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Thursday, July 27, 2017

Trader Checklist

Spend time with a broker or pit trader from the era when all trades were executed at an exchange and you will learn a lot about the auction process and the information it provides. Trading pits are spheres of activity that appear chaotic to the untrained eye. But for a seasoned observer. a trading pit reveals vital information. Every trader or broker monitors order flow. After assessing any number of variables from the market generated information, they decide to buy, sell or not trade at all.

For about 20 years I watched price action in many of Chicago’s futures pits. One of my duties was to report the information to institutional traders, fund managers and retail clients. I frequently felt like a color commentator at a sporting event. For example, a trader from New York would call and ask who or what firm was buying or selling.  Meanwhile another trader from London might ask how much was on the bid or how much was offered. Another client might inquire if volume was light or heavy or where should they look to buy, sell or set risk. The questions varied but there was some consistency to the information all traders seek.

To create a discipline or strategy, it is wise to follow the same path professional traders take. The goal…Find the answers to the questions pros ask, day in and day out. I condensed these questions into an easy to remember acronym, V.E.R.T.E.X.

To become a successful trader, it is imperative that you learn to address and analyze the components that make up VERTEX.

The “V” stands for Value. Value is that price where buyers and sellers trade most often over a given time frame. It is considered the high volume or fair price. Momentum is defined as the movement away from a fair price.  Which brings us the next letter.

“E” is for Energy or momentum. To catch a trend higher, it is important to recognize when bulls have taken control of momentum. And sellers will show dominance in a declining trend by hitting bids. There are many technical indicators that are used to determine momentum, most notably moving averages. I prefer to track fair prices to determine when momentum becomes apparent.

The “R” represents Risk. Risk can be defined as a change in momentum. Many traders asked about where they should enter a stop loss order. If a trader has entered a bullish position, it is important to enter a stop loss at a level where momentum turns negative and vice versa.

“T” stands for Timing. Markets do 2 things, they trend and consolidate or run and rest. When a market is considered overbought or oversold it has moved too far too fast, thus favoring a rest period or consolidation phase. Therefore, the timing is not right to enter a trend type trade. On the other hand, when ranges and volume are below average during a period of consolidation, odds increase for a breakout or trend to begin. A trader should track ranges in various time frames (day, week, month). When these measurements are far below average, the timing is often right for a trend to commence.

The second “E and “X” are for Entry and Exit. They are also known as support levels which are below the current price. And resistance levels are above the current price. They can also be thought of as projections or prices where profits might be taken. Old high-volume prices and low volume pockets tend to provide support/resistance when retested.

When creating strategy, a trader must address these variables. If you want to trade like a pro you will have to learn to think like one.

John Seguin

Senior Futures Instructor

Market Taker Mentoring Inc.

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Thursday, July 20, 2017

Making Option Adjustments

I have stated my thoughts numerous times about option adjustments in Group Coaching and this past weekend in Portland where we hosted our 4th Annual Options Retreat. 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 Inc.

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Tuesday, July 11, 2017

Option Traders Need Watch Lists Too

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 thought 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 stocks 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. This is very similar to determining potential strengths and weaknesses of a football 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. Go Broncos!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Wednesday, July 5, 2017

Option Delta and Gamma Work Closely Together

The market has been very volatile lately. Many big-name stocks have been moving in sometimes dramatic fashion on a daily basis. Now might be wise time to review how option prices change when the underlying changes. This is why almost every day, I give my traders a quiz on the greeks in Group Coaching. It is that important! 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Thursday, June 29, 2017

Will Implied Volatility Rise Soon?

With the latest jobs report due out this coming Friday and the markets seemingly being extra skittish as of late, volatility may come back into the picture. If you had not noticed, implied volatility levels have been at or close to their 52-week lows for many equity options for several months. 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.

Have a great Fourth of July!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Tuesday, June 20, 2017

Delta is Multiplied

As an option trader, there are quite a few areas to learn and master before being able to extract money from the market on a regular basis. If you are in Group Coaching, you know how I feel about learning the option greeks. I give you quizzes on them to make you a better and more knowledgable option trader. Learning what the option greeks mean and how they function alone and in relation to the other greeks is very important as an option trader. Here we will take a look at one of the greeks and consider what many option traders often fail to consider.

Option Delta

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context, one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

AAPL Example

What many traders fail to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple Inc. (AAPL) when the stock was trading at $145 and purchases 3 August 145 call options. Each call contract has a delta of +0.53. The total delta of the position would then be +1.59 (3 X 0.53) and not just 0.53. For every dollar AAPL rises all factors being held constant again, the position should profit $159 (100 X 1 X 1.59). If AAPL falls $2, the position should lose around $318 (100 X -2 X 1.59) based on the delta alone.

Using AAPL once again as the example, lets say a trader decides to purchase a October 145/150 bull call spread instead of the long calls. The delta of the long $145 call is once again 0.53 and the delta of the short $150 call is -0.37. The overall delta of the position is 0.16 (0.53 - 0.37). If AAPL moves higher by $3, the position will now gain $48 (100 X 3 X 0.16) with all factors being held constant again. If AAPL falls a dollar, the position will suffer a $16 (100 X -1 X 0.16) loss based on the delta alone.

Last Thought

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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