Options Trading Blog
Thursday, February 16, 2017
Probably the most common questions from traders pertain to order flow. Who is controlling momentum? Which direction is the market likely to go? On the trading floor, we had the luxury of watching order flow in real time. We could put a name on a trade. In other words, we often knew who was buying and selling and how much. Institutional traders, banks and fund managers are more long-term oriented and not as sensitive to short-term swings. Momentum becomes apparent when they enter the market as a group. If they bid or try to buy, higher prices follow. On the other hand, if they offer or try to sell, markets go down. This valuable information is no longer available since nearly all trading is done electronically.
However, when these longer-term, market moving traders enter the market they leave clues. They tend to be active around opens and closes. Volume is often highest early and late in the day. This means the markets are liquid enough for traders to execute large orders.
Candlesticks are a popular technical tool used to determine momentum. Simply, if a day closes above the opening price it is considered bullish and if a market settles below the open it is deemed bearish.
Another clue regarding momentum comes from the Market Profile school of thought. Highs made in the first hour of regular trading hours often lead to lower prices the next session. And higher prices are common the next session if the low is made in the first hour of the day.
One of the most logical and reliable signals for reading short-term momentum depends on where a market closes in relation to the fairest price that day. A close above the high volume price indicates bulls are in command and the market will likely probe higher in search of sellers. Conversely, a settle under the fair price suggests sellers have momentum in their favor. Thus, the market is apt to probe lower the entice buyers.
When setting up a trade we frequently need to make an assumption regarding direction. If you see a first hour low and settle above the high volume price, odds favor rising prices during the next session. On the other hand, if you see first hour high and a close below the fairest price, lower levels are apt to follow.
The recent price action in the equity indexes illustrates how positive short-term momentum reads led to continuation higher.
The S&P chart above shows the last 6 days using 30 minute bars. The yellow rectangles highlight the first hour of regular trading hours. The colored boxes cover daily value areas. Note that during the rally the lows were made in the first hour and the closes were either at or above the fairest prices of the day.
Although it is now more difficult to gauge order flow than it used to be, there are still plenty of clues traders can find. You just simply need to know where to look.
Senior Futures Instructor
Wednesday, February 8, 2017
Over the past 30 years, 20 of which were on the trading floors of the CBOT and CME, I have been a broker, analyst and educator for many types of traders. Whether they were speculators, hedgers or fund managers they were asking similar questions. Where is fair value or where has most of the volume traded? Are bulls or bears in control of momentum? What is a good price to buy or sell? Is the timing right for a trend? What is the risk once in a trade? What is the profit potential? How do I protect my profit? Markets are in constant flux, so it is imperative to have methods to answer and react quickly to the questions traders ask. In these first few articles I will focus on such inquiries.
In order to address the most common questions I created an acronym called V.E.R.T.E.X. I refer to it when creating strategies or writing daily commodity market updates. The V stands for Value, E is for Energy or Momentum, R means Risk, T is for Timing, E is for Entry and X is for eXit.
In this article, I will focus on ‘V’, defining the Value area and high volume price. The high volume price is simply that price which buyers and sellers agree upon most often. Time at this price allows volume to accumulate. Therefore, we can use time as a proxy to measure volume (Price + Time = Value). Many data providers and platforms show actual volume at price but for our purposes time will suffice.
Market Profile has been my technical tool of choice since the mid 80’s. It displays the required dimensions to implement a logical approach to trading. Most charts have price bars that are parallel to each other. This tool tracks time at price using 30 minute periods. Each period is assigned a letter and when stacked on top of each other a bell curve or profile forms (see fig. 1 and 2).
This structure allows the user to determine fair value. The high volume price, also known as the ‘point of control’ is shown in fig 3. It is that price that has traded in more 30 minute periods than any other. From that point of control, we can construct a fair value area which is one standard deviation of volume around that mean. It covers roughly 70% of the volume around that high volume price. Generally, any price that has 4-5 letters in the day profile holds value. Why is value important?
High volume prices and value areas help us determine momentum. Momentum is defined as the movement away from a fair price. In addition, value areas are useful when defining risk. The top of the value area defines risk when prices are declining and the bottom of value defines risk when prices are rising.
In the next issue we will focus on reading momentum.
Senior Futures Instructor
Thursday, February 2, 2017
We all have favorites. Favorite foods, favorite places to go and sometimes even favorite family members. You might laugh when I mention family members but let’s be honest, most of us have family we like to avoid and others we look forward to hanging around. The same can be absolutely true for option traders when picking stocks or ETF’s that they want to trade and also want to avoid.
There is no specific way to form a favorite stock list and to be honest with you, you might have one already and you did not even realize it. This was certainly true for myself. Before I realized which stocks I really loved, I realized there were a few stocks I should probably avoid. I know we talked about getting some “revenge” when it comes to certain stocks. You might have lost money on a trade and you wanted to get even so you put on another option trade on with that stock and most likely lost again. To me that was a good reason to stay away. Additionally, you might have run into some bad luck trading options on a particular stock that had nothing to do with revenge. For me, that is a good enough reason to leave those stocks alone and avoid trading them. Two I can name off the top of my head would be Starbucks Corp. (SBUX) and Facebook Inc. (FB).
As mentioned above, sometimes traders do not even know they have favorites until they look at their trading journal. Either they have traded them often in a particular span of time or they notice that every time they traded a particular stock, they had success. Once you have identified those stocks that are deemed your favorites, make a list. Every morning before I start searching for opportunities, I look at my favorite’s list first before I run scans or start searching in other places looking for opportunities based on technical analysis.
I have a list of about 15 stocks that I trade on a regular basis. The list includes Apple Inc. (AAPL), Alphabet Inc. (GOOGL), Amazon Inc. (AMZN) and Netflix Inc. (NFLX) just to name a few. Not only have I been successful trading these stocks in the past on a regular basis, I also like their charts, strike prices and bid/ask spreads because they fit my criteria according to my options trading plan. To me, these elements are just as important as being profitable trading these stocks in the past. I like to estimate that about 75% of all my option trades are within those 15 favorite stocks.
Like it or not, we all have favorites. This is probably true of the stocks you like to trade as well. Consider compiling a list of stocks that you feel comfortable trading, that fit your criteria and you have had some success with. Sticking to what you know and are comfortable with, can go a long way in your options trading career!
Senior Options Instructor
Thursday, January 26, 2017
I’ve been working with a 1-on-1 Coaching student lately. For the sake of privacy, let’s call her Sara. Sara is a somewhat newer student to options. However, she’s been a stock investor for a long, long time. And she’s done pretty well prior to getting started with options. In fact, I’d say she’s one of the best chart readers I’ve worked with. She’s just plain great at technical analysis and is probably right on direction more often than anyone I’ve coached for a long, long time.
OK. So… What’s the problem?
The problem is that even though she has real skill with her charting, and can pick stocks like a pro, her option trades consistently lose money.
This is not the first time I’ve worked with such a student. In fact, it’s pretty common. The problem generally tends to fall into one of a few categories: Risk management, not knowing proper adjustments, not identifying liquidity issues, etc. This time, it was the Greeks.
Sara’s main M.O. was to identify, say, a bullish trade candidate, and buy a call to position herself for profit. But what happens is that one of two things typically thwart her trade: Either 1) The move takes too long to come to fruition and theta eats up all her delta profits on her correct theses, or 2) Implied volatility collapses and vega ruins her trade.
So, I showed her a few simple techniques that can help her overcome these rather typical Greeks-based nuances that have been making her experience as an option trader so frustrating. It took a few sessions, but I straightened her out. I introduced her to alternate option strategies to trade directionally—debit spreads, long ITM calls, long OTM calls and put credit spreads—that have a different Greeks profile. And then I showed her how to use the Greeks to identify which strategy to use in which market scenario. In the end it was an easy fix.
But like I said, this “being right and still losing money” because of a poorly planned Greeks position is a fairly common problem among novice option traders. It’s easy to see how that can happen with simple long-call trades like Sara’s: Over a week’s time, delta profits get erased by theta losses. To illustrate, let me give an example of how that works…
Imagine a trader buys a short-term, near-the-money call with a 0.45 delta and a theta of 0.07 because she’s bullish. Then imagine she’s right. And over a week’s time (from say, Wednesday to the next Wednesday) the stock goes up a buck. The trader would make $0.45 on delta ($1 move x 0.45 delta), but would lose $0.49 on theta (7 days x 0.07 theta). That’s a loss of 0.04. She was right and still lost money.
And simple long-call trades aren’t the only trades that ill-attention to the Greeks can cause trouble for. All option strategies require Greeks-based planning. As another example, credit spread traders have just the opposite issue.
With credit spreads, the trader is hoping to make money on theta, but if the underlying moves in the wrong delta direction, theta profits get erased by adverse deltas. Here’s an example…
With the stock at $47, a trader sells the 50 – 52 call credit spread with a delta of 0.30 and a theta of 0.02. Say a week passes and the stock is $2 higher. The $0.14 he makes on theta is erased by the $0.60 he loses on delta.
What About YOU?
Maybe what we talked about in this post is old hat to you and easy to figure out; maybe it’s a whole new world. But the bottom line is: Greeks are important. They are important to all option strategies and all option traders. The more you know about them, the more likely you are to be successful trading options.
So… we’ve created a quiz so you can see for yourself exactly how much YOU know about the Greeks. Let’s see how you do…
Good luck on your quiz!
President and Founder,
Market Taker Mentoring, Inc.
P.S. Complete your quiz by the market close on Monday, January 30, 2017 and we’ll send you the answer key so you can see how you did. No looking up answers!
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