Options Trading Blog

Thursday, January 23, 2020

Implied Volatility Skews During Earnings

If you don’t trade options over earnings announcements, you may not have noticed what happens to implied volatility (IV) levels. Usually an expected volatility event like earnings increases the price of options. In other words, when implied volatility increases, so do option prices. That can give an option trader an edge, but that edge is based on a volatility event. Let’s take a quick look at a recent example.

International Business Machines Corp. (IBM) closed at $139.17 before its earnings announcement, which came after the close as seen below.

What if an option trader thought the stock might move higher after the announcement? There is some potential resistance around the $145 level, so he decides that looks like a good potential target. He can buy a long call calendar using the 145 strikes. He could sell this week’s expiration and buy the following. Take a look at the option chain below before the announcement.

Notice how much higher the IV is for the short 145 call (Jan-24) that expires the closest after the announcement. The long 145 call’s (Jan-31) IV is still elevated but much less than the short option. This is the IV skew that gives the option trader an edge because he is selling more expensive premium (62.49%) than what he is buying (37.22%). The unknown factor is what the stock will do after the announcement and up until Jan-24 expiration. There is an edge but also a big unknown.

After the announcement, both IVs are reduced with the short option (Jan-24) IV falling a lot more percentage-wise than the Jan-31 expiration. Take a look below.

Vega changes the premium for every 1% change in IV. In this case, it lowers the premium because of the IV drop. As you can see, the stock moved higher much to the delight of the option trader. The sold option has lost more than the long option, which can lead to a profit as well as some positive delta in this case.

There is a distinct IV advantage when it comes to IV skews over earnings. But there’s also uncertainty as to where will the stock go after the announcement. As always, everything in option trading is a trade-off.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, January 16, 2020

Helpful Hints for Using Moving Averages

When trading futures I tend to be more short-term oriented than when trading stocks. I often enter trades that are intended to be speculative, meaning I will be out of the position within 24 hours or even by the end of the trading session. Generally, stock market traders and investors plan to hang onto trades for more than a day and often weeks and months.

Trading style and the indicators you choose differ depending on time frame. Long-term traders, fund managers as well as many business news programs focus on the industry standard moving averages, or 50- and 200-day MAs. However, if you are a swing (week or two) or day trader those long-term averages are often useless when creating strategy.

Time is a forcing point. As a broker and educator, I’ve noted that many of my clients speak of trades in terms of time. Some might say “I had a great day or bad week.” Or “trading has been difficult this month” or “I need a good quarter.” The time you put in watching screens will dictate the moving averages you should use.

I prefer to focus on swing trades for 5- to 10-day positions. It does not mean I always hold positions that long; I just hope the trend will be in my favor for that period. Therefore, I use shorter times for my technical indicators. When swing trading I like to use a 5-day MA against a 20-day MA. There are 5 sessions in a week and about 20 in a month. Assuming time is a forcing point, it seems logical to watch MAs that suit my preferred time frame.

When day trading, I like to use 30-minute bar charts. There are around 14 30-minute periods during a regular trading day. So, for intraday directional signals I prefer a 9- vs. 14-moving average (30-minute bars) crossover for short-term directional signals.

Another helpful hint when using MAs is to calculate the difference between the two. When the difference between the averages is below a benchmark, odds for a trend or breakout increase. Thus, buying options might be the best choice. On the other hand, when the divergence of the averages is well above a historic average, chances are the trend is near exhaustion. In this situation, option spreads may be the better bet.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Thursday, January 9, 2020

Using Technical Analysis to Gain Edge

I work with traders all the time on how to decide what strategy to consider. To me, it all starts from the chart and the key is to look at different time periods. Technical analysis can give all traders an edge. By doing this properly, you can put the odds on your side. Let’s look at an example I recently went over with one trader.

I showed him this chart below and asked him to tell me what he saw.

He proceeded to tell me the stock gapped up recently and is now trading in a channel. I agreed with his assessment. I then asked him, is this chart bullish or bearish? He didn’t know how to answer. Knowing resistance has a better chance to keep the stock from moving higher around the $145 level, I told him that it is more neutral to bearish. That being said, I added, if you think the stock will move higher, you may want to wait until there is a trigger.

Below is a 15-minute chart of the same stock.

You can see that the stock has never closed above the resistance level around $145 even once. So, if I were going to look for a bullish trade, I would want the stock to make a 2-bar close (essentially 2 consecutive bullish candles in a row above resistance) above resistance. And by the same token, if I were going to take a bearish trade, I would exit that position with a 2-bar bullish close.

Wrapping this up, a chart does not necessarily need to be bullish, bearish or neutral. Many times, a case can be made for each. The key is to know what levels need to be violated or not violated to confirm your thoughts. This is something that takes time to master.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, January 2, 2020

Know the Numbers Before You Trade

Every new year I update a spreadsheet that consists of recent average ranges and benchmark ranges for many stocks, ETFs and commodities. Most charting platforms have the ATR indicator (average true range) to make the task of updating easy. One reason for comparing historic and current data is to identify trend potential. When recent day and week ranges are far below the benchmark (long-term average), odds increase for a breakout or onset of a trend. Under these circumstances buying options or the underlying tends to be a better strategy. On the other hand, when recent ranges are far above the standard, a consolidation phase typically follows. Thus, selling premium or executing option spreads may be better strategies.

Once a trend begins traders want to know how long the move will last, both in time and distance. I frequently use ATR to set targets over various time frames. For example, let’s say a market has had similar and below average ranges for a five-day stretch. When a breakout signal is realized the first target (T1) is the length of an average day. When T1 trades, move risk (stop loss) to cost. With this strategy you will scratch the trade for no loss if the trend does not materialize. If the trend does continue to extend, T2 is set at the average week range. When that price trades, risk goes to T1. Each market has traits and this management technique is ideal at the onset of trends.

The ATRs I prefer for comparisons are as follows:

  • 14 days vs. 200

  • 9 weeks vs. 50

  • 7 months vs. 18

  • 5 quarters vs. 9

Find time for research to create your own spreadsheet of average ranges of your favorite stocks or commodities. A good trader prepares and has pertinent data available to set risk and targets immediately after a position has been entered. To get you started I’ve attached recent ranges for some popular ETFs.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Tuesday, December 17, 2019

Why Expiration and Strike Prices Are Important

When it comes to options trading, traders have many strategies from which to choose. One could say there are plenty of options on your options. This can be particularly true for vertical spreads. Just to start with, there are vertical debit and vertical credit spreads. Generally vertical debit spreads are used when an option trader is expecting a move higher or lower. For example, if the stock is at $85 and the trader expects a move higher, he or she might buy an 85 call and sell a 90 call. A move higher can benefit the position and max profit is earned at $90 or higher at expiration.

Vertical credit spreads are often sold out-of-the-money (OTM). In other words, the trader thinks the stock will stay above or below a certain area. For example, with the stock at $85, the trader believes the stock will at least trade above $80. The trader can sell an 80 put and buy a 75 put. The trade benefits if the stock moves higher or time passes (theta). Theta measures the decline of an option’s value through the passing of time. Max profit is earned if the stock closes at $80 or higher at expiration. In effect, the stock has three out of four ways to profit: a move higher, trading sideways or even a move lower.

Synthetically, vertical debit and credit spreads are the same. Take a look at the option chain below.

The 185/187.5 vertical call debit spread (bull call) is essentially exactly the same as the 185/187.5 vertical put credit spread (bull put). The max profit on the bull call is 0.90 (2.50 (diff in strikes) – 1.60 (cost of the spread)). The max profit on the bull put is 0.95 (4 – 3.05) from the credit received. The slight discrepancy could be due to the bid/ask spreads. Even the greeks are very similar and synthetically the same too. This is exactly why option traders who trade vertical debit spreads need to start thinking in this manner. Theta can be just as important for profit as it is for vertical credit spreads.

Maximum profit and loss are earned at expiration on both debit and credit verticals. Setting your profit target at the maximum profit and risking everything on vertical spreads may not always be wise. But an option trader needs to consider this as part of the equation when trading vertical debit spreads. Option traders often buy vertical debit spreads with similar expirations as if they were buying long calls and puts. They may pick a month or even several months as their expiration date. With that comes trade-offs, and everything in option trading can be a trade-off.

Before going further, let’s define the other option greeks besides theta. Delta changes the premium based on the underlying. Keeping it simple, for every dollar change in the underlying, delta will change the premium by its amount. Gamma changes the delta based on the underlying. Keeping it simple once more, for every dollar change in the underlying, gamma will change delta by its amount. And to finish off the four major option greeks, there is vega. Vega measure the option’s rate of sensitivity to volatility. Keeping it simple yet again, for every 1% change in implied volatility, the premium will change by that amount. You are now almost an option greek expert, so let’s continue.

When an option trader buys a vertical debit spread, there will be positive and negative greeks. Take, for example, a bull call spread (vertical call debit). A long call is purchased and a higher strike call is sold with the same expiration. There is positive delta from the long call and negative delta from the short higher strike call. There is positive gamma from the long call and negative gamma from the short call. There is negative theta from the long call and positive theta from the short call. Lastly, there is positive vega from the long call and negative vega from the short call. Whatever greek is larger (between the positive and negative) controls the trade. For a vertical debit spread, positive will not change during the life of the trade. If it is a bullish trade (bull call), delta will always stay positive, and if it is a bearish trade (bear put), delta will remain negative.

Gamma, theta and vega may change during the course of the trade depending on the underlying and time. This is where an option trader can gain an edge particularly when it comes to theta. Theta can either start out as positive or move from negative to positive throughout the trade. When theta is positive, time passing helps the position to profit for either debit or credit spreads. This will be explained in greater detail as an example is examined.

Positive theta can be just as important for vertical debit spreads as it is for vertical credit spreads. It is understandable that most option traders focus on the positive theta when it comes to OTM credit spreads. Theta is positive or becomes positive for vertical debit spreads when the underlying is past the breakeven point of the trade. Think about it, if the stock is past breakeven, only positive theta will keep the spread from losing money.

For example, if a 45/50 vertical call spread (bull call) was purchased for 2.50, which means the breakeven is $47.50 (45 + 2.50), and the underlying is currently at $47.75 and closes there at expiration, delta would not have been a factor because the stock stayed the same from the purchase to expiration. Positive theta would have produced a 0.25 (47.75 – 47.50) profit because of the intrinsic value of the long call. If the spread starts off with positive theta, it will only turn negative if the underlying moves back below the breakeven point of the trade. Positive theta can be just as and sometimes even more important for vertical debit spreads if delta does not do most of the profit heavy lifting.

Let’s take a look at an example where a bear put spread (vertical debit) could be used when an option trader is expecting a move lower. If the trader is expecting a move lower sooner than later, a shorter expiration might be a smart choice. With the stock at around $166.36, an option trader could choose an expiration with 7 days to go or even longer. For this example, an expiration with 14 days to go was chosen to compare the two. This example is meant to show how one week could make a difference. Take a look at the option chain below.

The 165/170 bear put spread was chosen for each with 7 and 14 days to go until expiration. The 170 put is bought and the 165 put is sold. Maximum profit is earned at $165 or lower for each and maximum loss is realized at $170 or higher at expiration for each.

The Mar-22 (7 days) expiration has a cost and maximum risk of 2.79 (4.55 – 1.76), which means the maximum profit is 2.21 (5 – 2.79). The Mar-29 (14 days) expiration has a cost and maximum risk of 2.65 (5.30 – 2.65), which means the maximum profit is 2.35 (5 – 2.65). Take a look at the delta above. The shorter expiration has a delta close to -0.33 (0.4001 – 0.7271) versus -0.24 (0.4193 – 0.6601) for the longer. The stock will realize a bigger gain based on delta with the shorter expiration. The reason is that delta gravitates toward 0.50 the further out to expiration. The longer the expiration, the smaller the delta difference is between the strikes.

But that is not the only option greek with a discrepancy. Theta also plays a key role. Since the spread is in-the-money (ITM) and below the breakeven point for each spread, the position already has positive theta. The shorter expiration has a positive theta close to 0.03 (0.1739 – 0.1378) versus 0.01 (0.1203 – 0.1059) for the longer. Not a huge discrepancy for either delta or theta but this will change especially if the underlying falls and time passes. As good fortune would have it, the stock drops down to $160.47 several days later. Take a look at the option chain after the drop and time has passed below.

A profit of 1.91 (4.70 – 2.79) or $191 in real terms is realized on the Mar-22 expiration spread based on the ask price of the spread. A profit of 1.60 (4.25 – 2.65) or $160 in real terms is realized on the Mar-29 expiration spread based on the ask price of the spread. Although as the underlying moved lower the delta became similar for each expiration, look what happened to theta. They both increased to an even more positive theta but the shorter expiration is currently around 0.19 (0.2669 – 0.0760) versus around 0.06 (0.1436 – 0.0835) for the longer expiration. That is a positive theta difference close to 0.13 (0.19 – 0.13). That might not seem like much but if 10 contracts were purchased, positive theta contributed an extra $130 (0.13 X 100) to the profit, which can be directly attributed to choosing a shorter expiration that matches the expected move. Now that is exciting!

As noted above, choosing strikes can be vitally important for vertical debit spreads too. Many times, as in the previous example above, moving the spread deeper ITM makes sense despite a higher risk and lower reward trade. Let’s examine another scenario where there is an expected move higher in a short amount of time.

A stock is currently trading at $187.18 and is forecast to move higher in a short amount of time. An expiration of 7 days is chosen and the options have 2.50 strike increments to choose from. An option trader is considering either a 185/187.5 or 187.5/190 bull call spread (vertical call debit). Take a look at the first option chain below.

If the 187.5/190 spread was chosen, the cost and maximum risk is 0.98 (1.95 – 0.97), which means the maximum profit is 1.52 (2.50 – 0.98) if the stock is trading at or above $190 at expiration. The maximum loss is realized if the underlying closes at $187.50 or lower at expiration. The breakeven is $188.48 (187.50 + 0.98) at expiration. Delta is approximately positive 0.18 (0.4881 – 0.3063) and theta is approximately negative 0.02 (0.1301 – 0.1503).

But what if lower strikes were chosen? Take a look at the option chain below where the 185/187.5 bull call spread is chosen with the same expiration.

The cost and maximum risk for this spread is 1.52 (3.45 – 1.93), which means the maximum profit is 0.98 (2.50 – 1.52) if the stock is trading at or above $187.50 at expiration. The maximum loss is realized if the underlying closes at $185 or lower at expiration. The breakeven is $186.52 (185 + 1.52) at expiration. Delta is similar to the 187.5/190 spread. It is around positive 0.18 (0.6724 – 0.4881) and theta is close to positive 0.01 (0.1503 – 0.1388) instead of being negative like the 187.5/190 spread. Clearly the risk/reward ratio is better for the 187.5/190 (0.98/1.52) spread versus the 185/187.5 (1.52/0.98) spread. In fact, it is the opposite for this example. But does the risk/reward ratio tell the whole story?

Look at the maximum profit, maximum loss and breakevens. They are all lower for the 185/187.5 spread versus the 187.5/190 spread. An option trader may not want to risk everything and may not want to go for the maximum profit, but knowing there is more room for the underlying to move lower without potentially losing everything may help. In addition, the breakeven and maximum profit for the spread is closer for the 185/187.5 spread.

Getting back to the example, the stock moved higher but not as much as expected. Which spread did better? Take a look at the option chain below with the stock now trading at $188.16 or up $0.98 (188.16 – 187.18) from the purchase price.

The position is up $0.16 ((1.68 – 0.54) – 0.98) based on the ask price of the spread. Not bad but now the negative theta has grown to approximately 0.08 (0.2769 – 0.3557) because the underlying is still trading below the breakeven and 5 days have passed with only 2 days left to expiration.

Taking a look at the option chain with the 185/187.5 spread, the spread is even more profitable and theta is even more positive than the original position as seen below.

The position is up $0.46 ((3.60 – 1.62) – 1.52) based on the ask price of the spread. The positive theta has ballooned to approximately 0.14 (0.3557 – 0.2202) from about 0.01. Despite the greater risk/reward, the spread is more profitable and has a fair amount of positive theta on its side to help as time passes and the underlying does not move much lower. If 10 contracts were purchased, the profit would be $300 ((0.46 – 0.16) X 10) greater for the 185/187.5 spread.

There are similarities between vertical debit and credit spreads. Many option traders do not take that into account when trading vertical debit spreads. A bigger initial delta and a move to either positive or more positive theta based on a shorter expiration and deeper ITM strikes should be debated when modeling the spreads. Many times, shorter and deeper is the better option so to speak, despite surrendering a larger risk/reward ratio.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

 

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Friday, December 13, 2019

A Prepared Trader Is a Profitable One

This week was historic for more than a few reasons. The United States-Mexico-Canada Agreement was accepted by all three countries and should be passed in early January. Phase 1 of a trade agreement with China was signed. The pact included some resolution to theft of intellectual property. There will be large purchases in agricultural products and energy, thus the scheduled tariffs were postponed. In addition, China agreed to stem currency manipulation. The Fed left interest rates unchanged, which indicates they believe the trade headwinds have diminished. Furthermore, Conservative Boris Johnson won the U.K. election, and he plans to have Brexit finalized in January. This means a large trade agreement with the U.K. is likely down the road. Impeachment hearings appear to have had little if any impact, probably because many Americans are tiring of partisan politics and overpaid politicians wasting taxpayer dollars when there are far more pressing issues to address.

As a result, stocks soared to new highs, and grains rallied sharply as well. The pound and euro also had big up weeks while the dollar declined. Interest rates rose while gold and yen fell. These so-called havens have been moving opposite equities depending on news on the trade front.

Investors should always be aware of risk. When traders talk about event risk, they are usually referring to scheduled reports, which reveal fundamentals or supply and demand influence. Markets move mainly on domestic event risk. However, now that trade and tariffs are the hot topics, international events have more impact than in the past. Unscheduled events happen, so it wise to know the hot topics and market movers. Trade talks are at the top of that list.

Each week MTM conducts the Monday Morning Meeting. This session is designed to highlight pertinent scheduled events and the possible scenarios depending on whether the data are bullish, bearish or neutral. By preparing to face the weekly obstacles, we can react almost instinctively and immediately. Professional athletes spend countless hours honing their craft. When game time comes, they often enter zones where due to preparation they react to situations without hesitation.

Traders need to practice and prep like athletes. Be mindful of the fundamentals and the effects and relationships between the main sectors…interest rates, equities, energy, forex, metals, and even grains and softs. For the time being trade has the most impact on the main sectors, followed by inflation, employment and sales data. Consumer sentiment is scrutinized by the Fed, so we should pay attention to it as well. A prepared trader will be a profitable one.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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