Options Trading Blog posts page 2


Thursday, September 8, 2016

Is Option Gamma as Important as Delta?

Many option traders will refer to option delta as the most important option greek. It is debatable but in my opinion if you do consider it the most important, the next most important greek for me is option gamma. Option gamma is a one of the so-called second-order option greeks. It is, in theory, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Just over a week ago, I gave the traders in my Group Coaching class a quiz on the greeks which of course included delta and gamma as a big part of the test. I think most were a little suprised at how poorly they did on the quiz even though they may have thought they understood them better than their results showed. I will continue to work with them to improve their "greek" skills but it goes to show that there may be room fr improvement for many option traders.

Using option gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using option gamma:

When you buy options you get positive option gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL October 105 long call that has an option delta of 0.55 and option gamma of 0.05 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive option gamma is a good thing.

When you sell options you get negative option gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative option gamma is a bad thing and as I like to say it is never your friend when selling premium.

Start by understanding option gamma and of course delta from this simple perspective. Then, later, worry about figuring out the math, even if a calculator is still needed!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, September 1, 2016

Implied Volatility May Soon be a Factor Again!

With the latest jobs report in the rearview mirror and the Federal Reserve pondering their next interest rate hike, volatility may come back into the picture. Implied volatility levels have been at or close to their 52-week lows for many equity options. 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!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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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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