Options Trading Blog posts page 3

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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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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