Jul

23

Trumpification: Time and Volatility effects on Delta When Trading Stock Options

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What is Position Delta?
 
The use of options allows a trader to be more than just a directional player in terms of the direction of the underlying. There are two other things that you can trade using options. One is volatility. A second is the passage of time and quite often traders, when trading volatility or time, don’t want to have a Delta. If a trader can’t go Delta neutral, then they never really will be able to isolate trading volatility or time.
 
First, what is Delta neutral? To get a good idea, let’s consider how we incorporate Delta as a hedge ratio. For instance, if I buy 400 shares of XYZ, each share has a Delta of 1 that’s going to give us a total Delta position of plus 400. In order to get Delta neutral, a trader needs to figure out a way of offsetting these 400 long Deltas. You could buy 8 puts with a delta of 50 for each contract (.5 Delta per option share), which would equal negative 400 deltas. This would give a Delta neutral position in that the 400 long Deltas would be offset by the 8 put contracts. Whenever you have a position where your Delta adds up to zero or close (plus or minus ten), you are Delta neutral. So, what does all this mean?
 
Ron Ianieri says: “Typically, a stock trader who’s been trading stock their whole life, the idea of being Delta neutral is tough because they don’t understand how they’re going to make money. How am I going to make money? If I’m not playing the stock going up or going down, how am I going to make money?” That is one of the beautiful things about options; the ability to make money in more than one way. It’s much more sophisticated than stock. It gives a trader many more opportunities than stock. The idea of a position being able to become Delta neutral allows us to eliminate the Delta factor from our position. At that moment in time, we now can isolate price and only trade volatility or only trade time, otherwise the effects of Delta will interfere with these two strategies.
 
Trumpification
Trumpification is a Delta affect where time and/or volatility create an affect where the in-the-money options increase their Deltas as time passes or as volatility decreases and the out-of-the-money options lose Delta as time passes and volatility decreases.
 
Trumpification is affected by two things; decrease in volatility or the passage of time. We know that in-the-money options have their Deltas increase as the option gets closer to expiration. Out-of-the-money options decrease in Delta as time goes by and/or volatility decreases.
 
Time affects the Deltas of in-the-money options and Delta increases as time goes on. Why? Because options are in-the-money now and with even less time to go they will be even further in-the-money because there will be even less of a chance for them to fall out which means there is more of a chance for them to stay in; thus a higher Delta. 
 
Volatility is defined as the more an option moves, the better chance of that stock doing something to make an in-the-money option out-of-the-money. This is the reverse of the effects of time on Delta; higher volatility means lower Delta. As Ron Ianieri describes it in his Options Mastery Course (www.optionsuniversity.com), “with the volatility at 70 this stock is flapping around so much that there is now a higher percentage chance of this option making its way to being in-the-money. Because of the wild gyrations of the stock it’s got a better chance thus a higher Delta. If the stock is not moving as much the stock is probably not going to run up high enough to get this option in-the-money. If that’s true, then this option has less of a chance of becoming in-the-money when volatility decreases. Because it has less of a chance of being in-the-money its Delta must be lower. I know this sounds confusing, but read it over again and try to visualize what happens.

Jul

22

Hedging with Delta When Trading Stock Options

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The third important fact that all stock option traders and portfolio managers should understand about the Greek, Delta, is how to formulate a strategy to help reduce risk. This objective was the major motivation for the develop-ment of stock options.
 
As you know, Delta is one of the many important variables produced by the Option Pricing Model. Delta does three important things: 1) Provides an indication of the probability of finishing in-the-money; 2) Describes the correlation of price movement between options and underlying; 3) Provides ratios for options to stock for risk reduction. Let’s talk about this last topic commonly known as Hedge Ratio.
 
Hedge ratio tells us how many options at a certain Delta we would need to reduce the total position risk to near zero. For example, if we have 1000 shares of a certain stock, how many stock options will we need to buy or sell to offset potential losses of value in the underlying stock? This is an important tool for portfolio managers who want to “lock in” unrealized portfolio gains. Here is how it works.
 
Suppose you have 1000 shares of XYZ stock and you have realized a nice gain over the years. Now, the market seems to be entering a period of correction or there are potential short term problems within the company. To help protect the shares against losses, stock options in the form of long puts or short calls can act to offset potential losses. For out purposes, we will buy puts. But the big question is: How many puts must we buy and at what strike price to protect at a 100% correlation any downward move in price of the underlying stock. In other words, if the stock price goes down, how many puts must be purchased at a certain strike price to gain profits on the options to offset the losses on the underlying stock?
 
One share of a stock has a delta of 1. Its value is in itself. How many options must I buy to produce a Delta of 1? You could buy two options with a Delta of .5 to cover each share or 3 options with a Delta of .34; or 4 options with a Delta of .25. You get the picture. Keep in mind that a long position always has a positive Delta; a short position or a put has a negative Delta. Therefore, to reduce Delta to zero requires offsetting Deltas.
 
To test your understanding, try this example: You have 300 shares of ABC and you want to protect against a downward move. How many options should you buy (or sell) to cover the total downside risk? First of all, how many long Deltas does the position have? How many negative Deltas must I find to offset the long position? How many puts must I buy if I buy an ATM put with a .5 negative Delta or if I buy an OTM put with a negative Delta of .4?
 
Answer: The 300 shares of ABC have total positive Deltas of 300. To offset the 300 long (positive) Deltas would require 300 short (negative) Deltas. If you use the ATM options with 50 deltas (100 shares per contract) you would need to buy 6 contracts of the ATM options. For the OTM options with a .4 Delta, you would need to buy 40 (negative Deltas per contract) and divide that into the positive Deltas of the 300 shares. Thus, you would need to buy 7.5 contracts (round off to 7 or 8). Don’t forget to deduct the cost of the put positions from unrealized gains.
 

In summary, not understanding the power of Delta is to not understand stock options. For more information on the tremendous potential and flexibility of stock options, contact Options University (www.optionsuniversity.com) for a listing of online courses, seminars, webinars and other educational stock option opportunities.

Jul

21

The Importance of Delta When Trading Stock Options

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#8 The Importance of Delta
Wouldn’t it be nice to know before entering a trade what your chances are of making a profit? If you look at several potential trades and one has a much better statistical probability than the other of finishing in-the-money, which one would you choose? For example, imagine the normal distribution curve with the current price at the median. If the strike price is the same as the current price, there is a 50% probability that at the time of expiration the stock will be in-the-money. That is, if at expiration the sock price is at or above the current price it will be in-the-money. If it is below the current price, it will be out-of-the money and worthless.
 
Now, if you have a strike price below the current price at the meridian (50% point) there is a greater probability that the current price will end up ITM. The current price would have to move to the left and the additional distance between the median and the lower strike price increases probability that the current price will end up ITM. Moreover, the more the strike price is below the current price, the greater the probability of finishing ITM. As a matter of fact, if the strike price is near the low end of the curve, the probability of finishing ITM is near 100%. Of course, the greater the amount of volatility in the stock, the wider the end-points of the curve.
 
                $30       $38 strike                $50                                     $70
insert fig8-1
                                 .94 prob of ITM    .5 probability of ITM           
 
Strikes to the right of the current price (median) would be probability of ending out-of-the-money (OTM). The width of the curve is representative of the stock volatility; therefore even though a strike may appear to be close to the current price that doesn’t necessarily represent a high probability as defined by Delta. Additionally, Delta has two other definitions besides probability of finishing ITM.
 
Delta also tells us how much the derivative option will move in relation to the underlying stock. For example, if the stock moves $1 and the option has a Delta of 50 (a contract is 100 shares with a delta of .5 each), the option will move 50 cents in the same direction as the stock. When an option is deep in-the-money, it very closely matches the movement of the underlying stock. A Delta of 90 means if the underlying moves $1, the option contract premium will move 90 cents. Many beginning option traders don’t understand this important relationship. They think that an out-of-the-money option is just another less expensive surrogate for the underlying stock. As you now under-stand, an option has to be pretty deep ITM to act as a correlated surrogate. The more in-the-money an option is, the higher the premium. As a matter of fact, buying ITM is more expensive but with a greater probability of being a profitable trade. OTM options do offer a higher ROI (return on investment) but with less statistical frequency.
 
Finally, Delta provides an important input for hedging risk but this topic will be a subject for another article. Stay tuned.
 
For a complete education on the subject of stock options, contact Options University at www.optionsuniversity.com
 

Jul

20

Advanced Options Trading – A Brief Intro to The Greeks

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One of the main objectives of The Option Pricing Model is to come up with the theoretical value of an option, which allows a buyer or seller to come up with an estimated value within the context of the input variables. However, Theoretical value is not the only important output of the option pricing model. There are other important outputs produced by the model and these important outputs are called the “Greeks”.
In his Options Mastery classes at Options University, Ron Ianieri describes the Greeks in the following manner: “The Greeks tell us ahead of time, before we enter into a trade, what the potential risks are and to the exact amount that they are going to affect both our price and our position. You can’t ask for a more powerful risk management tool than the Greeks”.
There are four main Greeks that option traders need to understand. The first one is Delta. It’s called the first derivative because Delta measures the correlation of the movement of an option in relationship to the underlying stock. If an option contract has a Delta of 50, which means if the underlying stock moves $1 the corresponding option will move 50 cents. A Delta of 100 means that the option exactly mimics the movement of the underlying stock. This usually happens with deep in-the-money-options. As a matter of fact, an option near 100 Delta is really a surrogate for the underlying stock and much less an option in the classical sense.
The second important Greek is Gamma. One of the idiosyncrasies of stock is that some options are more sensitive to movements in the underlying stock than the others. Traders would like to know before entering a trade how much an option is going to move in relation to the underlying. From a statistical stand point, Delta measures rate of change of the option. Gamma is like the Delta of the Delta in that Gamma measures the rate of the change of the Delta with movements in the stock.
The next Greek is called Theta-a measure of time decay. An option price is made up of two components: intrinsic and extrinsic value. Theta is a measure of the rate of decay of the extrinsic component of the option price.
Finally, the last major Greek is called Vega, or volatility sensitivity. Volatility is an essential input into the option pricing modes and has an extremely important part to play in the price of an option. As a matter of fact, an option depends on volatility for its very existence. Traders would like to know the exact amount by which an option’s price may change with any movement in volatility. It’s Vega that identifies and quantifies that exact amount.
An option trader must understand the important roles that the Greeks can play to help measure risk. As a matter of fact, many traders actually look more at trading the movements of Delta and Gamma than the price movements. If you want to be an option trader, you need to fully understand the Greeks and what they can do to help appraise a potential trade.

For much more on the Greeks, Options University (www.optionsuniversity.com) has several online courses that go into great depth on this important subject to option traders.

Jul

19

Effects of Volatility When Trading Stock Options

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Write this down: Changes in volatility means changes in option price. It doesn’t matter if it’s a put or a call, front month or back; in the money or out -of- the-money, it doesn’t matter. If volatility goes up, the prices of options go up. Likewise, if volatility goes down, option prices go down.
 
Volatility not only prices but also affects all the Greeks. Out-of-the-money Delta increases but in-the-money Delta decreases. When volatility decreases, the opposite happens: in-the-money options gain Delta and get more in-the-money while out-of-the-money options lose Delta and value. (Academics call this Trumpification.)
 
As volatility increases, it increases the amount of extrinsic value (time value). When the amount of extrinsic value increases the amount of decay increases; the bigger the extrinsic, the bigger the decay; it’s as simple as that. The opposite also is. When volatility decreases, extrinsic value of the option also decreases. If there is less extrinsic value, then there is less time decay required to reach zero at expiration.
 

Volatility can have a profound effect on the shape of the normal distribution curve.

 
 insert fig6-1
 
The more range of variance from the mean ($ 60) the more volatility. More volatility normally means higher option prices. Moreover, as Ron Ianieri of Options University points out, without volatility there can be no option. When an option is out-of-the money, it has extrinsic value and this changes as a function of the pricing model. But when the OTM option expires, there is no extrinsic value because time to expiration is zero; no extrinsic in an OTM means their is no option. On the other hand, when an option is deep in-the-money it acts just like the stock and has no extrinsic value. The option now is just like holding the stock. For options deeply out-of-the money, they have no real extrinsic value. So, without extrinsic value and its corresponding volatility, there is-in effect-no option. When deep ITM the option is the same as the stock; way OTM has little to no extrinsic value so that also is not an option.
 

In summary, wider price movements means more volatility. More volatility means higher option price because big moves have a supposed higher capability to move into-the-money. By the same token, high volatility can mean more probability of moving out-of-the-money.

Jul

18

Fatten up Your Tail When Trading Stock Options

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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.

Jul

17

More about Volatility When Trading Stock Options

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Options University’s founder Ron Ianieri states in one of his Options Mastery Course: “As traders, we have to be able to determine for ourselves what the relative highs and lows for different stocks are going to be because obviously we don’t want to be buying an option that’s very high in terms of its volatility relative to what the stock normally trades at; nor do we want to be selling options when the range is very low. So we have to get an idea for ourselves of what the volatility ranges and measurements are”.
 
Measures of volatility are relative. For example a high volatility might be 30 while others might be high with a 90. High or low volatility is relative to the particular underlying stock. To derive what is high or low, we need to know what the mean or average for the particular underlying stock volatility is. To get the best idea of what monthly volatility is, we will look at the at-the-money strike price because it has the most attention and it’s the most accurately priced, but the second thing is it also has is the highest sensitivity to movements in volatility.
 
When we talk about measurements we talk about how we’re going to gauge whether present implied volatility is high or low. We do that by establishing a base volatility. The pros use a Volatility Cone-or Volcone Analyzer- to help measure historical volatility. Once a base volatility is determined, a comparative high or low volatility measure can be produced by establishing standard deviations based on the data. For example, if   a current variance of implied volatility is over one standard deviation to the right that means that the current implied volatility is outside of the normal 68% expected range and is statistically “significant” to the upside.
 
Volatility Skew
Different options of different stocks trade at different volatilities from month to month and strike to strike. Even two options that are corresponding options (same strike and same month) have a call and its put that trade at two different volatilities. When this happens, it’s called “skew”, and in the real world of option trading there are many volatility skews.
 
The “vertical skew” (also called the volatility “smile”) demonstrates that as the strikes in the same month move away from the at-the-money strike (both into and out-of-the-money), volatility increases. Volatility is normally the lowest at-the-money. If you chart the volatilities, it resembles a smile with the low point at-the-money. Moreover, front months display a bigger smile, while the outer months seem to produce lesser smiles. 
 
The “horizontal skew” (also called “tilt”) looks at what is happening to the same strike over different months. Same strike prices usually trade higher in the front month’s and decrease the further out you go. If the reverse happens, that is called a tilt inversion. This knowledge can become valuable when trading time spreads.
 

The last skew we’ll talk about today is the “put-call skew”. Theoretically, same month, same strike calls and puts should trade at the same price. However, in the real world, often the call price is trading higher than the corresponding put (positive skew). Likewise, put prices may be trading higher than the corresponding call (negative skew). Both of these situations can be important considerations when using different stock option strategies.

Jul

16

Volatility- The Essence of Stock Options

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The key to having a trade is that you, being the buyer, and me being the seller, have different volatility assumptions. What I think volatility is going to be versus what you think volatility is going to be makes the difference. Everything else we’re in total agreement with because those outputs are “hard numbers” processed by the Options Pricing Model. Current prices, selected strike price, days to expiration, interest rate and dividends are what they are. Just looking at the pricing model output based on these factors is the same for both buyer and seller. But what makes a trade is really the factor of perceived volatility. So, when we talk about volatility we are really talking about the essence of an option trade.
 
What is Volatility?
Basically, volatility is a measure of dispersion around the mean. A simple example would be comparing two stocks. Both have a current price of $40, however, the first stock has a price range of $15-$60 over a period of time and the second stock has a price range of $32-$52 over the same time period. The first stock is more volatile than the second stock; the range of past prices has a broader price range. Based upon historical movement, the price movement demonstrates the most probable price range. The potential outcome normally lies between the end points of the range for a certain time period.
 
When talking about volatility in the stock options market, there are basically four different types of volatility. The first is Historical Volatility. As Volatility has a direct link with price (higher volatility usually means higher prices) we try to predict future volatility (price) based a large part on the past history of a stock’s volatility. This leads us to extrapolate (guesstimate) the Future volatility for a specific time period in the future. This is where the art comes in. You may build your forecast on a set of assumptions different from mine. Once we input our forecast volatility into the pricing formula, the end result may be different. Differences make for perceived opportunities; you might think the option you are selling is correctly priced while the buyer feels it is under priced. However, just how much a difference in computed price may affect the actual trade is based on the individual cost-benefit perception. For example, there are times when I might feel that an option is over priced but I will buy it anyway because I think the profit potential will justify the purchase. However, for the most part, professional traders will stay away from overpriced options.
 
The third type of volatility is called implied volatility. We can actually figure out what your forecast volatility is by working your bid price. If you bid $3.00 and I put this into the model and solve for volatility, I can come up with your measure of volatility. This is the implied volatility as observed by your bid price. If the implied volatility for your bid is lower than mine, I am implying that I think there will be more future volatility and thus potential higher prices. Keep in mind that every time any of the variables change, so does the outcome of the pricing model.
 

The final volatility is future volatility. This is our “best guess” as to what we think the future volatility will be. The difference is that future volatility is not a product of the option pricing model.

Jul

15

Inputs to the Option Pricing Model

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Options start with the Option Pricing Model. The basic parameters of what goes into the model have not changed, just the methods of computation and error corrections. So, to help present a non-mathematical description of the model, let’s examine what key independent variables are imputed into the Option Model.
 
First, we put in the most recent closing price. Choosing the closing price is more a matter of consistency. If you use the high for the day and I use the close, we will be comparing apples to oranges. So, to create uniformity, the most recent closing price goes into the option pricing model currently in use. Most trading platforms out there use the same pricing model so that buyers and sellers are looking at the same thing. Price also lets the model know if the price is in-the-money or out-of-the-money.
 
After putting in the price, we need to choose and input the strike price. Next, we need to let the model know how many days are left until expiration. Another input, which is not quite as important as the others, but must be considered, is the current interest rate. As Options University co-founder Ron Ianieri describes: “there will be times you’re going to be long stocked and there will be times that you’ll be short stock. When you’re long stock; you’re taking cash that is receiving interest rate out of your account and replacing it with stock that’s not receiving any interest rate. So whenever you buy stock or make any type of purchase you are losing interest rate”. Also if you are shorting a stock, you’ll be selling something you borrowed and you will be replacing later and the cash that goes into your account will probably be earning interest.
 
Dividends are another factor that goes into the model. Theoretically, a stock price goes down by the amount of dividends that is paid out. This is because dividends come out of assets and if assets are reduced, that hits the stock price. There are other corrective factors such as kurtosis and skewness that are input but that is included in the structure of particular pricing model.
 

But there is one very important input that we haven’t considered and it is the most important factor that makes an option an option. If everyone is considering the exact same inputs, buyer and seller are looking at the same output (Theoretical Value) but both see different conclusions. Why does one want to sell at a certain price and the other to buy at a certain price? The mystery factor is Volatility. Volatility is such an important topic, that it will be covered in another article all of its own.

Jul

14

Advanced Options Trading – My Pricing Model has a Hole in It

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To develop an understanding of the power and versatility of stock options, it’s best to start with the Option Pricing Model. Stock options are mathematical creatures that derive from a Nobel Prize winning formula called the Black-Scholes model. However, the venerable model needed some evolutionary changes to refine the process and adapt to the American system of permitting early assignment. The Black-Scholes was developed for the European trading system, which only allowed option assignment after the expiration date.
 
But as a matter of fact, even the most current improvements to the original model are still unable to account for a basic flaw. It’s not perfection-yet- but the pricing models provide some very important information.
 
Basically, the pricing models attempt to come up with a theoretical value of what an option should cost in relation to the underlying stock. The results of the pricing model present probabilities of value depending on certain defined parameters at a specific time. Needless to say, the parameters are always changing as is the theoretical value. Keep in mind that the pricing model is a function that is based on probability and as such has an inherent flaw.
 
That flaw has to do with the famous “random walk” theory that states that price movements are random and as such can fall within the concept of the Normal Distribution Curve-commonly known as the Bell Curve of academic fame. The normal distribution curve demonstrates a certain predictable pattern of probabilities given randomness of each individual data point.
 
The Normal Distribution Curve
Insert fig1-1
 
To help give an under-standing of how the normal distribution curve works in relation to stock prices; consider today’s price of XYZ to be represented by the line bisecting the red column. Based on the history of random price movements of XYZ, the next price movement has a 68.4% probability of moving within the red column. This is called one standard deviation. Movement to the right is an increase in price. For the price to move into the green area to the right of today’s price would have a 13.5% chance. This is called the second standard deviation. And for the price to move into the blue area to the right would have a probability of 2.2 %. This is called the third standard deviation.
 
But in today’s markets, it is not uncommon to see prices move three deviations much more often than forecast by the normal curve. In other words, the basic premise that price movement is random is not really the case.
 
So, to summarize our foray into the foundation premise of the Option Pricing Model, we see a potentially serious flaw. But that does not diminish its importance in that it deals in probabilities and not exact measurements. Thus, no matter how much the mathematicians have tried to describe randomness; it may be close…..but no cigar.
 

For more information on stock options, go to www.optionsunitversity.com.

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