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Monday, July 18, 2016

An Options Watch List

If you are a NFL football fan, you probably know that we are getting ready to start training camp in about a week. Teams are gathering information about themselves and their opponents and trying to gain the upper hand over them which ultimately could lead to a victory. Just like in option trading, a well though out and well kept watch list can help a trader in a variety of ways including scoring profits. First and foremost it can help keep track of the underlyings and keep them all in one place so it is easy to reference them. Potential trade opportunities are often discovered by scanning and searching charts and options from stocks that are on a watch list just like determining potential strengths and weaknesses of a hockey opponent. Here are a couple of ways a trader might go about building a watch list or creating a better one.

Familiar Ones

If a person is relatively new to trading there are probably a few stocks that he or she is familiar with. To gather more names to add to the list, a trader can scan through an index (like the S&P 500 for example) and find more stocks to potentially add to the list. Some of the stocks listed may not be conducive for a variety of reasons. It makes perfect sense to check out the symbols and see if the charts and the options are at acceptable levels for the trader’s personality and plan. Things a trader might want to consider when deciding whether to put a stock on his watch list are the stock price, the stock’s volatility, option prices, bid/ask spreads and option volume just to name a few. When this process is complete, a trader should have a decent watch list in which to work with. This list may grow and sometimes shrink over time depending on the trader.

Services

There are numerous trading services (free and paid) out there that not only might introduce traders to stocks to add to the watch list which may lead to potential trade opportunities. The Market Taker Live Advantage Group Coaching is one such service that MTM offers. As mentioned above, the reason a watch list is created in the first place is to find potential trades. A service can not only introduce traders to new symbols but also provide trade ideas that can turnout to be profitable. But if the trade concept is unclear or deviates from a trader’s plan regardless of the source, it should be avoided until the concept is understood. In any case, if the trader thinks there may be an opportunity on the stock in the future it can be added the list.

List Categories

Once a trader has a watch list of stocks, it may be prudent to separate the list into different categories. There can be a list for stocks that are ready to trade now or very soon. Keeping this list the shortest might make sense for a couple of reasons. First a trader should probably not be trading more stocks than he or she can handle and secondly if there are too many on this list, some trade ideas might get lost in the mix. A short list makes it easier to monitor potential trade opportunities. There can also be a category for stocks that have trade potential in the near future (a day to a week for example). This list can be monitored maybe a little less frequently than the previous list. Another category to consider for the watch list are stocks that have no potential now but may in the future. For example, maybe a stock is trading in the middle of a channel and if it ever trades down to support a bullish opportunity may arise. Stocks should be moved up and down in these different categories as needed.

What’s Important

These were just a few ideas about how a trader can go about developing and monitoring a watch list and searching for potential trade opportunities. The most important part about having a watch list is not how it was acquired but that there is one. A well-refined and updated watch list can yield plenty of potential money making opportunities in option trading.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, July 14, 2016

A Butterfly Can be Used to Lock in Profits

If you had not noticed, the market has been trading at record highs. In fact, some of you might have bought some long calls on the SPDR S&P 500 ETF (SPY). Are there options now besides taking a profit?

There are several ways to make adjustments or lock in profits on a profitable long call or long put position. One of my favorites has to be converting the option position to a long butterfly spread. It may sound funny, but probably the hardest part about an option trader converting his position to lock in profits with a butterfly spread is getting to a profitable position in the first place; the rest is relatively easy! Let’s take a look at a scenario and an outlook in which this butterfly spread can be considered.

Butterfly Spread on SPY

Let’s assume an option trader some August 212 calls about a week ago when the ETF was trading around $212. At the time, the call was priced at 3.00. At the time of this writing, the ETF was trading right around $216. The trader thinks there may be a chance that the market may trade sideways at that level. Converting a long call position to a butterfly spread is advantageous if a neutral outlook is forecast (as in this case). A long butterfly spread has its maximum profit attained if the stock or ETF is trading at the short strikes (body of the butterfly) at expiration.

The option trader is already long the August 212 call which constitutes one wing of the butterfly so he needs to sell two August 216 calls which is the body of the butterfly and where the option trader thinks the ETF may trade until expiration. The $216 level represents where the maximum profit can be earned at expiration. An August 220 call (other wing) would need to be purchased to complete the long call butterfly spread.

The original cost of the August 212 call was 3. The two short August 216 calls sell for 3.05 a piece and the long August 220 call costs 1.10. The converted 212/216/220 long call butterfly spread produces a credit of 2.00 (-3 + 6.10 – 1.10). Now here’s a look at the possible scenarios that could happen and some possibilities that can be considered.

Take Profit

With SPY trading around $216, the August 212 call option has increased in value to 5.80. That means the trader can sell the call and make a profit of $2.80 (5.80 – 3). Certainly this is a viable option and should be considered on some of the contracts before adjusting the position.

Maximum Loss

Maximum loss for a long butterfly spread is realized if the ETF is trading at or below the lowest strike (lower wing) or at or above the highest strike (higher wing). In this case the maximum loss is not a loss at all but a credit of $2.00. In essence, the original $3 potential risk from buying the August 212 call is now erased and has turned into a guaranteed profit even if SPY completely collapses. If the ETF continues to move higher and past the 220 strike at expiration, the maximum loss is still achieved; albeit a $2.00 profit. But more could have been made by simply keeping the original position intact. That is why it may be prudent if there is more than one contract (long call) to maybe not convert all the positions to a butterfly spread, particularity if the trader thinks that the stock or in this case the ETF can still climb higher. Keeping the long call would have more profitable if this scenario played out.

Maximum Profit

Maximum profit is achieved if the trader is right and the ETF closes right at $216 at expiration. The current profit on the trade is $2.80 as discussed above. If SPY continues to trade sideways or ends up at $216 at expiration, that $2.80 profit has now grown to an $6.00 profit. The maximum profit for a butterfly spread is derived from taking the difference between the bought and sold strikes which in this case is $4, and adding premium received from converting the position to a butterfly spread ($2). Not too bad of a result if SPY trades sideways and ends up at $216 at expiration. It seems pretty clear that the long butterfly spread is very beneficial when a sideways outlook is forecast after the long option has profited.

As long as the strike prices align with the trader’s outlook, converting a long call or a long put to a butterfly spread can be very effective after gains are realized. If there are multiple contracts, it allows an option trader to take profits now and also potentially earn more if the stock essentially goes nowhere and ends up close to the short strikes at expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, July 7, 2016

Time for an Option Strangle?

The market has been quite volatile over the past month or so. The S&P 500 started out June trading close to the 2,120 level and then fell to around the 2,000 level before rebounding again. With the Federal Reserve threatening and then backing off from a potential rate hike and the continued threat of more terrorist activities around the globe, 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.

The Particulars

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.

Implied Volatility

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.

Example Trade

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 Kroger Co. (KR) looks good for a potential option strangle since at the time of this writing, the stock is trading around $37.50 after earnings a few weeks ago. With IV dropping big after earnings and the trader unsure in what direction the KR may move now, the option strangle could be the way to go. The trader can buy both an October 40 call and an October 35 put. For simplicity, we will assign a price of 0.80 for both - resulting in an initial investment of $1.60 (0.80 + 0.80) for our trader (which again is the maximum potential loss).

Kroger Stock Rallies

Should KR rally past the call’s breakeven point which is $41.60 (40 + 1.60) at October expiration (over 100 days from now), the 35 put expires worthless and the $40 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 $44 which means the intrinsic value of the call $4 (44 – 40), the profit is $2.40 (4 – 1.60) which represents the intrinsic value less the premium paid.

Kroger 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 KR is trading below the put’s breakeven point of the trade which is $33.40 (35 – 1.60), a profit will be realized. The danger is that KR finishes between $35 and $40 as expiration occurs. In this case, both legs of the position expire worthless and the initial 1.60, or $160 of actual cash, is lost.

Maximum Loss

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!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, June 30, 2016

Hedging Volatility Risk in Take-Over Stocks


Say you hear a takeover rumor. A $50 stock is rumored to be taken out at $55. Looks like a nice spec trade. You go to the option chain to look for some calls to buy. But, wow! The options seem to have gotten expensive. Implied volatility is jacked. Sometimes implied volatility can make options so expensive that even if the trade goes your way the profit is just not there--but the risk is. So, what's a trader to do?
 
One solution can be to buy a bull call spread instead of instead the outright call. The rationale? It's called hedging--hedging volatility premium. Whenever you buy options, you're getting long implied volatility. If implied volatility is expensive, the options are expensive too. And if implied volatility subsequently falls after you make the trade, those options drop in value too. So, what if you both buy and sell an option to create a spread? Let's look at the two legs of a bull call spread
 
Bull Call Spread - Long Leg
 
A bull call spread is when a trader buys one call and sells another that has a higher strike price. Look at it as two trades. The long call would be the one you might buy if you were to spec on the take-over stock. In the case of a take over, this call likely has high implied volatility as the market scrambles to buy up calls, making it pricey.
 
Bull Call Spread - Short Leg
 
Because there is a target price in which the take-over target is expected to be bought, you only need exposure up to a certain point--the take-over price. Why not sell a call at or above the expected take-over price? You're not giving up upside. But you are taking in (expensive) premium to hedge the (expensive) premium you're buying with the long call leg. It's a perfect spread.
 
Example
 
Let's look at this in terms of absolute risk. A stock currently trading for $50 is rumored for take over at $55. News is expected within a couple of weeks.
 
Buy 1 Dec 50 call at $4
 
Sell 1 Dec 55 call at $2
 
Net debit $2
 
Max loss = $2 (That's better than just buying the 50 calls outright)
 
Max gain = $3 (That's the $5 spread minus the $2 premium)
 
Break even = $52 (That's $50 strike plus $2 spread premium)
 
Here the max loss/max gain ratio of the spread is 2:3. The max loss/max gain ratio of the outright call would be 4:1 (Remember, you expect the stock only to rise to $55). The spread looks better so far. Let's look at the break evens. The spread break-even is $52. The outright call's break even is $54. Better still.
 
Wrap Up
 
With all option strategies, there are opportune times when they offer an advantage over an alternative strategy. Bull call spreads and take-over candidates are a natural fit. Traders always need to look for ways to construct the smartest position in terms of risk-reward.
 

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Tuesday, June 14, 2016

Choosing Between Different Risk/Reward Scenarios

As an option trader, you have so many different strategies and risk/reward scenarios to think about before initializing a trade. Many of my students in my Group Coaching class as well as my one-on-one students ask me all the time how do you decide between buying a debit spread and selling a credit spread as one example. Let's take a look at a scenario below and some things for an option trader to think about.

Risk and Reward

A debit spread such as a bull call spread or a bear put spread is considered to have a better risk/reward ratio then a credit spread such as a bull put spread or a bear call spread depending on how it is initiated. Usually the reason is because the debit spread is implemented close to where the stock is currently trading with an expected move higher or lower. A credit spread is usually initiated out-of-the-money (OTM) in anticipation the spread will expire worthless or close to worthless with the underlying barely moving. Here is an example we talked about in class several months ago. LinkedIn Corp (LNKD) was trading around $187.50 at the time. The stock looked like it could drop lower. The trader could consider buying a bear put or selling a bear call spread.

If the option trader expected a move lower into the close of Friday, he or she could have considered buying a 185/187.5 debit spread for August expiration (4 days). If the 187.5 put cost the trader 2.25 and 1.15 was received for selling the 185 put, the bear put (debit) spread would cost the trader $1.10 (also the maximum loss if the stock is at $187.50 or higher at expiration) and have a maximum profit of $1.40 (2.50 (strike difference) – 1.10 (cost)) if the stock was trading at or below $185 at expiration. Thus the risk/reward ratio would be 1/1.27.

If the option trader was unsure if the $187.50 stock was going to move lower but felt the stock would at least stay below a resistance area around $190 by August expiration, the trader could sell a 190/192.5 credit spread with August expiration. If a credit of 1.00 was received for selling the 190 call and it cost the trader 0.50 to buy the 192.5, a net credit would be received of $0.50 for selling the bear call (credit) spread. The maximum gain for the spread is $0.50 if the stock is trading at $190 or lower at expiration and the maximum loss is $2 (2.50 (strike difference) – 0.50 (premium received)) if the stock is trading at or above $192.50 at expiration. Thus the risk reward ratio would be 4/1.

Probability

The risk/reward ratio on the credit spread (4/1) does not sound like something an option trader would strive for does it? Think of it this way though, the probability of the credit spread profiting are substantially better than the debit spread. The debit spread most certainly needs the stock to move lower at some point to profit. If the stock stays around $187.50 or moves higher, the puts will expire worthless and a loss is incurred from the initial debit ($1.10). With the credit spread, the stock can effectively do three things and it would still be able to profit. The stock can move below $187.50, trade sideways and even rise to just below breakeven at $190.50 (190 (sold call) + 0.50 (initial credit)) at expiration and the credit spread would profit. Of course if it closes at $190 or lower, the maximum profit of $0.50 is achieved because the spread expires worthless. A loss is only realized if the stock closes above the breakeven level of $190.50. I like to say OTM credit spreads have three out of four ways of making money and debit spreads usually have one way of profiting especially if the underlying is basically around the long option when the spread is initialized.

Conclusion

There are several more factors to consider when choosing between a debit spread and a credit spread like time until expiration, implied volatility and bid/ask spreads just to mention a few. We will talk about these other factors in future blogs. The risk/reward of the spread and the probability of the trade profiting are just a few to consider mentioned above. A trader always wants to put the odds on his or her side to increase the chances of extracting money from the market. The credit spread can put the odds substantially on the trader's side but it comes at a cost of a higher risk/reward ratio as well.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Wednesday, June 8, 2016

Do Your Equity Options Have Insurance?

If you have ever bought an option and watched the premium go south because of the underlying traded sideways or moved the wrong way, I bet you have thought what it would be like to be the seller of that option. Selling options can be a great way to generate income but it can also produce a large amount of risk as well. If the underlying moves against the position, a huge loss can be realized. A better way to generate income by selling premium might be to consider a spread instead.

Selling a credit spread involves selling an option while purchasing a higher or lower strike option (depending on bullish or bearish) with the same expiration and with the short option being more expensive than the long option. For example, selling a put credit spread involves selling a put and buying a lower strike put with the same expiration. Maximum profit would occur if the underlying is trading at or above the sold put strike at expiration; the spread would expire worthless. Selling a call spread involves selling a call and buying a higher strike call with the same expiration. Maximum profit would be realized if the stock is trading at or below the sold call strike at expiration; the spread would expire worthless.

The long options are there to protect the position from the potential losses associated with selling options. With a spread, the most the position can lose is the difference between the strikes minus the initial credit received. This would occur if the stock is trading above at or above the long call or at or below the long put. Using a call credit spread as an example, if a trader sold a 50 call and bought a 55 call, creating a credit of $1, the most the trader can lose is $4 (5 – 1) if the underlying closed at or above $55.

The Objective

The objective of a credit spread is to profit from the short options' time decay while protecting gains with further out-of-the-money (OTM) long options. The goal is to buy back the spread for less than what it was sold for or not at all (meaning it expires worthless). Just like selling short stock, a trader wants to sell something that is expensive and buy it back for cheaper. The same holds true for credit spreads.

An Example

Here is a credit spread trade idea we recently looked at in Market Taker LIVE Advantage Group Coaching. When Amazon Inc. (AMZN) was trading around $545, an October 495/500 put spread could have been sold for 0.60 with about 25 days to go until expiration. This means the October 500 put strike was sold and the October 495 put strike was purchased for a credit of 0.60. The maximum profit in the spread was the credit received (0.60) and would be realized if AMZN was trading at or above $500 at October expiration. Remember that a profit would be realized if the spread could be bought back (closed out) for less than the credit of 0.60. The most that can be lost on the spread is 4.40 (5 – 0.60) and that would be realized if the stock was to close at or below $495 at expiration.

What’s the Point?

The risk/reward ratio of this credit spread begs the question why would anyone want to risk maybe eight times or more on what they stand to make in the example above? The simple answer is probability. Given the ability to repeat the trade over and over again with different outcomes, the trader will make $60 many, many more times than he or she will take the $440 loss. This was a hypothetical situation, but let's say that the strategies winning percentage was close to 85% like in the example above. The trader needs to look at prior historical price action of the stock to determine probability of success.

Insurance

How does this seem similar to insurance you ask? The credit spread strategy is similar to the insurance business because insurance companies get to keep premiums if people don't get sick or if people don't have accidents, etc. Traders turn themselves into something like an insurance company when they implement credit spreads and keep premium as long as something doesn't go drastically wrong.

Just like an insurance company has to decide if the risk is worth the potential reward, option traders that trade vertical credit spreads have to analyze how much can they collect, how much can they lose and the probability of having a profitable trade. In a future blog, we’ll discuss how a trader can use options implied volatility to help put probability on his or her side.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

 

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