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Thursday, December 8, 2016

Elements and Behaviors for Good Trading

Successful trading requires analysis, record keeping, money management and near flawless execution. Without all of these elements, profitable trading may very well remain elusive.

Analysis should be done in a systematic way that uncovers opportunities in “your” timeframe. The choice of timeframes can range from months to seconds. There is a saying that goes “there are a lot of ways to skin a cat.” Choose a method that suits your personality and capabilities. Some traders gravitate towards quantitative research because of their ability to conduct that type of analysis while others feel more at ease using bar formations and classical technical analysis. On the other side of the spectrum, depth fundamental research may be the ticket for others.

Whatever your choice, become an expert at your craft. Stick to it and you will be competing with some of the most motivated and successful people in the world.

Detailed record keeping is often neglected by traders. All actions and trades should be entered in a diary or log book where they can be analyzed at the end of the day, week or month. From the entry and the exit of each trade, print out a chart. The print out should include notes about why you entered and exited and any other notable observations during the trade. Track your trades. Did they have an edge and if so, did that that edge hold up over time?

The better records one keeps, the more prepared they are to make changes and adjustments to their program and trading plan.

Proper money management gives you the ability to keep you in the game when things are going wrong and live to fight another day as they say. Committing too much to any one trade or not adhering to your stop out point, can shorten a trading career exponentially. Using a small portion of your available capital per trade will allow for a bad streak without knocking you completely out of the game. At 2% risk capital per trade, a trader can have over thirty losses in a row, and still preserve more than half of his or her capital. Keeping your risk to a minimum also allows for a trader to maintain a cool head and not panic or let unwanted emotions rule your trading.

Predetermine the risk on each trade and stick to it. This will allow you to potentially be around long enough to see your edge pay off.

Flawless execution is a trademark of a focused trader. Unforced errors add costs to a trader’s business. Unforced errors are mental mistakes that are preventable. These errors can be in numerous forms. Buying when wanting to sell or selling when wanting to buy are common mistakes that traders face when they lose focus. Taking the whole trade off when the plan called for only removing a few contracts is also very common and potentially very damaging. Costly errors can also occur when a larger position was entered than what was intended. These errors are generally made due to poor mechanics or communication. Trading is difficult enough without introducing erroneous costs and stress. Be calm and focused when entering and managing trades and be free from the pitfalls of unforced errors.

Trading requires solid analysis and meticulous record keeping. Many traders may be tempted to stop there. Finish the equation and be sure to manage your funds with great care and focus. Follow this formula and you will put yourself in an excellent position to succeed.

Craig Garbie

Senior Futures Instructor

Market Taker Mentoring

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Thursday, December 1, 2016

Delta and Gamma are Close Friends

Not sure if you have noticed, but the market has been very volatile lately. Stocks have been moving in sometimes dramatic fashion on a daily basis so it might be wise to review how option prices change when the underlying changes. The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.

ATM, ITM and OTM

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

Enjoy the holidays!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Tuesday, November 22, 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. 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. Enjoy the holidays!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, November 17, 2016

Time to Consider an Option Strangle?

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 the past presidential election, 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 Colgate-Palmolive (CL) looks good for a potential option strangle since at the time of this writing, the stock is trading around $66. With IV lower than HV and the trader unsure in what direction the CL may move, the option strangle could be the way to go. The trader would buy both an December 67.5 call and a December 65 put. For simplicity, we will assign a price of 0.75 for both - resulting in an initial investment of $1.50 (0.75 + 0.75) for our trader (which again is the maximum potential loss).

Twitter Stock Rallies

Should CL rally past the call’s breakeven point which is $69 (67.50 + 1.50) at December expiration, the 65 put expires worthless and the 67.50 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 $70 which means the intrinsic value of the call $2.50 (70 – 67.50), the profit is $1 (2.50 – 1.50) 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 CL is trading below the put’s breakeven point of the trade which is $63.50 (65 – 1.50), a profit will be realized. The danger is that CL finishes between $65 and $67.50 as expiration occurs. In this case, both legs of the position expire worthless and the initial 1.50, or $150 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.

Happy Thanksgiving!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Wednesday, November 9, 2016

Ever Consider a Trailing Stop for Options?

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 yet lower again. 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!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Wednesday, November 2, 2016

Ever Consider an Iron Condor?

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.

Although we are getting close to finishing 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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