Options Trading Blog

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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Thursday, November 29, 2018

Neutralizing Positive Option Vega

If and when this market decides to move higher, implied volatility and option prices are destined to come back down. If you have an option position with positive vega, this might be a bit concerning. If it is, and it probably should be, there is one way you can offset that risk for a directional trade and that is by using a spread.

Let’s keep this lesson fairly simple. Option prices are affected by implied volatility. If IV is higher than normal, option prices tend to be high. If IV is in the lower part of its range, option prices tend to fall. Option vega changes the price of an option for every 1% change in IV. Take a look at the example below.

With IV at about 42%, if that moved up to about 43%, the option would increase in value by 0.15 because of vega. The new value would be about 8.05 (7.90 + 0.15). If IV decreased by 1% to about 41%, the new option value would be about 7.75 (7.90 – 0.15). Clearly if you bought the option, you would prefer it to increase in value, and it would (based solely on vega) if IV increased. But what if IV is high because the market has fallen and now you expect stock prices to rise and IV to drop again?

This is a situation where you would not want to have a positive gamma position like a long call. If IV decreases as the market and stock moves higher, vega would decrease the premium. So what should an option trader consider?

A spread like a bull call could neutralize that positive vega risk. A bull call involves buying a call and selling a higher strike call with the same expiration. The position can benefit from a move higher in the underlying and it is considered bullish.

In the example above, the 130 call is bought and the 133 call is sold. But take a look at the vega on the position. Before selling the 133 call, the position had a positive vega of 0.15. After selling the 133 call, the vega position is essentially neutral. So if IV drops, the position will not be as affected as it was before when the position had positive vega and would have lost premium.

This is just one way to offset vega risk, but it can be rather effective, particularly in down markets when a move higher is expected.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Friday, November 23, 2018

How to Gauge Trade Patterns

In the first of the two SPY charts below, we see a steady rally in 2017 where the average month range spanned about 8 points. Then in January 2018 the range more than doubled the average bringing on an overbought signal. It was the last thrust higher that ended the nearly nonstop yearlong rally. The range during the February reversal was nearly four times the norm. It took four months of sideways choppy trade to ease the oversold signal from February’s steep decline. The reason for the history lesson is to prepare for the next few months.

The second macrograph shows the October decline was just as dramatic as the one earlier this year. Subsequently, we should be prepared for very dramatic moves both up and down while the oversold situation dissipates. This phase of choppy trade may last well into Q1 of 1019.

At this point it is not clear if the indexes have cheapened enough to entice buyers. However, if we look back to February and April, we see that buyers became aggressive when SPY dipped below 260. Normally when markets return to old support areas, buyers emerge. If there is any truth to the phrase “patterns repeat in all markets and all time frames,” then the pattern over the few months will be akin to price action that occurred after the February decline. In that case 255-258 should be a solid support area and 280-283 should provide resistance through December and possibly longer. When either of these areas are tested look for changes in your favorite short-term trend indicator. During volatile times holding out for good trade location above and below the market will reduce risk and enhance profit potential.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Friday, November 16, 2018

Comparing Bearish Vertical Spreads

As an option trader, vertical spreads are most likely an integral part of your arsenal as a swing trader. What makes them so worthy of your consideration is the wide variety of risk/reward scenarios depending on one’s outlook. Let’s do a quick comparison of two verticals with bearish outlooks.

Verticals

One of the nice things about a credit spread is it can profit if the underlying doesn't move much or if it moves in the intended direction. A debit spread, such as a bear put spread, often needs the underlying to fall to profit.
 
A bear call spread involves selling a call option while purchasing a higher strike call option with the same expiration. A bear put spread involves buying a put option and selling a lower strike put with the same expiration. The bear call is a credit spread and is usually set up with calls that are out-of-the-money (OTM) in hopes that premium will decrease. The bear put is a debit spread and is generally set up close to at-the-money (ATM) or in-the-money (ITM) in hopes that premium will increase. 

Bear Call

An OTM bear call has a higher risk and lower reward. This is because the trade generally has three out of four ways to profit. The underlying can move lower, trade sideways or even move higher and it can still profit. The only way the trade can lose is if the underlying moves too much higher and through the short strike or higher.

Bear Put

A bear put that is ATM or ITM has a higher reward and lower risk than a bear call. The reason is it is more of a directional trade. The underlying generally needs to move lower for the trade to profit. This is why the risk/reward profile is better for the bear put.

Last Thoughts
When choosing whether to do a bear call or a bear put, a trader also has to consider his or her trading personality. Just because one spread may seem advantageous over another doesn’t mean it should necessarily be implemented. Some option traders cannot bear the thought of taking a maximum loss on a credit spread like the bear call and have trouble sleeping at night worrying about it. But if that is not a major concern for you as a trader, remember that depending on how it is implemented, a bear call spread may offer a lower profit potential but it also provides more of a chance to profit.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Friday, November 9, 2018

How to Select Strikes

Recently I have been reeducating myself with option strategies. It has been over 15 years since I executed an option order at the CBOT. After joining the MTM team, I viewed many of the teaching videos and listened to Dan and John K. talk option strategy with students. Thus, I am eager to use options in my trading and teaching again. It has come to me that some of the strategies I use to trade futures would be better suited for trading options. Learning options is not like riding a bike for me. It will take some time and work to get reacquainted with all the tactics, but I look forward to the rewards.

When publishing daily futures updates, I use a unique charting method for pinpointing support and resistance or buy and sell levels. I’ve found that when a market returns to an old high-volume price, a reversal frequently occurs. And when a market is between two high-volume prices, it often oscillates within those levels as premium deteriorates. If you like to short premium, seek patterns that typically lead to consolidation phases where premium decays.

When a market moves too far, too fast, it is thought to be overbought or oversold. Consolidation patterns and time decay are common after above-average moves. During a trend, low-volume pockets are often left behind. When returning to such areas while between two high-volume prices, options premium tends to decrease.

In the example below, note during the week of 10/14 that Nasdaq spent an entire week filling in a low-volume pocket between two high-volume prices. Old high-volume prices can be used as strikes in a containment-type trade. This phenomenon also occurred on the week of 10/28 through 11/6.

If a market enters a low-volume pocket between two high-volume nodes and the recent speed of the move is too fast (overbought/oversold), this is an opportunity to sell options and collect premium while the pace problem dissipates.


John Seguin
Senior Futures Instructor
Market Taker Mentoring, Inc.

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Thursday, November 1, 2018

Consider the Close of the Market

When the market closes, there is never a guarantee of whether it will open higher or lower the next session. If we knew that, trading would be a whole lot easier. But there is something I look for on a constant basis that I have found helps me tremendously. It is to see how the stock closes on the day.

To me, if I am looking for a bullish or bearish directional trade, this is vitally important. For example, if a stock is looking like it wants to move higher, I like to enter the bullish trade closer to the end of the session if the stock looks like it will close toward the high of the day. Naturally, I want the stock to close in positive territory as well, like the example below.

Many times, you will see the stock continue to move higher, particularly if it is breaking resistance or triggering a bullish reversal. For a bearish potential trade, look for a bearish close with the stock closing near the low and down on the session. I consider entering a bearish trade toward the close of the session like the example below.

Many times, the stock will continue to move lower, especially if support has been broken or that bearish close has triggered a bearish reversal.

Whether a stock closes bullish or bearish, there is no guarantee it will continue in that fashion the next session. Market risk can move stocks too. But being patient and waiting to enter a position when there are more odds on your side can improve your results.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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