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Thursday, September 29, 2016

Credit Spreads Can Act Like an Insurance Policy

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 Group Coaching. When the SPDR S&P 500 ETF (SPY) was trading around $215 towards the end of September, a Sep-30 211/212.5 put spread could have been sold for 0.25. This means the Sep-30 212.50 put strike was sold and the Sep-30 211 put strike was purchased for a credit of 0.25. The maximum profit in the spread was the credit received (0.25) and would be realized if SPY was trading at or above $212.50 at Sep-30 expiration which was less than a week away. Remember that a profit would be realized if the spread could be bought back (closed out) for less than the credit of 0.25. The most that can be lost on the spread is 1.25 (1.50 – 0.25) and that would be realized if the stock was to close at or below $211 at expiration.

What’s the Point?

The risk/reward ratio of this credit spread begs the question why would anyone want to risk maybe nine 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 $25 many, many more times than he or she will take the $125 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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Wednesday, September 21, 2016

Is There Such a Thing as Cheap Options?

It seems like every so often in my Group Coaching class or through an email, a student will ask me about buying a deep out-of-the money (OTM) options. Many option traders especially those that are new, initially buy deep out-of-the-money options because they are cheap and can offer a huge reward. Unfortunately many times, these “cheap” options are rarely a bargain. Don’t get me wrong, at first glance an OTM call that costs $0.25 may seem like a steal. And don't get me wrong again, a big move higher can certainly make it seem like a great trade. Since the baseball season is less than two weeks away, we can use a baseball analogy and say that if the trade works out, it could turn into a real home run; maybe even a grand slam. But if the call’s strike price is say $20 or $30 (depending on the stock price) above the market and the stock has never rallied that much before in the amount of time until expiration, the option will likely expire worthless or close to it at expiration.

Negative Factors

Many factors work against the success of a deep OTM call from profiting. The call’s delta (rate of change of an option relative to a change in the underlying) will typically be so small that even if the stock starts to rise, the call’s premium will not increase much. In addition, option traders will still have to overcome the bid-ask spread (the difference between the buy and sell price) which might be anywhere from $0.05 to $0.15 or even more for illiquid options.

Option traders that tend to buy the cheapest calls available are probably calls that have the shortest time left until expiration. If an OTM call option expires in less than thirty days, its time decay measured by theta (rate of change of an option given a unit change in time) will be often larger than the delta especially for higher priced and more volatile stocks. Any potential gains from the stock rising in price can be negated by the time decay. Plus each day the OTM call option premium will decrease if the stock drops, trades sideways or rallies just a tad.

Quick Example

With Alphabet Inc. (GOOGL) trading at around $800, a trader can purchase an October 900 call with about 30 days till go until expiration for about 0.45. Yes that is about $100 higher than the stock price. With GOOGL being a fairly expensive stock, in-the-money (ITM), at-the-money (ATM) and plenty of OTM options can be very expensive for many traders. Buying the October 900 call may look enticing. What many option traders fail to recognize is that the option has a delta of 0.02 and theta of 0.03. So even if the stock rose $5 over the course of two days, the call option would only increase by about $0.04 (0.10 - 0.06). This is computed by adding $0.10 from delta ($5 X 0.02) and subtracting $0.06 (2 days X 0.03) because of theta. So option traders need to ask themselves is it really a bargain?

Final Thoughts

A deep OTM call option can become profitable only if the stock unexpectedly jumps much higher. If the stock does rise sharply, an OTM call option can hit the proverbial home run and post impressive gains. The question option traders need to ask themselves is how much are they willing to lose waiting for the stock to rise knowing that the odds are unlikely for it to happen in the first place? Trades like these have very low odds and may be better suited for the casino then the trading floor.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, September 15, 2016

Adjustments on Options

I have stated my thoughts numerous times including this past week in Group Coaching about adjustments on options. Although I personally do not like using the word "adjustments" with options trading (I prefer your new outlook or just a new trade), there are many times they need or maybe should to be done. Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into winners. Given that, it's easy to see why it's important to learn to adjust options positions.

Adjusting 101

Adjusting options positions is a technique in which a trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market physiology changes and the original trade no longer reflects the trader's thesis. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.

This seems like a very obvious rule. And at the onset of any trade, it is. If I'm bullish, I am going to take a positive delta position. If I think a stock will be range-bound, I would take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.

Gamma

Option gamma and particularly negative gamma, is usually the reason for, or at least the consideration for adjusting.

Gamma definition: Gamma is the rate of change of an option's (or option position's) delta relative to a change in the underling.

Oh, yeah. And, just in case you forgot...

Delta definition: Delta is the rate of change on an option's (or option position's) price relative to a change in the underlying.

In the case of negative gamma, trader's deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).

Finally

Even though I am not a big fan of using the word "adjustments", it does not mean that you should not take a proactive stance and never adjust your option trades. Option traders must learn to adjust options positions, especially income trades in order to try and lessen the affect of adverse deltas created by the negative gamma that accompanies the trades. Once an option trader has a good grip on what changes need to be made based on his or her new outlook, potential profit can be an adjustment away!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, September 8, 2016

Is Option Gamma as Important as Delta?

Many option traders will refer to option delta as the most important option greek. It is debatable but in my opinion if you do consider it the most important, the next most important greek for me is option gamma. Option gamma is a one of the so-called second-order option greeks. It is, in theory, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Just over a week ago, I gave the traders in my Group Coaching class a quiz on the greeks which of course included delta and gamma as a big part of the test. I think most were a little suprised at how poorly they did on the quiz even though they may have thought they understood them better than their results showed. I will continue to work with them to improve their "greek" skills but it goes to show that there may be room fr improvement for many option traders.

Using option gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using option gamma:

When you buy options you get positive option gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL October 105 long call that has an option delta of 0.55 and option gamma of 0.05 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive option gamma is a good thing.

When you sell options you get negative option gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative option gamma is a bad thing and as I like to say it is never your friend when selling premium.

Start by understanding option gamma and of course delta from this simple perspective. Then, later, worry about figuring out the math, even if a calculator is still needed!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, September 1, 2016

Implied Volatility May Soon be a Factor Again!

With the latest jobs report in the rearview mirror and the Federal Reserve pondering their next interest rate hike, volatility may come back into the picture. Implied volatility levels have been at or close to their 52-week lows for many equity options. It is vitally important in my opinion for option traders to understand one of the most important steps when learning to trade options; analyzing implied volatility and historical volatility. This is a way option traders can gain edge in their trades especially when the volatility of the underlying may be reduced or inflated. But analyzing implied volatility and historical volatility is often an overlooked process making some trades losers from the start.

Implied Volatility and Historical Volatility

Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of a stock with another stock or to the stock itself over a period of time. For example, a stock that has a 20 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 now is more volatile than it was when its historical volatility was, say, 20.

In contrast to historical volatility, which looks at actual stock prices in the past, implied volatility (IV) looks forward. Implied volatility is often interpreted as the market's expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock's options. For example, the market (collectively) expects a stock that has a 20 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile.

Analyzing Volatility

Implied volatility and historical volatility is analyzed by using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are misinterpreted by new or less experienced option traders.

Volatility chart practitioners need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock's volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a "good" price. In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.

But that is not where the story ends. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sale; if it is below its normal level it may be a good buy.

Finally, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was typically in the past, the stock is now more volatile than normal.

If current implied volatility doesn't justify the higher-than-normal historical volatility, the trader can capitalize on the disparity known as the skew by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.

The Art and Science of Implied Volatility and Historical Volatility

Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are talked about above but there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is different. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade which is precisely what every trader wants and needs!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, August 25, 2016

Option Settlement

Traders and investors have been navigating through a mostly neutral and relatively low IV as of late. Despite the low IV, selling premium is an option strategy that many traders consider when attempting to extract money from the markets. Selling cash-secured puts is an option strategy investors consider when trying to purchase stock at a 'discount" or to just generate some extra premium for their portfolio. But when stocks fall like they could in this current environment, it is extra imperative that option traders know how settlement works.

A question that is often asked in Group Coaching and one that is probably not discussed enough when learning to trade options is that of the various settlement issues. Many option traders limit their universe of option trading to two broad categories. One group consists of individual equities and the similar group of exchange traded funds (ETFs). The other group is composed of a multitude of broad based index products. These two groups are not entirely mutually exclusive since a number of very similar products exist in both categories. For example the broad based SPX index has a corresponding ETF, the SPY.

The first category, the individual equities and ETFs, trade until the close of market on the third Friday of each month for the monthly series contracts. These days there are more and more ETFs and equities that also have weekly settlements too. These contracts are of American type and as such can be exercised by the owner of the contracts for any reason whatsoever at any time until their expiration. If the contract is in-the-money at expiration by just one cent, clearing firms will also exercise these automatically for the owners unless specifically instructed not to do so in many cases. The settlement price against which these decisions are made is the price of the underlying at the close of the life of the option contract.

When this first group we are discussing settles, it is by the act of buying or selling shares of the underlying equity/ETF at the particular strike price. As such, the trader owning a long call will acquire a long position in the underlying and the owner of a put a short position. Conversely, the trader short these options will incur the offsetting action in his account. Obviously, existing additional positions in the equity/ETF itself may result in different final net positions.

The second category, the broad based index underlyings, are also termed “cash settled index options”. This category would include a number of indices, for example RUT and SPX. As the name implies, these series settle by movement of cash into and out of the trader’s account. The last day to trade these options is the Thursday before the third Friday; they settle at prices determined during that Friday morning. Like ETFs and equities, these index options also have weekly settlements as well.

One critically important fact with which the trader needs to be familiar with is the unusual method of determining the settlement price of many of the underlyings; it is NOT the same as settlement described above. Settlement for this category of underlyings has the following two characteristics important for the trader to understand: 1.The settlement value is a calculated value published by the exchange and is determined from a calculation of the Friday opening prices of the various individual equities, and 2. This value has no obligate relationship to the Thursday closing value for the underlying.

Many option traders choose never to allow settlement for the options they hold, either long or short. For those who do allow positions to settle, careful evaluation of the potential impact on capital requirements of the account must be a routinely monitored to avoid any surprises. When in doubt the best way to go is to ask your broker how they will handle settlement for your particular situation and tell you what alternatives you might have.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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