Options Trading Blog posts page 2

Thursday, February 27, 2020

Coronavirus Creates Commodity Chaos

For a few decades the first thing I have done each morning after turning on the coffeemaker is to check the movement in futures markets. I follow the financial and energy sectors closely. My checklist includes stock indexes, interest rates, precious metals, crude oil and currencies. If these sectors have unusually large ranges, I immediately check news stories from around the globe to see what catalyst stirred the markets. I learned to do this very early in my career. Being already technically sound in my approach, this habit taught me how to react when the fundamentals changed.

The coronavirus has spread exponentially, and we have learned a lot from the extraordinary moves in many markets. Stocks have taken a huge hit because of the probable disruption in supply chains. Oil has gone down dramatically because of a likely interruption in travel, which causes demand to decrease while supply increases. Gold prices have risen quickly, and so have bonds and notes. These markets are commonly thought of as safe havens in times of chaos and conflict. The Japanese yen dropped at first but recovered quickly. It tends to rally when gold and bonds do.

By focusing on the correlations between the sectors, we may be able to identify when markets are ready to reverse. If gold, bond and yen prices stabilize, it may be the first sign that bear markets in stocks and oil may be nearing an end.

No one seems to know how deeply this virus will embed itself, though it has spread to all continents. The projections for affected humans and deaths are terrifying. My wife is an infectious control practitioner for a trauma hospital. Obviously, the staff there is taking this virus very seriously. She says there are ways to protect yourself. It is imperative that you wash your hands often. She claims a 20-second cleansing is ideal. Keep a bottle of sanitizer handy, especially when in public areas. Also, refrain from touching your face because that is how the bug enters your body. Be careful and pass this information to family and friends.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Thursday, February 20, 2020

Crazy Market? Consider an Iron Condor

This market is enough to make some option traders crazy and broke. Who would have thought new highs would be consistently made almost on a week-to-week basis? For the most part, the major indexes have moved higher over the past several months, but there have been times when the market inexplicably has done a reversal at some resistance levels, as it did last Thursday. There is an option strategy that can possibly help. Let’s take a look below.

An iron condor is a market-neutral strategy that combines two credit spreads. A call credit spread is implemented above the current stock price, and a put credit spread is implemented below. The objective of any credit spread is to profit from the short options' time decay while protecting the position with further out-of-the-money long options.

The iron condor is simply combining both the call and put credit spreads as one trade. The trade is based on the possibility of the stock trading between both credit spreads by expiration. Let’s use ABC stock as an example. If you have noticed that the stock has been trading between a range of $75 and $80 over the past few weeks, an iron condor might be an option with an expiration from about a week to about a month.

A call credit spread with the short strike call at 80 or higher would profit if the stock stayed below $80 at expiration. A short strike put at 75 or lower would profit if the stock stayed at $75 or higher at expiration. Both short options would need to be protected by further out-of-the-money (OTM) long options. Both spreads would expire worthless and both premiums are the trader's to keep if ABC closes at or between the short strikes. The total risk on the trade is also reduced because of both premiums received.

Max profit is both credits from each credit spread. Max risk is the difference in one set of strike prices minus both premiums received. Maximum loss would occur if the stock is at or below $75 or at or above $80 at expiration. No matter what happens, one of the credit spreads will always expire worthless. This, of course, does not guarantee a profit though.

Iron condors are a great way to take advantage of time decay when it looks as if the stock will be traveling in a range for a certain amount of time even in a market like we have seen. The key is to have your profit and loss parameters set before entering the trade.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, February 13, 2020

The 60-Minute Rule of Trading

Stock indexes continue to break barriers in response to positive economic data. The historic rise has also come with headwinds such as impeachment, coronavirus and conflict with Iran. The question on many traders’ minds is, what will prompt the next big downturn? The markets are sensitive to the spreading of the virus. As the number of infected people grows and the virus breeds outside China, confidence will likely wane. I wake up each day and immediately check the numbers and the impact the virus has had overnight. Each time the numbers rise unexpectedly, stocks typically take a hit and then recover within days.

When they recover there is a subtle response each time. The first and last hours of the day are critical moments. They are the highest volume times of the day and are historically the most liquid periods. Thus, professional traders are apt to be most active during those times. Some of the most reliable momentum reads come very early. For example, when stocks have opened sharply lower due to a surge in infestations, the low for the day is often made within the first hour of the session. This early response to cheap prices is a sign that professional traders are still bullish. During bull markets, daily lows tend to be made in the first hour of trade. While in bear markets, highs are frequently made early in the day. The second most liquid time of day is near the close. During a bull run there is often a buying spurt just before the close, and conversely sellers often get aggressive late in the day during a bear market.

With stocks at historic highs and no definable resistance areas, we must pay special attention to subtle changes during opens and closes. To time a reversal the first hour high/low may be a critical clue. Before a market heads down you may begin to see highs made early and lows late over a series of three to five days. Of course, when bottom picking, look for successive days where the low is made early and the high late. Timing the beginning or end of a trend is a tough task. However, if you study short-term price action and apply logic you are apt to become a better market timer.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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Thursday, February 6, 2020

Reducing Risk as an Option Trader

There is no sure thing as an option trader when it comes to profits, no matter how much the odds may be on your side. All trading is speculative, but as traders we do our best to improve the odds. But what if there isn’t a setup that matches our criteria for entry? The simple answer is, do not take the trade. But what if your gut is telling you something else? Well, let’s find a way to reduce risk.

Here is a recent example we covered in group coaching class. Take a look at the chart of Tesla Inc. (TSLA) below.

Clearly the stock had been in an uptrend for quite some time and was setting another all-time high. There was no bullish entry even on a smaller time frame because the stock was continuing to climb higher. What if an option trader thinks this pattern will continue for at least a couple for days and may not get an entry? The solution may be to reduce risk in one very simple way…fewer contracts.

Fewer contracts equals less risk. The math is simple. What I like to do when I am taking a gut feeling or more risky trade is to do fewer contracts and maybe risk a little more percentage wise. So instead of risking 25%, I might risk 50%. If I cut my contracts in half, that is not really reducing risk. So many times I will do less than half to try to reduce the overall risk.

So entering the trade below, if you normally do 10 contracts, consider 3 or 4. Take a look at the entry below.

Risking 25% of the ask would be rounded to about 1.20 or $1,200 (1.20 X 10) for 10 contracts. But if you reduced the contract size to 3 and risked 50% of the ask, the total risk drops to approximately 2.40 a contract or $720 (2.40 X 3) for 3 contracts. Of course, the potential profit is reduced too.

Taking a look at the position later that day, you can see that the bull call spread has benefited from a move higher (see below).

Despite only 3 contracts, a profit was made of 1.65 a contract or $495 (1.65 X 3) for the position. Not too bad for less than a day’s work. In addition, risk is off the table.

When in doubt, the best thing to do is not make the trade. But when you understand the risk and can reduce your risk on a trade you feel has some inviting odds, decrease your contract size. The risk manager inside of you will love it.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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Thursday, January 30, 2020

Coronavirus: How to Protect Your Trades

Stock indexes took a big hit this week following news that the coronavirus was spreading around the globe and that the death toll was rising. The initial reaction incited a decline over the next two days that spanned about 75% of an average month range. When a market moves that far in such a short time frame, an oversold situation kicks in. A week or two of choppy trendless trade typically follows when a market reaches oversold/overbought status. Therefore, be prepared for short-term trends that last two to three days before reversing. This is common price action when dealing with a pace problem.

The virus appears to be contained in the U.S. and no deaths have been reported. This news is positive for the equity markets and may mean the low posted Monday could be an extreme for some time. The virus takes a about a week or two incubate, so traders are apt to be apprehensive for another week or so — or at least until it is clear the virus is contained. 

Considering the technical backdrop and the positive responses to earnings, bullish strategies should pay. It may be a good idea to have a short hedge, like puts or covered calls, as protection from further virus threats.

John Seguin
Senior Futures Instructor
Market Mentor Mentoring, Inc.

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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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