Options Trading Blog
Thursday, January 19, 2017
We talk about option delta very frequently in this blog and although the concept may be well-known to many of you by now, it still bears revisiting time and time again because of its importance. I would venture to say that once an option trader learns what a call and put is and what their rights and obligations are, the next thing they learn is delta. Of course, as you move through your option trading career and learn more nuances and specifics about options, you discover there are more option greeks than just delta to comprehend. That being said, I find delta to be still one of the most important concepts to understand particularly for my style of trading.
As a quick reminder for those who are well-versed and also for those that may be newer to options, let’s take a quick look at delta before going any further. Delta is the rate of change of the price of the option relative to the change in the underlying. Keeping it simple, for every dollar the stock moves higher or lower, the option premium should change by that amount. Delta values range from 0 to 1 and can be positive or negative depending on if it is a call or put and whether the trader is long or short the position. As a quick example, if an option trader purchased a call option for 3.00 with a delta of 0.60 (long calls have positive deltas) and the stock moved $1 higher, the new value of the option would be 3.60 (3 + 0.60) due to an increase from the positive delta which correlated with the positive $1 move higher. Delta works the same for spreads but there is an element that many option traders may never think about that may actually change the way they think about delta as far as spreads go.
Let’s look at a vertical debit spread and examine what the “real” and what the so-called “effective” delta is on the spread. Let’s say an option trader had a bullish bias on Valero Energy Corp. (VLO). With the stock trading just under $67 and an expected move higher in about a week, the trader can purchase a January expiration bull call spread with just over a week to go until expiration. The trader buys the January 65/67 call spread for a price of 1.30. This means the maximum risk is the amount that was paid and would be lost if the call options expire worthless at $65 or below at expiration. Maximum profit is the difference in the strikes minus the cost of the trade or 0.70 (2 – 1.30) in this case.
The long 65 call has a positive delta of 0.72 and the short 67 call has a negative delta of 0.44. Adding those together, an option trader would say the current delta on the spread is positive 0.28 delta which means if VLO rose $1, the spread should increase in value $0.28 ($28 in real terms) with all other variables being held constant. Consider taking a look at this from another perspective. The maximum profit on the spread is 0.70. With the stock trading at $66.65 at the time, the stock would need to move just $0.35 higher and of course stay there at expiration for maximum profit to be realized. This means a positive $0.35 move higher at expiration would net a profit of $0.70. If you divide 0.35 into 0.70 you get 2 which could be argued that the spread’s “effective” or theoretical delta is 2 because if the stock moves $0.35 higher, it equates to a $0.70 increase in premium and profit at expiration. You probably never looked at it in that way huh?
As we can see and as many of you probably know, option delta can effectively tell an option trader how much the position’s premium will change based on a directional move. When it comes to spreads, there may be more to think about than what the current delta or “real” is. You may want to consider what the “effective” delta is at expiration based on how much a move is needed to achieve maximum profit at expiration.
Senior Options Instructor
Thursday, January 12, 2017
The new year has just started and you need to ask yourself will this year be the same as last and prior years? If you are profitable on a consistent basis, then the answer is hopefully yes! Unfortunately, many are not where they want to be. One of most important aspects of learning and growing as an options trader is to review your trades. If you are enrolled in Group Coaching, you have heard me mention this almost every single session. This is a great way to gauge how you are developing as a trader.
A lot of traders will concentrate on their profit and loss statement, but this can be deceiving. Why? Many good trades lose money and a lot of bad trades make money. Your goal as a trader is to follow your trading plan and take the best trades that make sense to you and hopefully put the odds are your side for a successful trade. With the new year just starting off, there is no better time to start then now!
Record Your Trades
The first thing an option trader needs to do is screen capture the trade at the moment of entry. This includes the stock chart and the option chain. If the trade is in effect for several days, screens shots can be taken periodically to help you understand what is happening on the charts and to the options. Once the trade is exited, screen shots should be taken again to compare the start and end of the trade. Lastly, depending on the strategy, screen shots can be taken after the trade was exited to help you analyze what could have been…good or bad! Some programs will even allow you o capture a video so you can methodically go through your trade thoughts from chart to option chain and everything in between.
Now that you have the concrete evidence of your trading it's time to look at the damage or lack thereof. Do this part after the close of the market so your full attention will be on the review process. Label the chart and option chain with what strategy was used. Where did your plan call for entry, stop and target? Then where did you actually enter and exit. Were there any discrepancies? If there were, you need to find out why. If the trade was stopped out but you followed your plan, was it just part of the odds or is there something you can do to improve the odds for next time?
Common Plan Violations
This is the where you try to destroy the trading demons that keep you from being the trader you know you can be. Was the entry valid? Did you risk more than you wanted too? Did you remember to check implied volatility before the trade was entered? It really doesn't matter what the violation was, it just needs to be recognized and taken into account for next time. Once a trader has recognized and corrected his or her errors, trading can become a whole lot easier.
One other option (so to speak) that can prove to a trader how important a trading plan is to simply put a contingent order like an OCO (one cancels the other) order on the trade. Have two orders, one for profit and one for loss and don’t do anything until one is triggered. The hardest thing to do is to not manage the trade and let the trade takes its course. In essence, you now have a trading plan and the odds are that it is a better plan then if a trader is managing the trade without a plan or letting his or her emotions do it for them. It might surprise a trader to find out how much better they do using this strategy then what they have been doing in the past.
The last part of this review process is to keep a trading journal. This is where you will keep your statistical trading records. Review every trade and be your toughest critic. Work to eliminate your most common mistake the next day, week or month whatever it may be. Set a goal for yourself like to have five consecutive option trades without committing that same mistake. When you have accomplished that, you are step closer to becoming that trader you know you can be!
The key to becoming successful and growing as an options trader is to learn to acknowledge your winners, but cherish and learn from your losses because that is what will make you profitable in the end. You will absolutely learn more from your losers than from your winners… I guarantee that!
Senior Options Instructor
Thursday, January 5, 2017
As option traders, there are some opportunities to profit week after week or month after month on the same underlying. These so-called opportunities can be based on the option market or charts, but usually it is a combination of both. The problem that some traders have is that they “go to the well” once too often meaning that they keep repeating the same strategy because it has worked in the past although the conditions have now changed. The other thing traders often do is to try and get “revenge” on a stock after suffering a loss. If a profit opportunity arises again even after a loss, there is nothing wrong with putting on another position provided there is another opportunity that the trader deems “putting the odds on your side.” Many times, traders will think there is another opportunity but in reality, they are just looking to redeem themselves after a loss and show the underlying who’s boss so to speak!
Let’s take a look at multiple opportunities we spotted on Amazon Inc. (AMZN) in my Market Taker Live Advantage Group Coaching class over the last couple of months. Take a look at the chart below.
The first thing we noticed was the 50-day and 200-day simple moving averages. After the stock gapped and closed lower after announcing quarterly earnings at the end of October, it has continued to trade below the 50-day sma and has never closed above it up to the time of this screenshot. In addition, the stock has never penetrated the 200-day sma to the downside as well. In class, we talked about using support and resistance (areas where stocks tend to stop and/or reverse) levels as target and management levels. Moving averages are often considered potential support and resistance levels.
With a neutral to bearish bias for the stock going forward since the beginning of November, we talked about selling call credit spreads above the 50-day sma on a weekly basis when applicable. The premise of the trade idea was that the moving average would keep the stock from moving higher and we would exit the position if the stock ever closed above the moving average. Although it came close to doing so late in December, it never did at the time of this writing which means every credit spread whose sold call strike was above the moving average, would have expired worthless for a profit. Of course, a profit can be realized anytime the spread can be bought back for less than it was sold which is often prudent when managing credit spreads since many times out-of-the-money (OTM) credit spread often have large risk/reward profiles.
A recent example of a potential trade idea that we looked at in class came on January 3rd. With AMZN trading around $755 at the time, we considered selling the 775-strike call that expired that Friday (Jan-06) and buying the 780-strike call with the same expiration for protection in case the stock moved considerably higher. At the time, the 775/780 call spread produced a credit of 0.55 which means the maximum risk was 4.45 (difference in the strikes (5) – premium received (0.55)). The next day towards the close (with just more than two days left until expiration), the spreads value had deteriorated to a value of 0.20 due to the stock trading sideways and not closing above the moving average. A profit could have been realized at that point of 0.35 (0.55 – 0.20) or $35 a spread in real terms.
Was this opportunity available every week since the beginning of November? The answer is probably no because the stock moved further away from the 50-day sma at times and there was probably not enough premium to sell above the moving average that made sense. Can this trade idea be possibly considered going forward? As long as the stock continues to trade below the 50-day sma or even above the 200-day sma, these OTM credit spreads can still be an option so to speak.
If there were continuous opportunities on every underlying we looked at on a regular basis, trading might be a whole lot more profitable for everyone. The key is to not overlook patterns and opportunities that continue to present themselves on a regular basis even after a profitable or losing trade on the same underlying. Just be sure you are not forcing the trade when the opportunity has changed or you are taking the trade looking for revenge because of a previous unprofitable experience.
Senior Options Instructor
Thursday, December 29, 2016
In trading, there are lots of ways to skin a cat. Let us count the ways. There are chart patterns, astronomy, astrology, Elliot Wave, Gann etc. etc. etc. They all have their devoted fans and followers. Most swear by the perfection of the methodology they employ and the advantages over all others.
But as always, all methods have short-comings.
I like trading levels. Price levels on charts are easy to identify and seen by all market participants who choose to view the data. It is a simple process to spot places where the market turned, not willing to go higher or lower. Levels can be thought of as support or resistance. Support are places below the market where buyers became interested, bought everything for sale, or stopped the selling. It may also be where sellers just sold all they wanted and stepped aside. Either way, the market and prices stopped going lower.
When support has been identified, traders have some information they can use to trade against. They know where prices seemed too cheap in the past and may remain too cheap in the future. Traders may be willing to buy in an area close to that level thinking that prices will again be too cheap and move upward again.
Support can be found in price data as represented by charts. It will be areas where important lows are seen. Let’s look at an example.
This area is where the up-move started after a small low was put in. Subsequently, prices revisited the same spot and provided a launching point for a tradeable move to the long side. These types of moves happen on all timeframes in all markets. Traders can consider a bullish trade just above the area and manage the risk if prices fall back through the support.
Resistance is essentially the opposite of support. These are points where buyers drove the market up. A turning point comes where sellers become interested, sell all that the buyers can handle, and turn prices back where they came from. The other way a market turns down is where buyers just gradually run out of enthusiasm, and selling once again become dominant or takes control.
Just as with support, we can identify places where the market turned down once buying dried up. Traders can consider bearish opportunities just below the areas in the expectation that sellers will show up again and provide profit opportunity for traders who sold. Again, these areas should be important points where selling took the market lower.
Here we saw the gold market make a sharp move down. A small rally, attempt to trade back up was stopped and turned down for even lower prices. Afterwards, that same level saw prices return only to be sent back down again. Traders who thought that level was too expensive at that point, could have profited by trading at those prices on the short side or implemented a bearish strategy. Traders need to manage the risk. Once price penetrates the former selling levels, traders should consider altering their behavior and see how far the prices advance while standing aside.
Trading levels provide a logical and simple way to view the markets. It is evident where prices were too high or too low. As traders, we may choose to buy at levels that buying took over or sell at levels that sellers took control to take advantage of advantageous prices.
The thought process in this form of trading is rather streamlined. There is no interesting jargon or complex theories to understand. Trading levels is just tracking supply and demand while trading in the logical direction.
Senior Futures Instructor
Market Taker Mentoring
Tuesday, December 20, 2016
Most traders trade price.
The truth is we all trade price. However, prices are determined by traders placing orders in the market. Those orders are what is seen on the bar and candlestick charts on our screens. Look under the surface and visualize what is taking place.
Most traders are either unaware or do not place enough emphasis on the fact that markets are moved by buying or selling shares or contracts in an individual instrument. Ultimately, supply and demand forces move price. Volume and orders move price.
Fortunately, one can use certain techniques and concepts to put order flow and volume on their side.
Markets are propelled through a process known as a dual auction. It is much like the auctions we are all familiar with only this process regulates price and volume in two directions. Normal auctions match buyers and sellers in an event that generally sees price work higher with multiple participants willing to purchase the auctioned item.
A dual auction involves shares and commodity contracts being bought and sold in a continuous process. This process moves price up and down in a price discovery mechanism. In a dual auction the auctioned items can come on or leave the market at any time. The unsteady supply and demand makes tracking participants intentions difficult.
One way we can get a handle on who is doing what is by tracking volume and volume patterns. Volume is how much traded at a given price or level. Volume patterns are how volume is coming into the market as price advances or declines.
Knowing how much traded gives traders a sense of participation at certain levels. That participation is opinions on value being voted on with dollars. The more dollars, the stronger the opinion. Moves often originate from levels where there is too much participation after an already directional move.
In the example, one minute E-mini S&P futures, we can see the over participation after a directional move.
This is on a short timeframe but the point is well illustrated. Too many participants leaning in one direction creates a possible vacuum on the opposite side. Lots of traders who sell in the same place or the same price at the end of a move creates unusual volume. When enough people buy or sell, that may be the end of the move. Nobody wants to trade in that direction anymore. They now need to seek orders on the opposite side to extract themselves from a bad position.
Likewise, selling or buying drying up well into a move can signal the lack of enthusiasm for continuation and an imminent reversal. This time traders built positions over the length of the move. As the price worked its way downward, traders became less interested for whatever reason. The realization became evident that mostly anyone who wanted to be short was. A two- way market ensued, buyers and sellers reached equilibrium. The forces just decided that the price needed to move up to facilitate trade.
The patterns repeat over and over. The market moves on positions being taken, order flow.
When order flow becomes too heavy, after a move, everyone who wants to buy or sell have already done so. Traders are now trapped with no new orders to let them out. The market pauses or reverses.
When the market moves far enough, buyers or sellers become disinterested at the new levels. The market stalls and pauses or will reverse.
Again, the market is a dual auction process always searching for order flow. When extremes are reached the auction trades in the opposite direction starting the process over again. Extremes and turning points happen when order flow and volume reaches an extreme or turns. Charts and technical tools are great, but remember what takes place when using these tools in your trading. The key is to be on the side of the dominant order flow.
Happy New Year!
Senior Futures Instructor
Market Taker Mentoring
Thursday, December 15, 2016
All trading requires in depth analysis and preparation if one expects to have success. There are many factors that can provide a roadmap or edge while trading. Putting the day’s trading plan in the context of the expected range can help traders manage their expectations. Putting the day’s range in the context of a larger timeframe like the weeklies, can provide an additional layer of context.
A simple way to estimate the daily range is by using an ATR (Average True Range) function. The Average True Range is the day’s, or week’s range plus any gaps that may be unfilled from the last time-period. For instance, if the SPY had a daily range of $4.30 but gapped up from yesterdays close by 0.25, the true range would be $4.55.
An Average True Range will be based on a look-back period. The look-back period can be ten to twenty periods, or whatever the trader sees as representative of the current trading environment.
The ability to set targets or construct trades utilizing normal market behavior is a confidence booster.
Using this data can be simple. Let us assume one is trading the front month of an oil futures contract. As a day-trader, it could be advantageous to know statistically what a given day’s range is likely to look like. We can get a good representation by using our ATR function. Consider some recent data.
The 20 day ATR is just over $1.80. Currently the day’s range is reaching towards that parameter. The average range would put the bottom in somewhere around $49.40, $5.21 less the $1.80 ATR, and we were just above that figure trading at support. A trader has a good setup for a long trade. The market is not likely to go much lower and we are trading at support as well. The trade has two forms of potential downside protection.
This example helps the trader with trade entry. However, you may also get creative and use the concept for target setting and trade exits. The concept is certainly not a trading system, but is a reliable guide to help traders form their expectations for price movement.
Senior Futures Instructor