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Thursday, June 2, 2016

ITM Put Options

There is always potential for the market or individual stocks to move lower. In fact, many traders never even think about bearish strategies because they are always looking for bullish options. Option traders know that stocks and markets do not always go up, but many will wait until they think the decline is over to once again look for a bullish strategy instead of taking advantage of bearish opportunity at hand. Understanding put options is a must for option traders but I am often asked how to choose strike prices. There are several different options to consider and here are a few things to consider specifically based on an expected small move in the underlying. But first let us take break down the anatomy of a put option.

A buyer of a put option has the right, but not the obligation to sell shares of underlying stock at a certain price on or before an expiration day. The price at which the buyer can sell the shares is called the strike price. There are many strike prices and expirations to choose from which can be overwhelming for a trader. When expecting a stock to make a small move especially if the stock is lower in price, it may be advantageous for the trader to select an in-the-money (ITM) put option. An ITM put option is a put with a strike price that is higher than the stock’s current price. Before going further, here’s a look at a possible scenario where buying an ITM put might be warranted.

An ITM put option can be used to capture a relatively small move lower. Suppose an option trader is watching a $10 stock in a downtrend. The stock then rallies higher and now he thinks it is a good time to enter a bearish position with a put option. He surmises the stock might be able to drop about $0.50.

A critical point about capturing this potential $0.50 move down revolves around option delta. Option delta is the rate of change in the option’s value relative to the change in the stock price. Puts have a negative option delta because if the stock rises, puts will lose some of their value. Since puts give the owner the right to sell stock, puts gain value as the stock falls. In this example, the trader is expecting only a $0.50 move lower. Buying an ITM put that has a higher option delta will profit more than a put with a smaller option delta if the anticipated move comes to fruition.

With the stock trading just under $10, the option trader looks at the 10 and 12 strike puts. The 10 strike puts have an option delta of about -0.55 and the 12 strike puts have an option delta of about -0.90. This means that for every $1.00 the stock moves down, the 10 strike put’s premium should increase by $0.55 and the 12 strike put’s premium should increase by $0.90 all other factors held constant. The reverse is also true. If the stock moves higher by $1.00, each put would lose value in the amount of their deltas. Since the expected move is only $0.50, half the deltas would be gained or loss depending on the direction of the stock.

Final Thoughts…

Buying an ITM put option is not always the best way to capture a stock’s move lower, but when it comes to profiting on a perceived small move, an option trader should consider a put option position with a higher option delta and do so with the satisfaction of knowing their loss potential is limited to the cost of the put option.

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Tuesday, May 24, 2016

Option Delta 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. 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 (AAPL) when the stock was trading at $111 and purchases 3 October 110 call options. Each call contract has a delta of +0.55. The total delta of the position would then be +1.65 (3 X 0.55) and not just 0.55. For every dollar AAPL rises all factors being held constant again, the position should profit $165 (100 X 1 X 1.65). If AAPL falls $2, the position should lose around $330 (100 X -2 X 1.65) based on the delta alone.

Using AAPL once again as the example, lets say a trader decides to purchase a October 110/115 bull call spread instead of the long calls. The delta of the long $110 call is once again 0.55 and the delta of the short $115 call is -0.40. The overall delta of the position is 0.15 (0.55 - 0.40). If AAPL moves higher by $3, the position will now gain $45 (100 X 3 X 0.15) with all factors being held constant again. If AAPL falls a dollar, the position will suffer a $15 (100 X -1 X 0.15) 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

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Wednesday, May 18, 2016

Option Delta and Gamma are 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Thursday, May 12, 2016

Outright Call and Put Option

Another topic that is brought up often in my Group Coaching class is buying call options and put options outright. When option traders first get their feet wet trading options, they often just buy call options for a bullish outlook and put options for a bearish outlook. In their defense, they are new so they probably do not know many if not any advanced strategies which means they are limited in the option strategies they can trade. Buying call options and put options are the most basic but many times they may not be the best choice.

If an option trader only buys and for that matter sells options outright, he or she often ignores some of the real benefits of using options to create more flexible positions and offset risk.

Here is a recent example using Apple Inc. (AAPL). If an option trader believed AAPL stock will continue to fall like it has been doing, he could buy a June 90 call for 2.75 when the stock was trading at $90. However the long put’s premium would suffer if AAPL stock rose or implied volatility (measured by vega) decreased. Long options can lose value and short options can gain value when implied volatility decreases keeping other variables constant.

Instead of buying a put on AAPL stock, an option trader can implement an option spread (in this case a bear put spread) by also selling a June 85 call for 1.10. This reduces the option trade’s maximum loss to 1.65 (2.75 – 1.10) and also lowers the option trade’s exposure to implied volatility changes because of being long and short options as part of the option spread. This option spread lowers the potential risk however it limits potential gains because of the short option.

In addition, simply buying call options and put options without comparing and contrasting implied volatility (vega), time decay (theta) and how changes in the stock price will affect the option’s premium (delta) can lead to common mistakes. Option traders will sometimes buy options when option premiums are inflated or choose expirations with too little time left. Understanding the pros and cons of an option spread can significantly improve your option trading.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Wednesday, May 4, 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 global economies struggling, 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 Twitter Inc. (TWTR) looks good for a potential option strangle since at the time of this writing, the stock is trading around $15 after earnings a couple of weeks ago. With IV much lower than HV and the trader unsure in what direction the TWTR may move, the option strangle could be the way to go. The trader would buy both an June 16 call and a June 14 put. For simplicity, we will assign a price of 0.55 for both - resulting in an initial investment of $1.10 (0.55 + 0.55) for our trader (which again is the maximum potential loss).

Twitter Stock Rallies

Should TWTR rally past the call’s breakeven point which is $17.10 (16 + 1.10) at June expiration, the 14 put expires worthless and the $16 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 $18 which means the intrinsic value of the call $2 (18 – 16), the profit is $0.90 (2 – 1.10) 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 TWTR is trading below the put’s breakeven point of the trade which is $12.90 (14 – 1.10), a profit will be realized. The danger is that TWTR finishes between $14 and $16 as expiration occurs. In this case, both legs of the position expire worthless and the initial 1.10, or $110 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!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, April 28, 2016

When to 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 lower. 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!

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