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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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Thursday, August 18, 2016

Volatility to the Rescue

Many of my students have emailed me in regard to the current market conditions. The low volatility of the broad market as well as the low option premiums (as measured in terms of implied volatility) has made trading of any sort, but especially option trading, a challenge lately.

Traders have little incentive to buy options because if the market doesn’t move, which has been the case for nearly 3 weeks now, option positions lose as a result of time decay. And option traders have little incentive to implement income (option-selling) strategies because the low premiums mean the profit incentive is very low. And if the market breaks out of the range, which it will at some point, the risk is very high.

The good news, seemingly ironically, is that volatility is likely to increase. From a simplistic standpoint, all traders know tight ranges can’t last forever, so each day that passes, while the market remains in a tight range, means we’re one day closer to a breakout. But more cerebrally, the term-structure of VIX futures indicates the market is collectively pricing in higher volatility with each successive futures expiration. VIX futures prices represent the market’s expectation for the forward value of the VIX (or the implied volatility of SPX options). VIX futures have higher prices the farther out in time we go. That means the market, especially the smart money, thinks we are in for higher, much higher, volatility through the rest of the year.

No one is saying the market has to move lower, or for that matter higher in the near future. Many so called “market experts” have been calling for the market to move lower for the past several weeks and yet it has not substantially if at all. With the expectation that implied volatility will increase at some point and uncertainty about market and/or underlying direction, buying a straddle or strangle may be worth considering.

A straddle is buying a call and a put with the same strike and expiration. A strangle is buying a call and a put with different strikes but with the same expiration. The trade can profit in two ways; underlying volatility and/or an increase in implied volatility. Since the position is both long a call and put, it can profit from a move in either direction. The position is also positive vega (measures the option’s sensitivity to changes in the underlying volatility on the option) because of both long positions. An expected increase in implied volatility should increase the overall premium of the straddle or strangle.

The potential risks are that the underlying does not move or move enough and/or the implied volatility does not increase. The position will lose money due to time decay because of the long call and put. In addition, if the implied volatility does not increase to help offset some or all of the time decay, the position will most likely lose value.

Learn more about how to make money in any market in this eBook, 3 Secrets to Making Money in Any Market markettaker.com/3_secrets_ebook/.

Dan Passarelli

Market Taker Mentoring

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Thursday, August 11, 2016

Options and Trailing Stops

The market has continued to move higher and keep the bears at bay for longer than many would have predicted. Even though the market has rallied as of late, the market will eventually move lower at some point. 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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Thursday, August 4, 2016

Short-Term Bear Put Spreads

With the market being possibly extended and at a resistance level with the threat of potentially moving lower, it may be time to look at short-term bearish strategies. Many of these pullbacks may last for only a couple of days to sometimes a week. Buying puts on these particularly high-priced stocks is one option a trader has but it can be very expensive for many traders even if implied volatility is relatively low like it has been. A trader can get around buying expensive puts by creating a lower-cost bear put spread on weekly options if they are offered. Weekly options are offered on Thursday and generally have expirations out about two months. Before going further, let’s take a look at the definition of a bear put spread.

Bear Put Spread


A bear put spread involves buying a put option and selling a lower strike put option against it with the same expiration. The cost of buying the higher strike put option is somewhat offset by the premium received from the lower strike that was sold. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The option trader will realize this maximum gain if the price of the stock is at or lower than the strike that was sold at expiration. Seeing that the bearish move is expected in a short amount of time and maximum profit occurs at expiration, a weekly bear put spread may be an ideal option. The most the option trader can lose is the cost of the spread. This maximum loss will occur if the stock is trading at or above the put that was bought at expiration.

Delta and a Bear Put Spread

 
A positive which can also be a negative thing about a debit spread such as the bear put spread is the delta on the trade. Delta measures the rate of change of the option value compared to the change in the stock. Since the trader is both long a put (negative delta) and short a put (positive delta), the delta is generally a lot smaller than being just long a put. If the stock moves higher, an option trader likes the spread because the trade should lose significantly less than a long put. If the stock moves in the intended direction down, maybe not so much.

An Example:

 
It is the beginning of August and Amazon Inc. (AMZN) was trading around $755. A trader notices that the stock has reversed after an all-time high and looks to be moving lower. The trader realizes this may be a short-term bearish sign for the stock. The trader can purchase an at-the-money (ATM) put that expires in about 45 days for 20.00 (2,000 in real money). The long put has a negative delta of 0.50 which means that if AMZN goes up or down a dollar the trade will make or lose about $0.50 currently based solely on delta.

Bear Put Scenario


Another scenario is to do a bear put spread which can lower the cost (risk) and the maximum profit. There are weekly options on AMZN that expire in ten days. A trader could buy the Aug-12 755 put for 9.20 and sell the Aug-12 750 put for 6.75. This lowers the cost of the trade to $2.25 (9 – 6.75) and makes the breakeven point $752.75 (755 – 2.25) on the spread versus $735 (755 – 20) with the September 755 put. One of the detriments to the bear put spread is that profit potential is capped. In this case maximum profit potential would be $2.75 (5 – 2.25). The maximum profit on a long put is almost limitless.
 
The delta on the bear put spread is 0.10 versus 0.50 with the long put. Now if AMZN goes up or down a dollar, the spread will currently make or lose $0.10. This could be a good thing if the stock rises because less will be lost with a lower delta and not so much of a good thing if the stock falls as expected because gains will be realized at a slower rate. The best-case scenario for the trade is for AMZN to be trading at or below $750 at next week’s expiration. The maximum profit is achieved regardless of the delta. 

Final Thoughts

 
A spread trade like the bear put may be viewed as a more conservative choice versus a long put. There are some great things about simply buying a long put like almost unlimited profit potential and a higher delta. But a trader needs to consider if he or she thinks the stock will drop enough to warrant buying more expensive puts especially if the drop in price is thought to be short-lived especially in a volatile atmosphere like we are experiencing. Compared to a long put, a bear put spread can lower the cost of the trade, provide a higher breakeven point and if the stock doesn’t perform as planned, create a smaller loss.
 
In addition, a spread with a shorter expiration can profit in a short amount of time versus a spread that might reach expiration in a month.

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Wednesday, July 27, 2016

Should You Ever Consider Short-Term Call Options

When an option trader buys a call option, he or she has the right to buy the underlying at a particular price (strike price) before a certain time (expiration). Keep in mind that just because the option trader has the right to buy the stock, doesn’t mean that he or she has to necessarily do so. The call option just like a put option can be sold anytime up until expiration for a profit or loss.

A lot of traders especially those who are just learning to trade options can fall in love with call options and especially short-term call options because they are cheaper than call options with longer expiration's. We can classify short-term call options as call options that expire in less than thirty days for the sake of this discussion. But there is a potential problem with purchasing short-term call options. The shorter the amount of time that is purchased, the higher the option theta (time decay) will be. The higher the time decay, the quicker the premium will erode away the call option’s premium. The call option may be cheaper due to a shorter time until expiration, but it may not be worth it overall. Let us take a look.

With Netflix Inc. (NFLX) trading around $91 last week, an option trader might have considered call options to profit from an expected move higher. He could have purchased the Jul-29 91 calls for about 1.00 that expired in 3 days. Yes, the options are cheap and yes they will profit if NFLX moves up vigorously in the next couple of days. But the option theta is 0.23 on the call options meaning they will lose $0.23 for everyday that passes with all other variables being held constant, In fact if the stock trades sideways, the option theta will increase the closer it gets to expiration since there is currently no intrinsic value (the in-the-money portion of the option’s premium) on the call options.

If an option trader purchased the August 91 calls for NFLX, it would have cost him 2.90 and it would have made the at-expiration breakeven point of the trade $93.90 (91 + 2.90) versus only $92 (91 + 1) with the Jul-29 call options. But the major benefit to buying further out is option theta. The August 91 calls had an option theta of 0.06 meaning for every day that passes, the option premium would decrease $0.06 based on the option theta and all other variables being held constant. This is certainly a smaller percentage of a loss based on option theta for the August options (3.7%) versus the Jul-29 options (23%) especially if the stock trades sideways or moves very little.

Fast forward a couple of days to Jul-29 expiration and let's pretend NFLX closed basically at $91.50. The Jul-29 91 call would have expired with an intrinsic value of $0.50 (91.50 – 91). If the option trader did nothing up until expiration, the long Jul-29 91 call would have lost $0.50 (1 - 0.50) because there would be no time value (option theta) left and only the intrinsic value. The August 91 call would have lost approximately $0.18 (3 X 0.06) in theta but also gained $0.25 (0.50 X 0.50) from delta based on a delta of 0.50 and a $0.50 (91.50 - 91) move higher. The August 91 calls would now be worth $2.97 (2.90 + 0.07) and profited $0.07 (2.97 – 2.90). The profit is not much but it is still a profit which is the point!

Having enough time until expiration is a critical element when an option trader is considering buying options like the call options we talked about above. Keep in mind that as a general rule, options lose value over time and the option theta starts to accelerate even more with 30 days or less left until expiration. Buying a call option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta, might be worth the more expensive price especially if the underlying fails to move higher.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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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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