Options Trading Blog

Tuesday, April 7, 2020

Is It Time for Directional Butterflies?

Obviously, the market has been on a volatile run. Stocks have dropped to levels not seen in a long time. At some point they will rally even more than they have recently, but who knows when or how much? There are so many great things about trading options --having the ability to set up low risk and potentially high reward trades is just one of them. Let’s look at a trading strategy I have been talking about in Group Coaching lately.

Directional Butterflies

Butterflies are generally used for neutral trades. But they can also be used when you have a directional bias. The risk/reward gets a lot better too. Let’s do a quick review of an options butterfly. The long butterfly spread involves selling two options at one strike and then purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered the wings and the short options are the body of the butterfly.
 
The trader’s objective for the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options’ strike price at expiration. The short options expire worthless or have lost significant value, and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. 

What some traders don’t realize is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money and using wide strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large or small profit zone depending on the size of the wings. The smaller the spreads, the better the risk/reward. The cool thing about doing a smaller spread butterfly is that the risk is low, and the butterfly can make money from delta and not just positive theta.

Recent Example

Let’s say you thought this stock was going to rally about $26 higher over the next week and a half back to its 200-day moving average. An option trader could buy the 303 call, sell 2 305 calls (the body) and buy a 307 call as seen below.

In this case the cost is 0.08 ($8 in real money) or less. Max profit is the difference in the wing and body strikes minus the cost or 1.92 ($192 in real money). But take a look below at the option chain. Although delta is really small, a move higher would benefit the position even without positive theta helping.

The risk is small and so might be the reward based on a tiny delta, but percentage-wise it might be 100% or more of a return based on the risk if the stock moves higher. Of course, positive theta can help too if the stock is trading around the $305 level as expiration approaches.

Last Words

You probably don’t want to make a living as an option trader doing low risk, high reward trades like a directional butterfly. But under certain market conditions, it might be worth it to invest a few dollars for a potential decent payoff.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Friday, April 3, 2020

A Look at Market Reversals and Relationships

These are tough times for all, and it will get worse before it gets better. For traders these highly volatile markets can be scary because the normal fundamental data do not influence markets like we are used to. Fundamentals trump technicals, but even now the fundamentals cannot be trusted. The day ranges for the equity indexes are around six times the norm. Thus, interpreting market sentiment by reading charts can help us navigate these tough times and still be profitable. Price action does not lie. It reveals true sentiment.

Whenever there is an unexpected event, I immediately turn to the main sectors to check the spontaneous reaction in the 10-year note, S&P, gold, U.S. dollar and crude oil. These markets are related in many ways. When one jumps, it frequently affects the others. This phenomenon was apparent this week when crude oil spiked higher on news that an emergency OPEC meeting was being scheduled and that Russia and the Saudis may agree to cut production. Furthermore, President Trump was set to meet with oil executives on Friday. All this good news prompted a rise in oil, equities and the dollar, while gold and treasuries softened some. The relationship between the sectors was revealed simultaneously.

The relationship I am most intrigued by is the one between equity and energy. These two sectors have moved in sync during major moves over the past year and a half. Therefore, pay close attention to how well the oil industry talks go. If oil forms a bottom, the stock market low may not be far behind.

I also like to look at the VIX when volatility is super high. Since the virus took hold, the fairest price for the VIX is about 65. It is around 50 today. If this fear index stays below 65, odds increase for steady to higher prices for stock indexes in the coming weeks.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Wednesday, March 25, 2020

Option Bid-Ask Spreads Are Crazy

What has happened over the past couple of months? The market has been crazy and volatile! As an option trader, volatility can be a very good thing. In fact, when option prices rise as they have, smart option traders can take advantage of selling expensive premium and gaining extra positive theta due to time decay. Sounds like a win-win situation doesn’t it? Well it can be, but option traders need to be cognizant of something besides increased volatility and expensive options. They need to be aware of larger bid-ask spreads as well.

Take a look at the recent call option chain of Shopify Inc. (SHOP) below.

The bid price for the 460 call is 15.40 and the ask price is 22.30. That is 6.90 (22.30 – 15.40) difference between them. Granted, an option trader can try to middle the market whether buying or selling closer to the mid-price. But it is usually not as easy trying to exit the position at the mid-price too. And sometimes, especially if the option goes deeper in-the-money (ITM), the bid-ask spread gets even worse.

For the example above, the stock was trading around $460. But even less costly stocks have seen their bid-ask spreads swell as well. Below is a recent put option chain of Alcoa Corp. (AA) when the stock was trading around $7.40.

The spread between the bid and ask price is still 0.90 (1.90 – 1) wide. That could be a lot of ground to make up for an option trader just to get back to breakeven on an option trade. Imagine if it was a spread trade and the bid-ask spread became even wider?

Volatility can be a very good thing for option traders. It can create a whole new dynamic as far as option strategies go. But it can also open up what you are paying or receiving for the option when the bid-ask spreads get pushed farther apart. Be careful of those spreads and good luck!

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, March 19, 2020

Level-Headed Fundamentals: A 'Coronavirus Market' Mile-High View

This is a Coronavirus market. We've got two things going on here: The human aspect and the economic aspect. Both are emotionally charged. And the good news is that it’s going to be OK. Seriously. It really is. It might not always feel like it at any given moment. And I’m not trying to take away from the reality of the situation. More people are going to get sick. A lot more. But it’s going to pass after that. For the most part, we’re going to have some battle scars. We’re going to have some loss. But it’s going to be OK for probably all of us here.

There are a great deal of unknowns. But market-wise, it is largely necessary policies that will drive future price action. There has needed to be social distancing. There may have to be a “shelter in place” quarantine, which I believe is at least partially, if not largely, priced into the market. To understand the real drivers of future price action, it’s important to go back to basics. Stocks are priced based on future earnings. Given quarantines and self-isolation policies, people will spend less money on products and services. Many corporations will then have lower earnings. That will hurt those companies’ stocks.

Further, if trade is cut off domestically and / or from other nations, that will be a drag on the domestic and global economy. We only have to go back a couple of months to have seen that in action with the trade war. When more tariffs were proposed, stocks tanked because tariffs curtail trade. If trade is limited, it will weigh on stocks—somewhat.

That's the fundamental valuation concept. But because of both the human aspect of the virus and the psychological aspect of such a profound drop in stock prices, we get a lot of noise in the market. Further it’s been discovered that foreign powers are spreading false information to create panic and chaos in our society and our markets. Despicable. So, don’t believe everything you hear—ESPECIALLY RUMORS. Prepare. Be smart. Keep a level head.

But here is the inevitable truth: As more reliable information on the pace of the spread of the virus and expected economic impact is made available, analysts can model expectations for the effect on earnings of individual companies. Those level heads will prevail and real price discovery returns to the financial system.

At the time of this writing, the S&P 500 was down roughly 30% from its high. Will the future corporate earnings of those 500 companies collectively cede 30%? I believe that’s an unlikely scenario. If the world economy entirely froze for 2 weeks, that’s 1/24th of a year lost, or around 4%. It’s not lost on me that that’s a non-direct relationship and fuzzy math at best. If that happened it could temporarily impact unemployment and consumer spending could suffer some as a result, etc. But it’s also a fact that a handful of companies are currently thriving. Who is not using Zoom (ZM) or similar platforms now? Gilead Sciences (GILD) is getting closer to a treatment for Coronavirus. Amazon.com (AMZN) announced last week it is hiring 100,000 workers to keep up with expected demand. The economy will take a hit, warranting lower stock prices. But this low? I think that’s probably unlikely.

Bottom line is, keep your head. Trade your plan. And take advantages of the opportunities available, of which there are many.

Dan Passarelli
Founder and President
Market Taker Mentoring, Inc.

 

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Friday, March 13, 2020

Now Is a Good Time to Review Your Trades

Option traders generally love volatility. It gives them an edge that stock traders cannot get. But when market volatility is running rampant as it has been over the past several weeks, it can make things a little more difficult for option traders.

Generally, option traders are not day traders. They typically hold positions overnight. With a market that has gapped unpredictably big almost every morning over the past few weeks, it makes holding a position the next day a little more tenuous. In addition, have you seen how wide the bid/ask spreads have become, particularly when the market has gapped down? It is hard enough to profit as a trader, and when the spreads are increased, odds go down too. So not only should option traders consider a more conservative approach like sitting on their hands at times, they should review some of their past trades.

This should absolutely be done year-round, but many of us do not do it enough. Here is the excuse you need to get started. I know you might have put off writing that trading plan for a long time, but I hope you have finally completed it or are close to doing so. This is an integral part of your trading, and putting it off is not doing you any favors.

The method is very straightforward and simple. Take some screenshots of the charts and option chain when the trade is initiated. If you are not doing this already, shame on you. You need to start. Then take a few throughout the trade and of course when the trade is exited. Did the trade work out as planned, or did you do something that was not planned? Was it a bad trade but it still profited? These are just a few of the questions that you might be asking yourself as you review your trades postmortem. Trust me, there are hundreds.

Lastly, review your trades when the market is closed so your full attention can be on the review and not on the active market. If you do this on a regular basis and not just during volatile market conditions, I promise you will put yourself in a better position to profit going forward.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, March 5, 2020

Top 3 Trading Strategies for the Coronavirus Market

[Click the image above to watch Dan's video; here is the transcript.]

I’ve had lots of questions on how to trade the markets during the Coronavirus outbreak. Should we sit it out? Should we be all in? Should we short everything? It can be nerve-racking to know what to do, so I’m going to share my plan.

Here are my top 3 trading strategies for the Coronavirus market.

#1 Strategy: Selling puts to scale in

We don’t know how the market will continue to play out through this viral outbreak. We could recover quickly or we could have a market crash or we could see anything in between. We just don’t know yet the extent of the human impact or the economic impact potential until we see how quickly and how far the outbreak will spread.

One thing we do know is that history shows when there have been market crashes, they’ve nearly always been preceded by an unexpected catalyst never seen before and artificially low interest rates. Is a crash within the possibility of what could play out? Yes.

However, history also shows that following crash scenarios, the market is almost always higher within 12 months. Meaning level-headed investors who sell overpriced puts and get assigned to accumulate long-term buy and hold positions can profit big time. It’s an opportunity that maybe comes along every decade or so.

And the great news with that strategy is if it’s not a crash and you accumulate stock from short puts, you simply make your return faster.

#2 Strategy: Short-term over-bought and oversold breakouts

This is a market that can make big moves fast. It’s nice to get on the right side of those moves. But it can be tricky. So it’s important to have a solid signal system using indicators to decide when to buy calls for a breakout to the upside and to buy puts to a breakdown lower.

We can use slow stochastics, and support and resistance levels to trigger entries. In fact, there are a number of breakout triggers that can work. But here, I’d like to focus on the most important part of a breakout strategy in this environment. The management.

Part one is it’s essential to use stop losses. When this market runs, the moves can be huge. Get on the right side of one and profits can be enormous. So getting out with a small loss on a loser should be an easy pill to swallow. Huge wins and small losses work.

Part 2 is profit taking. Though many of us are indeed in front of our trading platforms all day long, the market can move really fast. It’s a pity to miss profit opportunities. So, I put my exit orders in immediately following my entry consummation. I’ll put in an order to sell half at a reasonably good fill price, a profit of anywhere from 50% to 100% on a long call or put. Then I’ll put in an order to sell more (half or all of the remaining) at a 200% to 500% profit. And, yes, these numbers are possible in this market. And with a breakout strategy, we’re looking for this sort of price action.

#3 Strategy: Buying straddles

Buying straddles can be very profitable in markets like these. I’ve traded a good handful this past week and plan to do more if volatility keeps up. The key is not to overpay. I like buying straddles on a pull back when implied volatility falls. Options simply get cheaper and when the stock or ETF makes its move, it doesn’t need to move as far if you pay less for the straddle.

Yes, I like to look at the implied volatility to compare it to historical and to logic out fair value. That’s essential. But I also take a simplistic approach.

I look at a chart and get a feel for how much the underlying stock can move. Then I look at how much the straddle costs now. Then I expand the option chain and see how much the straddle would be worth if the stock or ETF makes a move of that size. If the profit is good enough, I take it. If not, I don’t. If I do take it, I sell half the position when the stock reaches that level and let the rest ride a bit. If I haven’t made money in 4 days, I close it to avoid time decay. It’s what I call a time stop.

For example, say there’s a stock at $200 that’s down from $230. It’s seen moves of at least $12 a day lately. And say the straddle is $11. I’ll look at the price of the straddle at the 188 strike (say it’s $15) and the straddle at the 212 strike (say it’s $13.50), and if I can expect to take a profit in one or two days on half the position (in this case of $4 or $2.50), that lowers my cost basis on the rest and gives it room to breathe.

It’s a great strategy and should keep working as long as the volatility lasts.

Dan Passarelli
Founder and President
Market Taker Mentoring, Inc.

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