover, the option trader must assess how closely trading parameters and procedures are followed for each trade.
The idea is to track the option trading system’s performance and not the trader’s. It’s like using a mathematical function; use a consistent system of indicators and plug in the numbers and look for a consistent result. If the trader alters the parameters and procedures, it only measures the option trader.
The idea is to identify high probability option trades and use consistent option trading procedures. If the trader’s system is good, it will produce a win-loss ratio of over 50%. Some successful traders who have learned to identify high probability trades and execute an option trade with consistent discipline have win-loss ratios above 70%.
Dec
19
Don’t just stand there, do something! If you want to invest and just wait for the rising tide to carry your boat, stock options probably aren’t for you. Nowhere is it more obvious that “time is money” than in trading options. Traders are faced with not only correctly predicting the underlying security’s future price, but also choosing the appropriate option time period for the price change to take place. Once that’s established, the trader can then decide which option strategy is best to capture profit while minimizing risks. Some stock option traders mistakenly figure they can easily make the transition from stocks to options. As easy as falling off a log, right? Maybe not. There are differences that option traders need to keep in mind when making the transition to stock options.
Stocks Don’t Expire. Options Do
The major difference between stock and option trading is the impact of time on stock and option prices. With stocks, time is a trader’s ally, as the stocks of quality companies tend to appreciate in value over time. However, with options, time is an "enemy." As each day passes, there is a decline in the value of the time pre-mium for the option. An option trader must not only correctly estimate the direction of price movement the option but also the time frame for the movement. The more time an option has to make the hoped-for movement, the better the chances of it happening. Conversely, as time on the option decays, the probability of the movement happening diminishes; thus, the importance of the “time value” of an option. Because of time value, as an option moves closer to expiration date, the time component of the premium declines more rapidly. An option trader who holds a position for too long will face the inevitable decline in premium value.
Given the accelerated impact of time decay, the closer the options are to the expiration date, option buyers are well advised to purchase more time before expiration than will be needed. Normally, once into the last month of an option period, time decay picks up speed and the option can lose value rapidly. That is why it’s a good idea to “buy time” in an option even though the option premium will be higher. This allows the option buyer to avoid the especially painful time decay, which occurs in the final month before expiration. Moreover, thegreater the certainty about an option’s value at expiration will usually produce a lower premium time value; the greater the uncertainties about an option’s value at expiration, the greater the premium time value.
When an option is in the money, premium time value also decays more rapidly.
The market usually views an in-the-money premium time value as less a factor and holders of in-the-money options who wish to close out their positions will usually discount the time value to attract buyers.
There are ways to profit from out-of-the money options. For example, Credit spreads (one type is a spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating) can offer a trader a profit if they expire out of the money. The time premium (net options value) that a trader collects when establishing a spread will fall to zero ifthe spread remains out of the money upon expiration. The premium initially collected is thus retained as profit. Another potential happy camper is the writer of covered calls when they see the time premium portion of the option go lower as this improves the probability that their underlying stock won’t be called away and they can keep the premiums they’ve received and the stock they had pledged; win-win. Without a doubt, in the world of options, “time is money”.
Dec
18
Are you one of the “misinformed? Are you losing the tremendous opportunities that using stock options can offer? No, options are not one of the more risky investments. “Oh, yea” you say sarcastically. “That’s why my broker looks down at the floor as he hands me a risk disclaimer statement which warns the reckless investor about the dangers of trading stock options”, you say. Well, I say to you, dear reader that most investors don’t want to take the time to learn about options-one of the most versatile in-vestment tools available. Too many investors go into trading stock options without adequate education and take the fall. They blame it on the vehicle….not the driver. Like anything, lack of knowledge can cause problems and that holds in spades for options.
Consider the fact that the risk of purchasing an option is limited to the premium paid. Owning stocks, however, usually have a much larger ex-posure to risk.
For example, if you purchase 100 shares of Home depot (HD) you might pay around $ 3400. To purchase an option contract for the rights of 100 shares of HD for a specific time period, you might pay about $ 200. If properly set up, the most you could lose on the option contract (100 shares) would be the $200 premium (premium is the same as the option cost for 100 shares). On the other hand, it’s possible for you to lose all-or certainly a large percentage of your $ 3400 on the purchase of the 100 shares of HD. A sudden bankruptcy or some unforeseen event can make this unlikely event a reality; it has happened before and will happen again. The risk exists. Not so for stock options; the maximum risk is the option contract premium which is a fraction of the cost of buying the underlying stock. It’s a fact.
Options and other derivatives probably get a bad rap because investors, option traders and speculators focus on the leveraged reward options offer but lack the knowledge to control the risk side of the option equation. Fortunately, it’s just a matter of education.
Stock Option Basics
There are many ways to take advantage of the tremendous flexibility of options. Some of the most common strategies employing options are: 1) To hedge an existing long or short position in the underlying equity (like purchasing insurance.) 2) To leverage a position either short or long; 3) to make a profit by selling the rights to the underlying stock. With options, a trader can make a profit when the market is going up, down or flat. But for the most part, options are high leverage-controlled risk investments with the potential for high returns.
Options can be an effective way to leverage investment assets that can reduce shorter term risk while freeing up assets to purchase for the longer term. For example, an individual investor could use 10% of investment funds allocated for equities to purchase volatile, higher risk-reward, options (volatility is good for trading options) and use the 90% to purchase positions in less volatile, long term positions.
As trading options is more complex than trading stocks, bonds, or mutual funds, many investors don’t want to spend the time to become better educated on the mechanics and benefits of trading options. But as returns on most traditional investment products become anemic, investors are starting to look at options as a way to boost profits with the least risk. Options offer a very attractive way to accomplish this goal.
Our modern times require more education for those who want to participate in the benefits that a more complex society can offer. Many have been forced to become computer literate and found out they could make the transition with little or no difficulty. What might at first seem to be daunting can turn out to be easy and interesting. At no time in history can it be more app- ropriate to say that “knowledge is power”, and learning to trade options is an excellent example.
Nov
4
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:
Figure 6-23
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:
Table 6-24
|
Trade
|
Bought
|
Sold
|
Profit/Loss
|
|
Long $15 call
|
$6.70
|
$7.30
|
+60 cents
|
|
Long $17.50 call
|
$5.60
|
$5.80
|
+20 cents
|
|
Long $20 call
|
$4.80
|
$4.70
|
-10 cents
|
|
Short $15 put
|
$2.50
|
$1.55
|
+95 cents
|
|
Short $17.50 put
|
$3.90
|
$2.60
|
+1.30
|
|
Short $20 put
|
$5.50
|
$3.90
|
+$1.60
|
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:
Option Advertisement
There is one critical secret to buying options. It’s quite simple really…value investing.
When you buy stocks, you look for an undervalued company. The rules are the same for options investors: Buy only undervalued options and sell them only when they’re overvalued.
Before you buy any option you need to carefully assess its value to make sure that you’re adhering to this easy principle. In my free DVD seminar, I’ll tell you how …
|
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:
Table 6-25
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…..
Jul
18
Ron Ianieri, one of the founders of Options University and ex-market maker in Dell Computer, related a story about how to handle negative skew. But first, what is negative skew?
You probably remember the standard bell curve for normal distribution. It looks like chart below.
insert fig1-1
Notice the symmetry on both sides of the mean. Under the regime of normal distribution, a trader could expect about one price move into the third standard deviation about once each year. For example, if the yearly price range for XYZ stock is $80-$160; about once each year the price might be down to $80 or up to $160 (white portion of the tails). But in reality, many volatile stocks may move more than 3 standard deviations more than the forecast 1-2% of the time. If this is done unevenly, the normal distribution will become skewed. In Ron’s case of Dell, much larger and more frequent price moves were to the downside. The distribution had a negative skew and looked like middle to the left.
insert fig5-2
As Dell had as many as eight three standard deviation excursions to the downside on the same year, Ron purchased many more out-of-the-money puts than out-of-the-money calls. He calls this compensation “fattening up the tail”, which in this case meant more puts (left tail) than calls in the right side of the curve. Of course the reverse is also true for a stock with a positive skew. In that case, the trader would fatten up the right side of the curve by purchasing more out-of-the-money calls. Additionally, on the side of the skewness, the price of puts or calls will be higher than on the non-skewed side. Another way to look at it is that if you expect more of a possibility for large moves to the downside, you would want your OTM puts to be more expensive than comparative OTM calls.
This is different than positive or negative put-call skew because this term refers to corresponding options (put and call volatility at the same strike price). This pertains to one particular option whereas positive or negative skew refers to the distribution itself. If there is more of a probability of large downside excursions than upside, it is negative skew; more probability of moves to the upside would be positive skew. When playing the probabilities, a trader might consider a heavier weighting of OTM puts for negative skew and the reverse for OTM calls for positive skew.
Jun
8
Ready for some MORE exciting video highlights from the Superconference?
Just press ‘Play’ below… (Stay tuned for more videos in the coming days)
- Brett
Jun
7
Here’s a another quick video sample of what attendees are getting at this year’s Investor Superconference.
Friday was the second full day of speakers, with popular trading experts like Toni Turner, John Carter, Norman Hallett, Ron Ianieri, and Tom Sossnoff.
Click ‘Play’ below to view some more video highlights from the 2008 Investor Superconference below…
Brett & Ron
Jun
6
Here’s a quick video sampling of what you’re missing at this year’s Investor Superconference. Thursday was the first full day of speakers, and we’re gearing up for another great day of world-class trading education today!
But we wanted to send out this brief clip of what attendees are learning here in Orlando. Just click ‘Play’ below to view.
The event is being professionally recorded, and the DVD’s will be going on sale next week. Every year we sell out, so be on the lookout for how you can get on the pre-release list to be notified first (and for special discounts).
For now, enjoy the preview!
Brett & Ron
Jun
3
http://www.optionsuniversity.com/blog presents Greg Wolfe’s weekly preview of the United States financial markets covering upcoming, news, data, technical and option related trading information.
May
15
After a week that saw downside in the major US equity indices for the fist time in quite a while, the markets are posting some modest early gains this morning. Weakness echoed again last week in the financial sector globally and domestically with negative bias from AIG, UBS and C shaking markets overseas, especially Asia, as well as here in the states. The dollar saw an end to its recent strength, trading this morning with 1 Euro buying $1.5493 and 1 British Pound fetching $1.9609. Crude is trading off its highs from last week this morning, at $124.78 last and the May contracts for Gold were last seen at $879.40.
With mainly stronger than expected economic data last week, and the ECB and Bank of England deciding on a “no move” in their monetary policies, remaining at 4% and 5% respectively, it would seem as if conventional wisdom would expect the FOMC to lean towards the status quo at the end of June meeting, and that is what the fed fund futures are saying as well. However, although the official GDP designation of a recession has not yet to be declared, two pieces of economic data from last week caught my eye. The Consumer Credit number was a whopping $15.3 Billion versus $6.0 Billion expected and $6.5 Billion from the previous period. In addition, the monthly trade deficit was less than expected (-$58.2B vs. -$61.3 expected). Although some may think that the improvement in that number is due to the weak dollar making US goods more competitive (we are still talking about -$58.2B in a month!), the logical assumption can be made that the obscene amount of Consumer Debt can be attributed to the fact that credit is being used to subsidize necessities like the egregiously priced food and energy (which allegedly shouldn’t count towards inflation) and the only real reason why the deficit decreased was because the US consumer is buying less foreign goods, because the US consumer is buying LESS OF ALL GOODS. It’s kind of sad when that is the only way that the US can chew into that deficit, with the $ still hovering around historical lows.
Regardless, the forthcoming week should be very active from earnings and economic data to technical and volatility scenarios. Tomorrow before the open, retail giant Wal-Mart is announcing with $.76 per share expected. There has been strong guidance from Arkansas as of late and many analysts are expecting a robust number there. In addition, French financial kingpin Societe General will report before the bell, perhaps shedding some light on the murky European financial picture, and Whole Foods is expected to announce $.30 per share after the bell. Wednesday will see results from John Deere, Macys, and Freddy Mac before the open with much scrutiny to be applied to the latter, as inauspicious results from Fannie Mae last week were not received well by the markets. Thursday, JC Penney will continue the retail sector’s announcements, as it is expecting $.50 per share before the open, and Kohl’s and HPQ will publicize their earnings reports after the close.
From the macro economic calendar, Tuesday will see retail sales for April and business inventories for March. Wednesday, we have the all important consumer price index for April. Thursday, industrial production for April, and the recently dire Philly fed index for May will be announced. To finish up the week, Friday is the day for building permits and housing starts for April, as well as the preliminary University of Michigan sentiment for May.
From a technical aspect, the INDU had a difficult time breeching its 200 day SMA last week and both the COMP and SPX met resistance as well. The CBOE Volatility Index was 18.85 last, still languishing at levels not seen since late December which came before the significant sell off that occurred in the ensuing months. The apparent lack of fear or demand for front month options is being reflected in the very cheap relative implied volatility in issues that will announce this week, namely the aforementioned WMT and HPQ. Lastly, keep in mind that Friday is the expiration date for all individual May contracts.
