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Wednesday, April 26, 2017

Different Risk/Reward Scenarios

If you have heard me before, you have often heard me say that options have so many moving parts. There are so many more areas to learn and understand than there is for say just trading stocks. 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. Let's look at a theoretical example using ABC Corp. (ABC). Let's say the stock is currently trading at $187.50. 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 December expiration (let's say 4 days from now). 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 December (4 days from now) expiration, the trader could sell a 190/192.5 credit spread with December 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, April 20, 2017

Market Reversals

Fundamentals trump technicals. Economic and supply and demand reports often alter sentiment and are frequently responsible for changing trends or extending them. When there is no data to affect a market, many traders rely on technical signals to interpret momentum, pinpoint entry /exits levels and define risk.

In this issue, we will focus on market turns and how to spot when reversals are likely. During rallies, markets tend to make lows very early in the day and highs are often seen late in the session. During declining trends, highs tend to be made early and lows late in the day. So, when this type of price action ceases, anticipate a pause in trend or possibly the end of one.

Markets tend to consolidate before reversals and there are subtle changes that often telegraph change. The most liquid times of the trading day are during the first hour and last hour. It is during these times that big ticket orders are often executed, in order to be discrete.

In the Japanese Yen chart below the first hour of regular trading hours is highlighted in a yellow rectangle.  Note that during the rally, lows were made very early in the day session.  Also, note when the market turned down highs were made in the first hour of the session.  

When markets are ready to turn they frequently leave clues.  A high or low made during the most volatile time of the day is often a subtle change, a change nonetheless.

 

John Seguin

Senior Options Instructor

Market Taker Mentoring

 

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Wednesday, April 12, 2017

Earnings are Coming!

The market has been relatively quiet over the last several weeks. Occasionally there has been some volatile days mixed in but as a whole, there has not been much volatility. Sooner or later, volatility will reenter the picture and the upcoming earnings season might just give the market a nudge. Although there is no official start to quarterly earnings, Alcoa Inc. (AA) which is expected to announce on April 24th is widely regarded as the start.

There are plenty of option strategies for option traders to consider where the position is meant to be held over the announcement and we will talk about in futures blogs. But there is also a strategy to consider that is meant to be closed out prior to the announcement that most option traders are familiar with. It is buying a straddle or strange ahead of earnings. Let’s take a look below what a straddle and strangle is if you are no familiar with them.

Keeping it fairly simple, a straddle and strangle is buying both a call and put with the same expiration on the same underlying. A straddle is buying the same strike call and put and a strangle is buying to different strikes. Naturally the position is a debit to your account since both a call and put are purchased. There are two ways in which to profit. Either from delta or vega or both.

Since both a call and put are purchased, it is beneficial for the stock to move distinctly in one direction. Then you will have either positive or negative delta and the trade will benefit from a continued move in the direction of the delta. Up and down action is not beneficial usually. Vega effects option premium based on the implied volatility. Options increase in price when IV rises and vice versa. Since the position is long a call and put, it is beneficial for IV to increase.

What hurts the position is vega sometimes and theta always. A decrease in the IV level would decrease the premium by the amount of vega. And since options are a decaying asset, time passing will always decrease the premium by the theta amount.

A straddle and strangle is implemented when there is an expected move in the underlying and the direction is unknown. In addition, IV is expected to increase. Earnings may be a perfect time to consider this option strategy but there are a few things to consider.

The plan for buying a straddle or strangle based on earnings is to put the position on ahead of earnings and exit the position (hopefully for a profit) before the actual announcement. Of course, the position can be held over the announcement, but a big move is probably needed to profit because the IV will drop and so will the option premium after the announcement.

Although past performance is not indicative of future behavior, it might be beneficial to look at a stock’s previous earnings to gauge if it may be a good candidate. The goal is for the stock to move decisively before the actual announcement. Consider buying the position anywhere from about a month to about a week prior to the announcement. Remember time decay (theta) is a concern so be sure to allow enough time and maybe not just pick the expiration that takes place right after the expected announcement.

What usually benefits this pre-earnings position is vega. Since IV generally rises as the earnings date nears, option premiums should rise as well minus any time decay. If the stock moves decidedly higher or lower after the position is put on and IV increases, it is a win-win for the position. Consider managing the position for profit based on an expected return like a certain percentage. Consider managing the position on the stop loss side of things based on two criteria. An exit at a certain point (like before the announcement) and/or a certain percentage of risk just like for profit.

A straddle and a strangle can be very effective option positions. Using them ahead of an earnings announcement may greatly increase your chances for success if the guidelines above are considered. In future blogs, we will go through an example of this option strategy.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Thursday, March 30, 2017

Delta Can Still be Your Friend

As I have said many times in the past, delta is probably the first greek option traders learn after mastering the basics of call and puts. Of course as an option trader advances, he or she also learns the importance of theta, gamma and vega. When an option trader gets to the level of understanding the other greeks, sometimes the importance of delta and direction is forgotten. Let’s take a look at a trade idea we initially talked about a couple of weeks ago in Group Coaching. The trade was meant to profit from theta but delta did the heavy lifting.

When the SPDR S&P 500 ETF (SPY) was trading in the $237 to $238 area a couple of weeks ago, a trader asked me if I knew of a low risk with a potential high reward strategy that he could implement if he thought the market was going to drop at some point over the next month. So in class, we took a look at a long directional put butterfly. Before we go further, let’s take a look at a directional butterfly spread.

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered to be the wings and the short options are the body of the butterfly.

What some option traders don’t realize is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money and using wide strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the size of the wings. In this case, the forecast was for a move lower so a long put butterfly makes sense.

Of course, theta is crucial to make this trade work. If the stock closes at (where max profit is earned) or close to the short strikes at expiration, theta (which is highest ATM) increases the spreads premium up until expiration. But what many option traders neglect when it comes to directional butterflies is the possibility of profiting from delta. When a butterfly is configured OTM, there will generally be a delta greater or less than zero.

We talked about implementing a long 225/230/235 (long the 225, short 2 230’s and long the 235 puts) put butterfly for April monthly expiration. The $230 area was chosen as the body of the butterfly because it acted as previous resistance (target). The cost of the spread and the total risk was 0.50 (or $50 in real terms) which means the max profit would be $450 (5 – 0.50) X 100 if the ETF closed right at $230 at expiration.

The original delta of the spread was -0.11 which means for every dollar the SPY dropped, the spread should increase by 0.11 ($11) based on the delta alone. At the time theta was essentially zero. This past Monday, the SPY dropped over $4 from when the trade was initiated and was trading at $233.75 close to the end of the day. The bid price on the spread increased to 0.95. That means the spread could have been sold for a 0.45 (0.95 – 0.50) profit or $45 in real terms with still 26 days until expiration. In fact, since the drop, the negative delta increased to -0.16 because of gamma. The profit was made almost entirely from a correct move lower and a negative delta as theta was barely positive (just over a penny) and contributed next to nothing to the profit.

Theta is a huge component when profits and a long butterfly are discussed. That there is no doubt. A big advantage of a directional butterfly spread is that it can be a relatively low risk and have a potential high reward depending on how the spread is designed. And as we have seen, an OTM butterfly gives an option trader an opportunity to profit because of delta based on a correct directional forecast even if theta has not joined the profit party as of yet because of too much time left until expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Thursday, March 23, 2017

Trade Location

One of the more difficult issues traders face is choosing prices that are apt to be extremes or highs and lows over a given time frame. Pinpointing daily entry and exit levels, also known as support and resistance areas, requires some history of the market you are trading.

When charting, it is important to label prices where momentum kicks in. Areas where buyers take control of momentum often provide support when retested. Resistance levels form at prices sellers previously showed to force the market lower.

Extremes (highs or lows) made in the 1st hour of regular trading hours frequently provide reversals when retested.  Generally, the high volume and most liquid time of the day is the first hour of the day session. This may explain why it we see reversals when early extremes are retested.

In the 10y note chart below, the prices highlighted in yellow show the first hour range.  On 3/13, the high was made during the first hour.  The high (resistance) for the following day was made when that extreme was tested.  On Friday 3/17 the lower extreme was made in the first hour.  When that extreme was tested on Monday, it was the low (support) for the day.

Extremes often form at old high volume prices as well.  Note the green rectangle covering 3 consecutive sessions (3/10-3/14) of overlapping value areas.  Value areas are the colored rectangles that include about 70% of the volume each day.  When value areas overlap for consecutive sessions volume accumulates in a relatively tight range.  High volume prices tend to provide support / resistance when revisited. This high-volume zone was retested on 3/15 and provided support for the day and it was also the onset of a trend higher.  “Momentum begins and ends at high volume prices.”  A market will typically continue in a direction until it runs into an old high volume area. 

Extremes also regularly form when old very low volume prices are retested.  On 3/15 the Federal Reserve Committee raised interest rates.  The chart shows a spike higher that afternoon. The lowest dip after the rally is noted. That the same level provided support the very next day.  When momentum accelerates, low-volume zones are left behind.  Reversals often occur when such areas are retested.

The crude oil chart below shows a few more examples of support and resistance. Like the chart above when a 1st hour extreme was retested it provided resistance.  On 3/20 the market found support when it retested an old very low volume price from 3/14. The high on 3/21 was made when the 3 sessions of overlapping value (3/15-17) was revisited.  And on 3/23 the overnight high was made when a very low volume price from 3/21 was retested.

To pinpoint extremes, keep track of critical levels where momentum accelerated (very low volume prices).  Note highs and lows made in the first hour the regular trading day.  And when old very high volume prices (congestion areas) are retested expect support or resistance.

John Seguin

Senior Futures Instructor

Market Taker Mentoring Inc.

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Thursday, March 16, 2017

Why Options Trading?

I am often asked this question and truth be told, a whole book can be written to answer that question and literally hundreds have been including two by Dan Passarelli himself. In this blog, I am going to give a few of my thoughts in a couple of paragraphs. Just like many things in life, like working out, eating blue cheese or getting married, options trading is not for everyone. But if you trade in some capacity, it seems to make sense at least to me to consider options trading.

Probably the first thing that got me interested in options and I am sure many of you as well is the ability to resemble owning shares of stock at a greatly reduced rate. For example, with Apple Inc. (AAPL) trading at around $139 at the time of this writing, a trader or investor can buy 100 shares for $13,900 (100 X $139). Or an option trader could buy a Jan-2018 120 call with over 300 days till expiration for around 23.00 or $2,300 ($23 X 100) in real money. As more experienced options traders know, this is not a perfect tradeoff. Stock has no time decay like options (every day that passes options decrease in value due to time) and stock has a delta of 1 meaning for every penny the stock moves higher or lower, the position’s P&L will change by that amount.

Option delta for simplicity is for every dollar the underlying changes, the premium will increase or decrease by the amount of delta. For the AAPL example above, the current delta was around 0.76 so if the stock rose a dollar the position would only gain about $0.76 all things being held constant. The stock position would of course gain a $1 per share. But think of the tradeoff in price and what you could possibly do with the extra money if you purchased the option instead of the stock. In this case the difference is $11,600 (13,900 – 2,300). That is quite a few more potential option trades to consider!

The other aspect of option trading that jumps out at me is the potential to make money of the underlying is trading sideways. That is certainly not an option for stock traders since they can be either long or short the stock and if it trading sideways, there is not much chance to profit. Take a look at this 3-month daily chart below.

Essentially the stock was trading at around $54 three months ago, and three months later, it is still around $54. Now sure the owner of the stock would have collected a dividend, but he or she would have made zilch on the underling itself. Without going into great detail (to be discussed in future blogs), an option trader could have potentially collected premium with the stock trading sideways over the last several months. Out-of-the-money (OTM) vertical credit spreads could have been sold above and below the stock’s sideways range. So wrapping this section up, the ability to sell premium against an underlying or all on its own, gives an option trader an advantage in my opinion over other types of trading.

Certainly, we are just tipping the iceberg on the advantages and of course some disadvantages about options trading. But the ability to set up a strategy no matter what the market or underlying is doing, gives option traders a distinct advantage over other trading vehicles in my humble opinion!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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