Options Trading Blog

Thursday, January 17, 2019

Using Spreads to Offset Volatility Risk

When options traders purchase call options, they knows they will have limited risk (the most that can be lost is the amount paid for the option) and at the same time unlimited profit potential. One of the reasons traders love options so much is that they are usually far cheaper to buy than shares of stock. But sometimes even options can be quite expensive, so a trader may consider a spread such as a bull call spread or bear put spread. In addition to a potentially cheaper trade and lower overall risk, there could be another benefit. 

A bull call spread (debit call spread) may be able to help control risk even better than a long call. What if the options are very expensive or the trader is worried that the stock might fall? One or both of these scenarios may cross a trader’s mind, especially in the volatile environment we have seen. If that is the case, then implementing a bull call debit spread might just make sense for the options trader. Although the spread is still a debit, an option is bought and sold, which can possibly lower the cost and risk of the trade. But what else could benefit an option trader by doing a spread versus just buying a call or put?

The answer is offsetting your volatility risk. Vega changes the option premium for every 1% change in implied volatility. If implied volatility (IV) rises, so does option premium. Generally, IV rises when stocks move lower and vice versa. For long puts, this could be good. Not only can you make money from the stock falling, an option trader might be able to make money if IV increases because the put premium will increase too.

The same could not be said for an expected move higher especially if IV is elevated like the most recent market conditions. Long calls can still profit from a move higher, but IV may drop and that could offset some delta gains. If a spread trade like a bull call is implemented, vega could be “neutral” as seen below.

The long 325 call has a positive vega of 0.1405, but the short 330 call has a negative vega of 0.1405. The positive and negative vegas offset so that changes in IV will not affect the premium if the IV basically changes the same for each strike.

Just like everything in option trading, there are risk/reward trade-offs. Just knowing what they are can greatly benefit you as an option trader.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, January 10, 2019

Key Economic Sector and ETF Watchlist

Most days in futures class we review direction indicators for the major sectors of the economy. These sectors often correlate either directly or indirectly. For example, a rise in interest rates may affect currencies, which might have an impact on stocks or precious metals and energy. A small move in one of these sectors is often the first clue of an impending large directional move, which will have an impact on the correlating sectors.

The main sectors and the most liquid futures and ETF symbols…

When stocks began the historical correction down in October, petroleum products turned over and fell into a steep decline as well. Around that same time treasuries, precious metals and yen began to rally. Markets frequently move like dominoes. If one correlating sector begins to move, the others will fall or rise around the same time. So, by watching Japanese yen we may get an early clue on how to trade the dollar, gold or stock indexes before those dominoes begin to fall (react).

We are about to enter the first earnings season of the new year with extreme volatility. When moves both up and down are so fast and furious it is imperative to have a quote board or symbol list that includes the major sectors as in the table above. Some of the best and well-timed trades come from paying attention to a correlating market. I believe interest rates are the economic engine and the other sectors follow. However, on occasion a currency or stock index will be the catalyst for the start of a trend. To recognize subtle changes, I prefer to use 30-minute bar charts and check each sector a few times a day. Pay special attention to the time of day the high and low prices trade. Early identification of a reversal of trend or the acceleration of one will improve your timing for entering and exiting trades. Great timing reduces risk and improves profit potential.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Thursday, January 3, 2019

This Is a Rough Time for Many Option Traders

The gist of this blog is you don’t always have to trade. Market volatility has been crazy as of late. The market had its most bearish Christmas Eve ever, and then on the next trading session the Dow closed up over a thousand points. And then the session after that, the market declined yet again. How is that for volatility? If you are swing trading options, these wild swings cannot be very helpful.

Just think about it: You have a bearish trade on and after one day it is doing pretty well making money. You don’t have any intention to sell it after one day, but the next day comes and the market reverses, putting the trade back into negative territory. You don’t want to be forced to take profits for a position you have held for less than a day, but this market is so volatile it sometimes forces a swing trader to do so.

With the market being so volatile, option prices have increased as implied volatility has risen. So if you do not like to sell premium as an option trader, it is a little more difficult to find trades suitable for these conditions. In my Group Coaching class, we have been buying time spreads (calendars and diagonals) to take advantage of the IV skews that have been in abundance for option traders.

Of course if you like to sell premium as many investors do with options like cash-secured puts and covered calls, this market is good for premium. The only bad thing is that stock prices have dropped as premiums have increased. The bottom line is, if you are not comfortable with selling premium, day trading or using strategies you are not familiar with, then don’t trade. No one says you have to.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, December 20, 2018

Protecting Profit During Volatility

This year has been quite volatile, possibly the most volatile ever for stock indexes. The first and fourth quarters saw average day ranges that spanned nearly twice the norm. Day ranges have been closer to the length of a historic average week. When the moves are so extraordinary, risk doubles, as does profit potential. An average of 20-day ranges is adequate to be current with volatility. It is important to be current with range length because it is frequently used to calculate risk and profit targets.

In the daily futures class we search for trades where trend potential is high. We endeavor to enter at prices where the reward is three or four times risk. One of the more effective methods we use involves average day ranges or ATR (average true range).

For example, let’s say we are bullish and have chosen a level to buy the market. After taking a long position the risk (stop loss) is immediately entered at 25% of an average day range below the entry level. The first profit target is at 50% of a day ATR higher. The first objective is not where the trade is exited. When the first target is tested, the stop loss is moved to the entry price. This strategy is designed to reduce risk to zero as soon as the market begins to trend. Assume the profit objective is 100% of a day ATR above the entry price. As the market moves higher, trail the stop at 25% of a day ATR. With this method you can protect profit in case program trading and panic instigate big swings up and down.

Program trading and social media have added to the volatility. These days markets frequently reverse in the blink of an eye. Now more than ever it imperative to define risk immediately after executing a trade. Having a methodology that locks in profit reduces risk and stress as well as helping to avoid the panic trade.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Wednesday, December 12, 2018

Option Trading Is Always a Trade-Off

Here is just a quick reminder that everything you do has consequences in option trading. In other words, everything is essentially a risk/reward trade-off. Just think about it for a second: If you give up potential profit, you get a better risk/reward and vice versa. Let me go through an example with you below.

Suppose a stock you are watching has some potential support around the $130 level. At the time, the stock was trading around $132. An option trader could sell a put credit spread and know the odds are on his or her side to profit because the stock could move higher, trade sideways or move a little lower. In any of those three cases, the trade can profit so it makes sense the trade should have a greater risk than reward.

In the chart above, the 130 put was sold and the 128 put was purchased creating the credit spread. Max profit is the credit received, which in this case is 0.60 (2.35 – 1.75). The risk on the trade is 1.40 (2 [diff in strikes] – 0.60 [credit]). The delta on the short put is about 0.39. which means the odds of that put expiring worthless using the “option trader’s” definition of delta is 61% (1 – 0.39). Clearly the odds are on the option trader’s side so there is greater risk.

But what if the spread was lowered? Now the odds are even more on the option trader’s side but the risk is even greater and the reward smaller. Take a look at the chart below.

If the spread was lowered and the 126 put was sold and the 124 put was bought, the credit and max profit would be 0.33 (1.26 -0.93). The max risk goes up to 1.67 (2 [diff in strikes] – 0.33 [(credit]). The delta on the short put is about 0.23, which means the odds of the options expiring worthless is about 77% (1 – 0.23). The trade has more wiggle room but it comes with a greater risk and a smaller profit potential than the 128/130 put spread.

This was just one example and in future blogs we will discuss more. Just remember, there is always going to be a risk/reward trade-off in options trading.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Friday, December 7, 2018

Watch Trade Truce's Impact on Price Action

Last weekend Argentina hosted the G20 summit, which comprised 20 leaders from around the globe. There were three agenda priorities: the future of work, infrastructure for development and a sustainable food future. Trade and tariffs may not have been listed as priorities, but they certainly were.

When the commodity markets opened Sunday night there were huge gaps in price from Friday’s close to the open. Some markets saw big moves up and others down. Now there was no way to predict the outcome or impact this summit would have. But we did learn a lot about the effects trade between China and the U.S. will have on many commodities. Talk of fair trade sent ripples around the globe. Though we may not have access to research teams, we can get a better understanding of the fundamentals that are driving economies and trade by tracking price action at critical moments.

The most recent critical moment occurred Sunday evening (12/2/2018) when the futures markets opened. What we learned that night…

Stocks here and abroad took the “fair trade” news very well, thus opening sharply higher. The U.S. dollar fell against the currencies of our continental trade partners, the Mexican peso and Canadian dollar. Interest rate futures weakened while precious metals and crude oil prices rose. Natural gas declined while soybeans, corn and wheat opened acutely higher. There was little or no impact on livestock. Cotton was the only soft commodity that rose sharply.

So, if fair trade agreements occur, we have a good idea of the likely direction for many commodity sectors and currencies. If a pact cannot be negotiated, the rolls in price movement should reverse. By late Monday many of the markets that rose on trade talk reversed and moved sharply lower when it was reported the trade agreement may be fictional. Thus, the markets that fell rebounded.

The point is to monitor price action after a major event. Focus on the futures from each of these sectors to get a handle on economic impact and trade relations: equity index, interest rates, precious metal, foreign exchange, energy and grains.

John Seguin
Senior Futures Instructor
Market Taker Mentoring, Inc.

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