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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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Thursday, June 15, 2017

Define Value and Define Risk

For traders, risk is one of the hardest things to define after entering a trade. Risk is a change in momentum. If a short position is taken due to negative momentum, that trade should be held until momentum turns positive. Conversely, a long position should work until momentum turns negative.

To define risk, we must first determine a fair value area. A value area is a market profile term that includes approximately 70% of total volume (one-standard deviation) around the mean or high-volume price.

The 30-minute bar chart for gold shows daily value areas. The daily value areas are constructed during regular trading hours which is also the high volume or most liquid time of day. Generally, if a price trades in more than four 30-minute periods during regular trading hours, it is considered part of the value area. Note that the top and bottom of each shaded box has been visited at least 4 times during the trading day. 

Once a direction has been established, a value area can be used to define risk.  For example, in the gold chart the top of value is used to determine risk in a falling market. By using this method, a trader may lock in profits each day using a trailing stop or another exit. The trade is exited when an objective is met or the top of value is violated. On the other hand, the soybean meal chart shows how to trail a stop using the bottom of value area in a rising market.

This method of defining risk is useful for day to swing type trades. When momentum or direction becomes clear, value areas can reduce risk and protect profit.

John Seguin

Senior Futures Instructor

Market Taker Mentoring Inc.

 

 

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Wednesday, June 7, 2017

Using a Butterfly to Lock in Profits

Here is a topic I have talked recently and quite frequently with several of my one-on-one students; locking in profits with an adjustment. There are several ways to make adjustments or lock in profits on a profitable long call or long put position. One of my favorites has to be converting the option position to a long butterfly spread. It may sound funny, but probably the hardest part about an option trader converting his position to lock in profits with a butterfly spread is getting to a profitable position in the first place; the rest is relatively easy! Let’s take a look at a scenario and an outlook in which this butterfly spread can be considered.

Butterfly Spread on AAPL

Let’s assume an option trader has been watching Apple Inc. (AAPL) stock and noticed the stock pulled back slightly from the uptrend in which it has been trading in the middle of May. When Apple stock was trading around $150, he decides to buy the June 150 call options for 3. Lo and behold the stock moved higher over the last couple of weeks and is trading close to the $155 area. The $185 level is potential resistance for the stock because it has previously traded to that area twice before and the trader is concerned it might happen once again. The trader thinks there may be a chance that AAPL may trade sideways at that level. Converting a long call position to a butterfly spread is advantageous if a neutral outlook is forecast (as in this case). A long butterfly spread has its maximum profit attained if the stock is trading at the short strikes (body of the butterfly) at expiration.

The option trader is already long the June 150 call which constitutes one wing of the butterfly so he needs to sell two June 155 calls which is the body of the butterfly and where the option trader thinks the stock may trade until expiration. The $155 level represents where the maximum profit can be earned at expiration. A June 160 call (other wing) would need to be purchased to complete the long call butterfly spread.

The original cost of the June 150 call was 3. The two short June 155 calls sell for 2 (rounded for ease) apiece and the long June 160 call costs 0.50. The converted 150/155/160 long call butterfly spread produces a credit of 0.50 (-3 + 4 (2 X 2) – 0.50). Now here’s a look at the possible scenarios that could happen and some possibilities that can be considered.

Take Profit

With AAPL trading around $155, the June 150 call option has increased in value to 6. That means the trader can sell the call and make a profit of $3 (6 - 3). Certainly, this is a viable option and should be considered on some of the contracts before adjusting the position.

Maximum Loss

Maximum loss for a long butterfly spread is realized if the stock is trading at or below the lowest strike (lower wing) or at or above the highest strike (higher wing). In this case the maximum loss is not a loss at all but a credit of $0.50. In essence, the original $3 potential risk from buying the June 150 call is now erased and has turned into a guaranteed profit even if AAPL completely collapses. If the stock continues to move higher and past the 160 strike at expiration, the maximum loss is still achieved; albeit a $0.50 profit. But more could have been made by simply keeping the original position intact. That is why it may be prudent if there is more than one contract (long call) to maybe not convert all the positions to a butterfly spread, particularity if the trader thinks that the stock can still climb higher. Keeping the long call would have more profitable if this scenario played out.

Maximum Profit

Maximum profit is achieved if the trader is right and stock closes right at $155 at expiration. The current profit on the trade is $3 as discussed above. If Apple stock continues to trade sideways or ends up at $155 at expiration, that $3 profit has now grown to an $5.50 profit. The maximum profit for a butterfly spread is derived from taking the difference between the bought and sold strikes which in this case is $5, and adding premium received from converting the position to a butterfly spread ($0.50). Not too bad of a result if the stock trades sideways or ends up at $155 at expiration. It seems pretty clear that the long butterfly spread is very beneficial when a sideways outlook is forecast after the long option has profited.

As long as the strike prices align with the trader’s outlook, converting a long call or a long put to a butterfly spread can be very effective after gains are realized. If there are multiple contracts, it allows an option trader to take profits now and also potentially earn more if the stock essentially goes nowhere and ends up close to the short strikes at expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Thursday, June 1, 2017

Sprints Initiate Trends

Every trader’s dream is to catch a trend early and ride it to the end. It is a tough task and nearly impossible to sell the absolute high or buy the absolute low. However, there are short-term patterns that frequently precede trends. Patterns of consolidation are probable just before trends and sprints are frequent when trends begin.

A ‘sprint’ occurs when a market rapidly leaves a fair value area. SPRINT is short for single prints. Single prints define a series of low volume prices left behind as a market rises or declines. To get a visual of sprints refer to the crude oil 30-minute bar charts.

The different color boxes within the charts display the fair value area during regular trading hours. Regular trading hours are the most liquid or high-volume time of day. A ‘value area’ captures approximately 70% of the days total volume or roughly 1 standard deviation. When consecutive value areas overlap, odds increase for a vertical move or sprint away from fair value.

In chart 1 note that after 3 sessions of sideways trades (overlapping value) a sprint lower occurred about mid-session Monday 4/17. That single bar is a sprint and was the onset of a trend lower. And once a market begins to trend there many days with sprints as the market accelerates in a direction, in this case lower. Sometimes, markets forecast when a market is ripe to trend. More often trends begin after a few days of below average ranges with overlapping value areas. So, to increase the odds of catching a trend early, search for markets that are wound a bit too tight. 

In chart 2 note the trend higher began with a sprint higher on Monday 3/27. That day was followed by a few more days with sprints as the market accelerated higher. Also, that trend resumed after a few sessions of sideways trade (3/30-4/3).  Markets rest and run or consolidate and trend. This short-term pattern of about 72 hours of consolidation may be an alert to prepare for a breakout and recognizing a sprint should enhance your timing to catch a trend early.

John Seguin

Senior Futures Instructor

Market Taker Mentoring

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