Options Trading Blog
Wednesday, May 4, 2016
The market has been quite volatile over the last several months.With the Federal Reserve threatening to raise rates, a mixed bag of quarterly earnings and global economies struggling, there is a decent opportunity that the markets may continue to be volatile. Let's take a look at an option strategy that may be able to take advantage of this uncertain outlook.
An option strangle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With an option strangle, the trader is betting on both sides of a trade by purchasing a put and a call generally just out-of-the-money (OTM), but with the same expiration. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price.
However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this or any other option strategy sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.
An option strangle has two breakeven points just like the option straddle. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put's strike (to calculate downside breakeven). If at expiration, the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (for upside moves). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss a trader can take on an option strangle is the net premium paid.
The implied volatility (IV) of the options plays a key role in an option strangle as well. With no short options in this spread, the IV exposure is concentrated. When IV is considered low compared to historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant which is certainly a bonus for long option strangle holders.
To create an option strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. An option trader may think Twitter Inc. (TWTR) looks good for a potential option strangle since at the time of this writing, the stock is trading around $15 after earnings a couple of weeks ago. With IV much lower than HV and the trader unsure in what direction the TWTR may move, the option strangle could be the way to go. The trader would buy both an June 16 call and a June 14 put. For simplicity, we will assign a price of 0.55 for both - resulting in an initial investment of $1.10 (0.55 + 0.55) for our trader (which again is the maximum potential loss).
Twitter Stock Rallies
Should TWTR rally past the call’s breakeven point which is $17.10 (16 + 1.10) at June expiration, the 14 put expires worthless and the $16 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example at expiration the stock is trading at $18 which means the intrinsic value of the call $2 (18 – 16), the profit is $0.90 (2 – 1.10) which represents the intrinsic value less the premium paid.
Twitter Stock Declines
The same holds true if the stock falls below the put’s breakeven point at expiration. The put is in ITM and the call expires worthless. At expiration, if TWTR is trading below the put’s breakeven point of the trade which is $12.90 (14 – 1.10), a profit will be realized. The danger is that TWTR finishes between $14 and $16 as expiration occurs. In this case, both legs of the position expire worthless and the initial 1.10, or $110 of actual cash, is lost.
Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Profits and losses can be realized way before expiration and it is up to the trader to decide how and when to close the position. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position. Consider managing the position for profit and loss based on a certain percentage or a certain number of days or both!
Senior Options Instructor
Market Taker Mentoring
Thursday, April 28, 2016
The market has moved higher, lower and higher again over the last month or so. Even though the market has rallied as of late, there's still a potential for the market to move lower. Regardless, whether the market continues to move higher or lower once again it is always a good time to talk about stop losses. Traders may hear the terms trailing stop loss and stop loss order and wonder exactly what those terms mean and how a stop loss can potentially enhance a trading strategy. Well, worry no more because that is exactly what we will review in this blog entry. To get more educational ideas like this, sign up for a free two-week trial of Market Taker Mentoring's Options Newsletter.
Let's start with the basics which is defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it's a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let's take a look.
Stop Loss Example
A trader could purchase a stock for $20.00 and set a stop-loss order at $18.50. This means that the position will be closed at the market price once the stock drops below $18.50, pretty simple right? It is called a stop loss order because it stops the trader from taking any more losses. Many traders use a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are followed.
Trailing Stop Loss Example
A trader chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is violated. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.
Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).
A trailing stop loss can be used very effectively in profit taking and it is a strategy I have used often myself. Let's revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let's say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).
Consider this option next time you are in a profitable position!
Thursday, April 21, 2016
The new baseball season just kicked off a few weeks ago and already the Chicago Cubs are fighting for first place in their division. In addition, a new round of quarterly earnings did as well. With Apple, Amazon and Alphabet just to name a few all expected to announce its earnings week and a plethora more of them to soon follow, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education; double calendars vs. double diagonals.
Double Calendars vs. Double Diagonals Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as "long double calendars" and "long double diagonals" in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold.
The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options. The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.
Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in other words, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of the placement of the long strikes being closer to ATM, responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions has a negative impact on double calendars more strongly than it does on double diagonals.
If you have only traded a single-legged calendar or diagonal through earnings season even not during earnings season, it might just be time to give them a look (maybe even paper trade one). Maybe you have never traded a calendar or a diagonal. This might be the time to find out about these time spreads. Once a single position spread makes sense, a double might make even more sense and be more profitable too.
Senior Options Instructor
Tuesday, April 19, 2016
With the S&P 500 moving higher over the last couple of months, it probably makes sense to keep at least a moderately bullish bias towards many stocks at least as long as the index stays above its 200-day moving average. With quarterly earnings just getting started once again, a lot of negative sentiment may push stocks lower at some point, but certainly there is no guarantee it will. Even if a pullback does happen sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.
When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching just about a month ago. UnitedHealth Group Inc. (UNH) moved up and closed at $122 and formed a bullish base. With implied volatility (IV) generally being low at the time (which is advantageous for purchasing options as with a bull call spread) and a directional bias, a bull call spread can be considered.
The trader's maximum profit on a bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let's assume that at the time one April 120 call (ITM) was purchased for 3.00 and one April 123 call (OTM) was sold for 1.00 resulting in a net debit of $2 (3 - 1). April expiration was about a month away. The difference in the strike prices is $3 (123 - 120). He would subtract $2 from $3 to end up with a maximum profit of $1 per contract. So if he traded 10 contracts, you could make $1,000 (10 X 100). He would need the stock to move a dollar or more higher ($123) by expiration to realize the maximum profit ($1).
Although he limited his upside profit potential, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to stay at its current price of $122 (the strike price of the purchased call (120) plus the net debit ($2)) at expiration. Effectively, the trader has created a theta (time decay) neutral position at the onset of the trade since he would break even if the stock never moved penny off of its current price of $122. The same could not be said of a long call position. A long call always has some type of negative theta meaning that for every day that passes, the option premium will get smaller due to the passing of time.
Advantage Versus Purchasing a Call
When trading the long call, a trader's downside is limited to the net premium paid. If he simply purchased the in-the-money April 120 call, he would have paid $3. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option as well.
By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. In addition, buying an ITM debit spread like the bull call can offset time decay (theta). A long call or put position cannot be structured to offset theta completely. These are a couple of the advantages when comparing purchasing options outright to spreads. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the different strategies is a good way to limit potential losses.
Senior Options Instructor
Thursday, April 7, 2016
Making stock option picks with huge profit potentials, whether the market is up or down, depends on diligent market research and a thorough understanding of stock option fundamentals. In my class, I often talk about how essential it is for traders to take into consideration the overall market sentiment when choosing strategies.
Finding profitable trading opportunities can be tough. But you don't have to do all the work yourself. Some professional trader services, such as Market Taker’s Group Options Coaching, make stock option picks that they share with protégés, saving individual traders time and effort.
But whether you do your own research or rely on a seasoned professional for your stock option picks, its essential to understand some basic facts about options trading.
Making stock option picks based on individual stock assessment requires an understanding of specific fundamental parameters. Traders may learn how to read an annual report and 10K stockholders report for income statements, past earnings, sales, assets, new products, and overall industry trends.
Stock option picks based on technical analysis is essential for success and requires the investor to examine the historical price movement and volume in order to determine price patterns and forecast future price movements. The single most important technical analysis technique is the simplest: Support and resistance lines. Specifically, horizontal support and resistance lines at the same price level in two or more multiple time frames.
Stock option picks based on broad market analysis examines overall activity based on performance indices. Is the overall market bullish (moving up), bearish (moving down) or neutral (moving sideways)? The broad market will affect individual equities and don't forget to take into account implied volatility and possible changes.
Stock option picks based on psychological market indicators attempts to interpret the facts and gauge whether a change from bullish to bearish (or vice versa) is in the wind. Successful options traders are frequently contrarians who buy puts in a bullish market and purchase calls in a bearish market -- against convention.
Bottom line, a lot goes into stock option picks. Either doing it on your own or using the help of a professional with experience in “putting it all together” can make the process easier and can result in better trade ideas with greater profit potential.
Senior Options Instructor
Tuesday, April 5, 2016
An iron condor occurs when an option trader combines a bear call spread and a bull put spread. It is essentially combining two credit spreads as one trade. The trade is executed by buying a lower-strike out-of-the-money put and selling an out-of-the-money put with a higher strike. Then the trader sells an out-of-the-money call with a higher strike and buys another out-of-the-money call with an even higher strike. Learning to trade more advanced option strategies like an iron condor is not essential for option traders, but it can give you more means in which to possibly extract money from the market.
One of the rationales behind selling an iron condor is implied volatility (implied volatility is - simply defined - the volatility component of an option price). When IV is inflated (meaning the implied volatility has pushed the option price higher) it lifts the premium values for option sellers. In addition, the profitable range on the iron condor is can be rather large depending on how it is implemented.
An iron condor consists of four legs and results in a net credit received. As for profit potential, the maximum potential profit is the initial credit received upon entering the trade. This profit will occur if the underlying stock price, on expiration date, is at or between the two middle (short) strikes.
One of the benefits of an iron condor (and potentially options in general) is limited risk. For iron condors, the maximum loss comes when the underlying stock price drops at or below the lowest strike or at or above the highest strike. If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or the two higher-strike options) less the initial credit for entering the trade.
Being that we are getting close to another round of quarterly earnings, it may be best to construct the iron condor to expire before the actual announcement. If not, then it may be best to exit the trade before the announcement especially if the trade is profitable up to that point.
Senior Options Instructor