Pocketoption warren buffett binary options.
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Here is an example of the profit and loss graph for this trade.
Option assignments are frequently related to dividends, so keep an eye on the ex-dividend date of the underlying equity. Short calls are frequently assigned right before the ex-dividend date of a stock; therefore, be sure to verify the stock’s dividend schedule when creating a bear call spread.
Example of a Bear Call Spread.
In order for a bear call spread to remain profitable at the expiration of the two contracts, the underlying stock price needs to retreat below the strike price of the short call. This typically isn’t very far, as the strike price may only be a few dollars or even less from the stock price at the start of the trade. A major collapse in stock price isn’t necessary; in fact, a bear call spread will earn just as much as if the stock only retreated below the short call’s strike price. There isn’t a third leg in the trade that increases in price if the stock declines substantially.
You begin looking for stocks that you think are overvalued and therefore might decline in price in the near future. The stock screener that is available on your broker’s website has a feature that allows you to look for equities that have a high amount of short interest. This means that many investors are shorting the stock. Such bearish sentiment indicates a high degree of confidence that such a stock is overbought.
You see that Netflix has a lot of bearish interest. Although the stock has a great performance history, many investors think the price is too high and is set for a pull back. You analyze the stock using both fundamental and technical methods. You see that the company is not set to pay a dividend within the next four weeks. Based on your research, you decide that NFLX is a good candidate for a price decline in the near future.
Submitting the Order.
You’re fairly confident in your analysis of Netflix, so you decide to trade three contracts per leg. You sell three call options with a strike price of $187.50. Netflix is currently trading at $188.50, so these written contracts are ITM. The sale earns $6.50 per share. With three contracts, that’s a total inflow of $1,950 (300 × $6.50).
The second and final leg is a long call with a $190 strike price. The cost is $5.20 per share, for a total expenditure of $1,560. Because this leg has a lower cost than the first, the bear call spread earns a profit at the outset. The details of the trade are seen in the following table, for a net credit of $390:
The contracts expire in four weeks. The hope is that the short contract, which is ITM immediately, isn’t assigned before the stock retreats below $187.50.
Outcome.
Going into the first week, Netflix experiences quite a bit of volatility. The price reaches a low of $187 on the third day of the trade, which puts the short option OTM. This is what you were hoping for, and you can close the trade at this point by buying to close the short contract and selling to close the long one. Choosing this route so early in the trade, however, will be very expensive because there’s a lot of time value left in the contracts. You look at this possibility and see that the price would be $370, leaving you with just a $20 profit, not considering commissions, which will exceed $20. So you decide to leave the trade as it is.
The second week, Netflix experiences less volatility, although it moves back above $187.50. Now the short contract is assignable once again. Going into the third week, investors continue to push NFLX higher, sending it to $189.
You become concerned at this point that you may receive an assignment. If this happens, you can meet your obligation in one of two ways. You can either go into the market and purchase 300 shares of Netflix and sell them to your counterparty, or you can exercise your long call at $190.00 and use those shares for the assignment. Since the stock is under $189, you would buy in the market.
The fourth and final week shows up, and robust trading activity continues to send the stock higher. NFLX reaches $191 by the end of the week, and you receive an assignment on the last day of the trade. You exercise your long call, which allows you to purchase the stock at a cheaper $190. After buying these shares, you immediately sell them at $187.50 to meet your assignment.
Determining the Loss.
This trade is definitely going to result in a loss because the stock went in the opposite direction that you were expecting. The total loss can be discovered with the following equation:
It’s a $360 loss before commissions are thrown into the equation. If you had exited the trade after the first week, you would have saved over $300. Don’t forget that the IRS will allow you to use this capital loss to offset capital gains in the same tax year. And excess capital losses can be carried forward for future tax years.
Stock Market and Options Market.
One of the lessons we can gain from this hypothetical trade is that the stock market can never be divorced from the options market. While the derivative trade looked good on paper, trading activity in NFLX created an unprofitable environment. While the market price of Netflix may be in a bubble, you don’t get to buy and sell based on fundamental value. Options reflect market value, not fundamental value. Whatever the actual worth of NFLX, buyers and sellers decide what the stock price is going to be, and this impacts option prices.
Vital Points.
The maximum gain a bear call spread can earn is the net credit received at the start of the trade. Commissions will lower this limit. This maximum point is achieved if the market price of the underlying equity is below or equal to the strike price of the written contract.
The highest possible loss is the difference between the options’ strike prices minus the net premium earned. Trading fees should also be added to increase the maximum loss.
There is one breakeven point. It is the short option’s strike price plus the net credit per share.
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Considering the market over the last 18 months is up over 15%, it is very unlikely that our next pullback will be over 15% (granted it has happened in the past). There is a pretty good chance if I waited on the sidelines for a deal, I missed price levels we will never see again.
To combat this problem, many investors turn to dollar cost averaging — investing a little bit every month and hoping you average out on a good basis. While this is a good idea, and I do this at times, it is not my favorite approach. At least, I like to dollar cost average with a twist.
Using Options To Lower Your Basis.
If you are like me and unwilling to sit around waiting for a discount on your favorite great company you seek out ways to lower your basis in other ways. Take Amazon for example. If you are a traditional value investor you have never had a chance to own this company. The stock price has never dropped enough to own this company at a discount and the stock price has grown like a weed over the last 20 years!
I own Amazon and I think I have a pretty good “synthetic” basis. What I call a synthetic basis is the act of generating a profit on a short-term trade and using that profit to buy stock in a great company.
Let’s say I want to own $20,000 worth of Amazon, but I want to originate my investment at a discounted price. One thing I might do is to buy a leap call option on Amazon for $1,000 leaving the other $19,000 in a saving account. With a leap call option, if the stock goes up in value, you are likely to have a big outsized return. If the stock goes down, you are likely to lose the entire $1,000. Of course, if the stock stays flat, you’re likely to lose the $1,000 as well.
Since leaps are over a year out to expiration, the $19,000 in the savings account most likely gained some interest to help offset the $1,000 in the case of a complete loss of the $1,000. Also, if the leap expired and became worthless, you avoided a loss in the stock had you invested the entire $20,000 at the start.
In case the stock goes up in value, the leap likely had many times over again. Let’s say the leap is now worth $4,000. If you were to close out that leap, you would have $23,000 + the interest you earned on the $19,000 in savings (let’s say $150). Now you have $23,150 to invest in Amazon. I know what your thinking. If the leap went up in value the stock price of Amazon also did. Maybe it is a wash. This is true. But odds are it is not a wash as leaps have the power of leverage (since one option contract controls 100 shares).
Let’s assume it was a wash. Fine no big deal. Just wait for a pullback in Amazon. Now you’re sitting on $23,150 waiting for a good price to enter the trade at. If the stock keeps going you made $3,150 on $20,000 — not a bad trade anyway.
Walking away with the $3,150 is an option but what I would do at this point typically is dollar cost average into the stock. Maybe 10% of the $23,150 every week or month (depending on the market).
If this all plays out well I will own Amazon on a reduced basis. I did not have to wait until some pullback. I did not sit on the sidelines waiting for a discount.
Another Way to Reduce Basis.
My leap buying strategy above was nothing more than one of many tools in my basis reducing toolbox. One strategy I use rather often I refer to as the overflow approach. Since I have mentioned it in other blog posts I will not go into too much detail here. But the basic concept is to take the profits from short-term trades and use them to buy long-term buy and hold positions. I would call this reducing my “synthetic” basis.
Back to Amazon…….but this time let’s say all I have is $10,000 to invest in Amazon but I really want a $20,000 position. I might use the $10,000 and start trading put credit spreads on the SPY. I might continue to trade put credit spreads until I have $20,000 in total. Now I can go buy $20,000 on Amazon. As long as the duration of time it took me to get $20,000 was not too long (say a year) I would consider my basis in Amazon to be $10,000, not $20,000. In a way, I am buying Amazon at a 50% discount (a discount value investors would salivate for). At that discount, I don’t really care what the price of Amazon stock is. I just care that I still think Amazon is a great company and will grow for years to come.
The Best Way To Get Rich Is To Lower Basis.
Yes, I am the first to admit there are tons of flaws in the examples I listed above. There is an additional risk as well. But I would also submit there is the opportunity cost of sitting on the sidelines with cash waiting for a discount in the market that may or may not come. I would also point out I have an entire portfolio strategy. In the case of the leaps, or put credit spreads there is a chance I could lose a fair amount of money and get into Amazon after losing some of the money effectively increasing my basis. My overall portfolio strategy assumes some of these trades will not work and losses are built into the plan. As a whole my play to lower basis before entering any buy and hold strategy tends to work.
The lesson I am trying to convey here is when I put on my long-term investing hat the number one thing I am concerned with is reducing basis. I truly think it is the best way for retail investors to get ahead. Waiting for a discount in a stock or using margin to buy more stock are strategies for slower overall portfolio growth.
If I was a rap artist I most certainly would have a single called “Reduce Reduce Reduce Your Basis” :).
Mon, 14 May 2018 20:38:00 -0700.
Example of a Short Strangle.
Suppose you think Johnson & Johnson (JNJ) will move sideways for the next few months. The company doesn’t appear to have any new technologies in the pipeline, nor will it release any earnings. You also don’t expect any major news announcements. If JNJ doesn’t make any major revelations, the stock price is likely to remain fairly calm.
With a current stock price of $132, you sell a call option for $1 per share. The contract is worth 100 shares and has a strike price of $134. The total premium received is $100. At the same time, you sell a put option that is also out-of-the money. It has a strike price of $130 and is valid for 100 shares. You’re able to receive $1.50 per share, for a total of $150. The grand total for both contracts is $250. Remember that this income will be reduced by any trading fees your broker charges you.
Equations for the Short Strangle.
Looking at the numbers in our example reveals the following breakeven prices:
In the Johnson & Johnson example, the upper limit is $136.50 ($134 + $2.50). The lower limit is $127.50 ($130 – $2.50). These figures assume no commissions are paid to the broker-dealer.
Short Strangle Hazards.
As long as JNJ experiences no significant volatility and stays within that trading band, between $127.50 and $136.50, the derivative investment will be profitable. If the stock moves outside this rather narrow band, the trade will begin to lose money.
Remember that any option contract that is in-the-money by a penny or more at expiration will be automatically exercised. Contracts can also be exercised early. This could force you to buy shares of JNJ from a holder of a put contract (at an inflated price), or sell shares (at a below market price) to a holder of a call contract. If you don’t already have the shares in your brokerage account, you would have to buy them at market price.
If JNJ went to $140, the put option would be worthless and the call would be worth $6 per share, for a total of $600. You received $250 in premiums, so the total loss on the trade would be $350. Because the loss is calculated by subtracting the call strike price from the stock price, there is in theory no maximum to the loss if the equity goes up.
If it were discovered that one of the company’s products causes a health problem, and the stock goes down to $120, the call option would have no value, while the put contract would be worth $10 per share, for a total amount of $1,000. Subtracting the amount made in premiums, the loss would be $750. Because the stock can’t go lower than $0, the loss on the downside is limited.
Fri, 04 May 2018 00:00:00 -0700.
My rule of thumb is to always close trades at the end of day if the current SPY stock price is below the short strike of my SPY Put Credit Spread.
While it might be painful it is much better to lose a small amount of money than lose 100% of the money. One of my trades got completely away from me (the 100% loss) — while one of my trades was only a 30% loss as I was able to close it before it got too far past the short strike of my Put Credit Spread.
This month was an opportunity to remember to be humble in this trading strategy. As a reminder it is important to always be prepared for down months.
Wed, 04 Apr 2018 00:00:00 -0700.
Fri, 02 Mar 2018 00:00:00 -0800.
If February 2018 was your first month trading Put Credit Spreads on the SPY you might not think this is a great strategy. However there is another way of looking at this. I have not had a loss in nearly 18 months. Over the last 18 months my returns have been rather outsized compared to other investment opportunities. From time to time you have to take some losses but if you have a stock pile of wins in your account you tend to still outperform (by a lot) any other traditional investments.
Sat, 03 Feb 2018 20:11:00 -0800.
Thu, 18 Jan 2018 17:34:00 -0800.
Enter the world of options, where it’s possible to profit in either direction. There are two types of derivative strategies that can be successful regardless of whether a stock moves up or down, as long as the stock moves a sufficient amount. These are the strangle and straddle plays.
Using Straddles and Strangles.
With both strangles and straddles, you buy one call option and one put option. The two contracts have the same underlying equity and expiration date. For the straddle, the strike prices are the same. For the strangle, the call option has a higher strike than the put, and both contracts are out-of-the-money.
Straddles v. Strangles.
Because both contracts of a strangle position are out-of-the-money, the investment is usually a little cheaper than the straddle. However, the break-even points of the strangle are further apart than a straddle. The strangle also has a greater chance of resulting in a complete loss than a comparable straddle. Time decay is a greater risk for strangles, which means they will deteriorate in price more quickly over a given time period.
Timing is Key.
Like other investments, buying at the appropriate time is crucial in either a straddle or strangle play. Entering the trade a few days before an earnings announcement is not recommended, because at this time the cost of the option premiums will be too high. Implied volatility also tends to be higher right before an earnings release.
A good time to enter a long straddle or strangle position is two to six weeks before a company is set to release its quarterly earnings data. If you try to buy a week before the announcement or earlier, you’ll probably see higher prices for the contracts.
Choosing the Correct Strike Price.
You want a strike price that is near-the-money. This will keep the cost of the trade to a bare minimum, while maintaining the unlimited potential gain. For example, if the cost of a stock is $79, you would buy a straddle with a strike price of $80. If you wanted to try a strangle instead, you would buy a put option with a strike price of $75, and a call option with a strike price of $80.
Getting the Right Expiration Date.
Time decay erodes a contract’s value, especially during the last month of its life; so you want to avoid options that are set to expire in under 30 days. You also want to allow at least two to three weeks for an earnings announcement to affect a stock’s price. If you buy a month before the earnings announcement, and you want half a month of time after the release for the stock price to move, and you want to avoid the last month of a contract’s life, you should purchase options that have at least 2½ months of life in them.
Example.
Suppose you were expecting an earnings surprise from Dillard’s, Inc. in its next quarterly release. The stock trades on the Big Board under the ticker symbol DDS. The share price has been hovering around $73 for a few weeks. The company is set to announce its earnings data soon. What should you do?
For the straddle, you would buy one call and one put, each with a strike price of $73, if the contracts exist. If they don’t, you could buy contracts with strikes of $75. For the strangle play, a call with a strike price of $75 and a put with a $70 strike would work. The cost of either trade is the maximum loss you can suffer. You can’t lose more than premiums plus commissions on either a long straddle or long strangle.
Suppose you buy a Dillard’s straddle three weeks before the earnings release. You purchase one call option for $4 per share and one put contract for $3 per share. The strike price is $72.50, and both contracts are for 100 shares each. The total cost of the trade is $700. Assuming no commission paid, that’s the most you can lose.
You could have bought the stock instead, hoping for a positive release. If you had done so, you would have guessed very wrong. Analysts were expecting 21¢ per share of earnings, but on August 10, 2017, the company reported a loss of 58¢ per share. By the end of the trading day, investors had sent the stock down to $61, a loss of 16%.
In just one day, the call contract you bought is worthless, but the put has a value of $1,150. Subtracting the $700 you paid in premiums, it’s a one-day profit of $450.
And yes, you could have shorted the stock. But that would entail an unlimited amount of risk on the upside and a limited gain on the downside. The straddle, on the other hand, had a maximum risk of $700 with unlimited return potential.
Tue, 09 Jan 2018 00:00:00 -0800.
Ticker Type Spread Expire Date Open Date Closed Date Open Credit Closed Debit Profit / Loss SPY PUT 245 / 247 12/29/17 11/14/2017 12/08/2017 $0.21 $0.03 9% SPY PUT 246 / 248 12/29/17 11/13/2017 12/08/2017 $0.21 $0.03 9%
This month is a good example of why you never second guess your strategy. You will notice I put on 2 spreads a day apart with nearly the same strikes prices and the same expiration. Some might see this as too much risk. My strategy is based on the fact that around 11% of my trades will loss money. I never know which 11% so I just place trades if there are trades to be had. Never second guess. Build a strategy, backtest it, monitor it, and only make lasting changes to your strategy (no one off, second guessing, changes).
Sun, 03 Dec 2017 00:00:00 -0800.
Keep in mind this is normal. Many volatility based options traders with a consistent strategy often have dry months.
Thu, 16 Nov 2017 18:29:00 -0800.
Wed, 08 Nov 2017 19:44:00 -0800.
Have you heard of the brokerage API “Tradier”? It’s a powerful software/toolset that is literally reshaping the investment brokerage field. Tradier is making it possible for option traders to use powerful, specialized option software, such as Options Cafe, and to integrate it directly into trading. Beyond options, Tradier is revolutionizing trading with other assets, such as stocks.
Here’s how the old way worked: You picked a broker, you used that broker, and you used their tools. Sometimes, you could buy upgraded premium services. Other times, you could buy external software/tools and use it separately from your broker. This software, however, could not be integrated with your broker or your trading. As a result, it was difficult to access a complete toolset, and to have up-to-date and in-sync data. This was true for options investors, stock traders, and everyone else.
Tradier and the Broker API Revolution.
For options investors, this was a big hurdle because many brokerages simply don’t offer good options trading tools. Specialized software and tools can go a long way towards increasing your profit margin and increasing the likelihood of producing a profit. However, options traders now have more options (pun intended) when it comes to software and tools, and companies like Tradier are a big reason why. Now, you can pick your broker and your tools separately.
So what is Tradier? The company has been called a “brokerage API on steroids” by Investopedia, and that’s a pretty accurate description. First, API stands for Application Program Interface. An API is a set of tools, routines, and protocols for building software. Basically, an API provides the “building blocks” needed to build software. In layman’s terms, an API allows users to connect directly with a provider’s data and software, and to even use it to build their own unique software. API’s usually work through the cloud, meaning you can access the data and software online, and in some cases can even use their servers to carry out various processes.
So let’s circle back to Tradier, a brokerage API. This means you can use Tradier’s data and software to build brokerage and trading software. Tradier does this by working with data directly from markets. While Option Cafe focuses on options, Tradier aggregates data regarding a wide range of investment vehicles, including equities, ETFs, mutual funds, stocks, and of course, options.
What Does a Broker API Actually Do?
Importantly, Tradier enables trading. A software developer can build trading functionality into their software or even website. In some cases, blogs and other information websites have been using Tradier to offer trading services directly to their audience. Essentially, Tradier creates a “white box” brokerage service, through which software developers can use the Tradier API to create their own brokerage services. Instead of having to reinvent the wheel and reinvent brokerage capacities, software developers can use the tools provided by Tradier.
Tradier is FINRA licensed and working with more than 30 clients. This means the company is legitimate and regulated. When Options Cafe launches later this year, we’ll be another one of Tradier’s clients.
Tradier charges fees, of course. They have to pay their staff, and maintain and refine their software. However, the commissions are quite affordable. Since Tradier can conduct trades, it can act as an investment broker, enabling options investors and others to trade. However, their API-driven model allows them to dramatically reduce costs. That means they can pass on savings directly to their customers.
Options With the Tradier Brokerage API.
For options, Tradier charges only 35 cents per contract (plus a $3.95 ticket charge). Compare that to eTrade, which charges a 75 cent fee (with a bigger ticket charge). This means that Tradier charges less than half of what eTrade does.
Crazy right? Who doesn’t want to save on trades? One of the biggest challenges with trading options is keeping fees and commissions low. This is especially true for people who want to invest smaller amounts, or execute a high number of options trades. Some platforms, like eTrade, offer discounts for active options traders, but these commissions rarely approach Tradier’s flat rate.
However, there are always tradeoffs. With Tradier by itself, you won’t be able to access as much expert advice, advanced trading tools, data, and all the rest. Tradier does offer some tools — in fact their web application is pretty delightful to use for basic interactions.
Tradier Web Application.
This is where Options Cafe comes in. Our platform will be able to plug directly into Tradier, meaning you can use their brokerage services to conduct trades while using Options Cafe to engage. Options Cafe will be able to provide you with tons of advances options trading tools. We built Options Cafe precisely because we realized there was a gap in options software services. Perhaps more so than any other type of investment, options trading can benefit tremendously from powerful, data-informed tools. And that’s what Options Cafe provides.
Options Cafe Reports.
Options Cafe Plus Tradier.
The end result of Tradier + Options Cafe is a powerful option trading platform that costs less than most other brokers. By using the Tradier API, we can keep costs manageable. By building software that has been designed by options traders and for options traders, we can deliver the most powerful options software possible. It’s a win-win.
With Options Cafe, we make it easy to implement advanced options trades, such as an Iron Condor. Combined with Tradier, it’s not only easy but affordable to set up such trades. In the past, setting up advanced options trading strategies was often a headache in and of itself. With multi-leg option strategies, you also have to execute several trades at once. This meant that fees quickly ate into your profit potential. Tradier’s low fees, however, will help alleviate that pain point.
Sun, 29 Oct 2017 13:55:51 -0700.
If you used a put spread, the long contract you hold will develop intrinsic value if the underlying stock turns south. Thus, you can have a bearish view on the underlying equity when using puts in the time spread. If you used calls, the contract you hold will increase in value if the stock heads north; so you can be bullish in your long-term expectations.
Example of a Long Calendar Spread.
Kimberly-Clark (KMB) reported earnings last week while trading at $122. The data was in line with market expectations. You don’t foresee any major changes in the stock’s price, other than a gradual rise over time. You decide that a calendar spread with calls would be a safe method of earning some extra income.
You sell one call contract out-of-the-money for $350 with an October expiration date. At the same time, you buy another call contract, with the same strike price of $125, for $450. It expires in November. The total cost of the investment is $100. This net debit is the maximum loss the investment can produce.
If KMB hovers around $122, the short contract will be worthless at expiration. The long contract will decrease in value, but will still have some time value left in it. At this point you can sell the contract. If it has a market price of $300, the net profit on the investment will be $200 ($300 – $100).
If KMB increases to $130, the short contract will be exercised, but the contract you purchased will also rise in intrinsic value at the same time. If the stock declines to $105 at expiration, both contracts will have zero value, and the investment will be over, with the maximum loss of just $100.
Tue, 17 Oct 2017 19:31:49 -0700.
Many options traders first cut their investing teeth with stock trading. In some cases, these investors have enjoyed a lot of success with stocks but want to branch out. In other cases, they have been trying to make a living off of day trading with stocks but it isn’t working out. No matter the motive, options trading is a great choice for many investors.
By trading options you can use new strategies to produce profits with different methods and during different market conditions. For example, with an iron condor you can make money off of horizontal price movements.
Options trading opens up a whole new world of potential. That probably sounds a bit high-minded but it’s true. Options can be used with a wide range of investment strategies. Many stock investors start buying options as a form of insurance for stocks they own. Other investors use options to gain alpha. In other words they want to produce a bit of extra profit.
Still, many investors turn to options trading after they find that day trading isn’t working out. It’s difficult to make a living off of day trading unless you are willing to expose yourself to a considerable amount of risk. You’ll either have to invest huge sums of money, or you’ll have to invest in risky penny stocks.
Options can offer a higher potential to produce profit while also lowering your exposure to risks.
Why Options Trading Beats Out Day Trading & Penny Stocks.
Many stock investors who move into options trading are coming from either day trading or penny stock trading. Day traders attempt to make money off of temporary inefficiencies in the market.
Penny traders try to make money off of trading in higher risk, low-cost stocks. Penny stocks sell for $5 or less per share. Often, these stocks are for struggling companies that are at risk of going bankrupt or are facing major legal cases, etc.
Day trading can involve a variety of different risks. Usually, day traders care more about volatility and price movements, rather than the fundamental underlying qualities of an asset. Many options trading strategies also focus on price movements rather than underlying fundamental values.
Probably-Based Options Trading.
I tend to promote “probably-based options trading.” Basically, my primary method focuses around calculating the probability of profit, or POP as it’s sometimes called.
There are a lot of tools that you can use to determine the probability of profit (soon Options Cafe will help with this). There are also a variety of trading strategies, such as the Iron Condor, that you can use to increase the probability of producing a profit.
Probably-based trading can produce high returns, especially when compared to stocks. With probability-based options trading, you often sacrifice some profit potential in exchange for lowering risks and increasing the likelihood of producing a profit.
High-profit, low-risk investments are rare, and usually the result of aberrations in the market. However, probably-based options trading allows you to consistently produce considerable profits. Over time, these profits can add up to a tremendous amount.
Options Offer A Lot More Bang For the Buck.
Stocks are expensive. Options allow you much better leverage. This means you can turn a small amount of money into a lot of money.
Let’s say you are very confident that Acme Computers is going to launch a revolutionary new virtual reality technology. The VR tech is scheduled to be unveiled at the beginning of next month. You believe that this technology is going to be a big hit. It could the next iPhone or iPod.
Problem is, Acme Inc. stocks are selling for $100 dollars a pop and you only have $1,000 dollars to invest. You know Acme stocks are going to climb. You believe they could even hit $120 in the days that follow the VR tech release.
Yet you can only buy ten shares. Even if stocks reach $120, you would make only $200 bucks in profit. While that return is substantial, you know there is a lot more money to be made.
One option is to buy options for Acme stock. Let’s say you buy Acme stock options due to expire on the third Friday of the same month that the VR tech will be unveiled. Let’s assume that options to buy Acme stock ($100 per stock) are selling for $5 per option. Numbers like this are commonly seen in options trading.
Instead of buying 10 stocks, you buy 200 options. Your prediction turns out to be correct. Acme unveils its VR tech, and stock prices climb to $120 dollars in the days that follow. Now you can exercise your option contract, gaining a $20 dollar profit for each contract. That adds up to $4,000 dollars! This is certainly a lot more than $200.
Using Options As Stock Insurance.
Another common reason for stock traders to start trading options is to use as a form of insurance.
Let’s continue with the Acme Computers VR technology example. The unveiling has already been planned. This time, let’s assume that markets are very excited about the potential technology. As such, stock prices have been slowly gaining, and have reached $100.
You, on the other hand, are not so excited. Let’s assume that you are a virtual reality expert. You’ve been following the technology for years. So far, everything you’ve heard about Acme’s virtual reality technology suggests that it isn’t all that revolutionary.
You believe that markets may be over-pricing ACME stock at the moment. Once markets come to the same conclusion, they could swing dramatically. Let’s assume that you own 1,000 stocks, or $100,000 dollars worth of stocks.
This represents a big chunk of your retirement portfolio. You have a lot of confidence in Acme and love their fundamentals. However, you’re worried about the VR tech unveiling and a potential price correction. You don’t want to sell your Acme stocks, but you don’t want to be exposed to any risks either.
So what should you do? Again, options are the answer. You can buy put options, which will allow you to sell your options at a predetermined price. So, you buy 1,000 put options granting you the right to sell Acme stocks at $100 in three weeks time. Let’s assume you pay $3 dollars per option. Again, this number is theoretical but realistic.
So you pay $3,000 for the option, or right, to sell your 1,000 shares at $100 dollars. Your dire prediction comes true. Acme unveils its VR tech. It’s a dud. Questions over leadership start swirling. Stock prices plummet.
Suddenly Acme shares are trading for only $75! You’ve lost $25,000 out of your retirement portfolio! But wait, you have your options! You sell your Acme shares for $100 instead. Instead of losing $25,000 like many other traders, you’ve lost only $3,000.
Other Reasons Stock Traders Love Options.
Let’s go over some other reasons stock investors trade options. Turns out that there are plenty of reasons. For example, with stocks you make money off of price movements. If you buy stocks, you want prices to go up. If you short-sell, you want prices to go down.
With options, you can set up an iron condor for example. If you do, you want prices to remain stable, or within the trading range set up in your iron condor. If this happens, you will make money! There are only a few ways to generate substantial returns off of flat markets. An iron condor is one such way.
Speaking of short-selling, put options offer another way to make money off of dropping prices. Except, put options are far less risky than short selling. When you short sell a stock, you expose yourself to unlimited risk. No matter how high stock prices rise, you will have to buy those stocks.
With a put option you automatically know how much you can lose. When you buy put options the maximum loss will correspond with how much you paid for the options. In fact, the upfront risks of buying options are one of the chief reasons many stock investors start investing in options.
Further, there are now a ton of tools that you can use to analyze potential options trades. The nature of options means you can often plot out risks and scenarios with these tools. When you use these tools properly, you can greatly increase your probability of producing a profit.
Let’s Conclude With a Brief Stock to Options Trader Story.
As you can see, there are many reasons why stock traders should consider trading options. This article is far from exhaustive. I’ve met so many stock traders over the years who started trading options and fell in love. Many have their own unique story.
In fact, I’d like to end with the story of a friend of mine. He’s quite well off, to be frank. I had been urging him to try options trading for quite some time. He recognized the advantages, but also didn’t want to leave his comfort zone.
With his investing returns stalling out, however, he decided to give options a go. He started with a small amount. I provided quite a bit of tutoring. Options made up only a small portion of his overall investment portfolio. However, he quickly found that he was making more money off options than his much larger stock portfolio.
He’s still trading options to this day. I’ll be honest, I get at least some of the credit for his success. I won’t say that I taught him “everything” he knows about options, but I taught him a lot. Fortunately, you can keep reading our blog here at Options Cafe and I’ll fill you in!
Thu, 12 Oct 2017 18:33:20 -0700.
If a stock is soon to make a major move, either to the upside or downside, a short calendar spread is one method to profit from the price change. The derivative strategy has limited profitability, which is capped at the net credit earned, less commissions. The potential loss in theory is unlimited when using calls and considerable when using puts.
Making a Short Calendar Investment.
The short calendar spread can be used either with calls or puts, but not a mix of them. With this strategy, you buy one contract while simultaneously selling another. Both options have the same underlying stock and strike price, and they should both be at-the-money. The written contract has a longer expiration date, by a week, a few weeks, or a month. Because the contracts have different expiration dates, the strategy is called the calendar or time spread.
With a larger amount of time value, the written contract is more expensive. Thus, entering the short calendar should produce a net credit.
Short Calendar Example.
Suppose you hear in the news that Biogen, a major player in the biotech industry, will be releasing the results of a study on an experimental drug for the treatment of multiple sclerosis. If the results are favorable, you expect the stock to experience a major upswing, but if the results are a disappointment, the stock price will probably see a drop.
You want to be able to profit regardless of which direction the stock heads. Knowing that the short calendar play will earn money in either direction, as long as the stock does make a move, you decide to take a short calendar position.
Biogen is currently priced at $286 in the open market. You decide to trade put options. You sell one put contract with a strike price of $285 and simultaneously buy a put option with the same strike price. The written contract expires one week after the purchased contract. It sells for $700, while the purchased contract has a $500 price tag. Thus, the net credit for the option play is $200.
The results of the study are released, and there is no difference between the drug and a placebo. The stock price drops quickly to $250 and hovers there. Because both contracts are put options, they both increase in value; and since they both have the same strike price, they will experience similar increases.
You decide to sell the contract you hold and realize a profit. You receive $3,800. The short contract is still live, and you receive an exercise. This forces you to buy 100 shares of Biogen for $28,500, which you immediately sell for $25,000. This produces a loss of $3,500 on the short contract. Subtracting the loss from the $3,800 gain on the long contract produces a profit of $300 on the long contract. Adding this to the net credit you received at the outset produces a total gain of $500.
Gains and Losses.
The short calendar strategy with puts becomes risky whenever the stock price declines, the long contract expires, and then the stock price goes down even more. This situation will increase the intrinsic value of the short contract. If you’re concerned about this issue, you can mitigate this type of risk by keeping the gap in expiration dates to a week, rather than a month. This gives the stock less time to decrease after the first contract expires.
Using the spread with call options could result in a similar situation if the stock increases in value, the first contract expires, and the price continues upward. This situation would increase the value of the second contract, outweighing whatever you made on the first contract at expiration.
Mon, 09 Oct 2017 21:13:00 -0700.
The Risk & Reward of Butterfly Options Trading.
Before digging into how you can produce profits off of butterfly trading, let’s first discuss the risks. When investing, it is important to know what you’re getting yourself “into.” Different options trading strategies will have vastly different risk and reward profiles. So let’s go over the risk and reward profile of the butterfly trading strategy.
In terms of risk profile, butterfly spreads are generally low risk. This also means that the profit potential is also restrained. Generally, higher profit potential correlates with higher risk, while lower risk correlates with lower profit potential. This is true not just of options trading and strategies, but investing as a whole. While profit potential is low with the butterfly trading strategy, the chance of actually producing a profit is high.
Butterfly trading strategies are similar to the “iron condor” strategy in that they produce profits with horizontal price movements. Both the butterfly and the iron condor are useful for producing profits off of price stability. The two strategies are different, however. If you want to learn about iron condors as well, we suggest checking out our Iron Condor article here.
Understanding Vertical Spreads In Options Trading.
Before we dig into butterfly strategies, it’s important to understand what vertical spreads are. A butterfly strategy will use both a bear spread and a bull spread, with each of these being vertical spreads. So what is a vertical spread?
With a vertical spread, you buy one option with a lower strike price and sell them, and then purchase options with a higher strike price. In other words, you buy and sell two options of the same type at the same time, with the exact same expiration date, but they have different strike prices. Vertical spreads can be created with either all calls, or all puts. They can also be bullish or bearish. A butterfly strategy is both bearish and bullish, but we’ll dig into that later.
How a Butterfly Spread Works.
We’ve already outlined the basics of the butterfly options trading strategy. Can you recall them? First, the butterfly will use four different options. All four options with have the same expiration date. One option will be set at a higher strike price, another option will be set at a lower strike price. Two of the options will be placed in the dead center, meaning the difference between the upper bound option and the lower bound will be the exact same.
It’s important to note that there are two types of butterfly spreads. The following example will be a long butterfly spread and will create a net debit. A short butterfly spread will create a net credit. We will outline the difference between the two in the next section.
Let’s assume you want to execute a butterfly strategy for ACME Computers, which is currently selling for $100 dollars a share. You believe prices will hold steady over the next month so you execute a long butterfly trade. As such, you sell two call options with an expiration date in one month and with a strike price of $100 dollars. Now, it’s time to buy two call options, one at a higher price, and one at a lower price. So, you buy one call option at $110 and buy another at $90. Notice that they are the exact same distance from the middle options you sold.
Let’s assume that the ACME $90 call option sold for $10 dollars, and the one ACME $110 option sold for $7 dollars, and that the two $100 call options that you sold netted you $6 dollars a piece. Remember, when you write a trade, the money is credited to you, meaning you get money but have to cover the options. You will notice, however, that the overall trade in this case is a net debit of $5 dollars. Since options are sold in batches of 100, you multiply 5 X 100 to determine your maximum loss, which in this case is $500 dollars (+ commissions & fees with your broker).
In this case, the butterfly strategy basically creates two trades at once. There is a long $90 dollar trade and a short $100 dollar trade. This is the first trade. The second trade is a short $110 call and a long $100 dollar call. With a butterfly spread, your profit is maximized the closer the ACME stocks are to $100 dollars (the middle) upon expiration. Let’s assume your instincts are proven 100% correct, and Acme is at exactly $100 dollars upon expiration.
If this were to happen, the ACME $90 call would expire in the money with an intrinsic value of $10 dollars. The ACME $100 dollar calls would expire worthless, meaning you get to pocket the credit you received, which was $12 dollars. The ACME $110 options would also expire out of the money and would be worthless, meaning you’d lose all of the money you invested in them ($7 dollars per share). Remember, the above numbers are multiplied by 100 because options are sold in batches of 100.
If Acme’s stock prices rise or drop, but stay close to $100, you will still produce a profit, but it’ll be reduced.
Long vs Short and Call Versus Put Butterfly Spreads.
A butterfly spread basically “revolves” around the two center options. These two options will determine the overall nature of your butterfly strategy, and whether it is a long or short option. The butterfly option example outlined above was a long call option. This means that you sold the two middle options, collecting a credit. The upper and lower options, however, were bought, requiring you to pay for them. Generally, this will create a net debit. A long put option is basically the opposite. You buy the two middle options, and sell the two outer options. This will generally create a net credit.
There are also long put butterfly spreads, and short put butterfly spreads. With a long put butterfly spread you buy one put at a higher strike price, sell the two at-the-money puts in the middle, and then buy one put at the lower price. The short put butterfly spread is the opposite. You sell (or write) one the higher strike price put option (meaning it’s out of the money). Then you buy the two middle in-the-money options, and sell another out-of-the-money option with a higher strike price.
All the various choices for your butterfly options trading strategy can get confusing. Don’t worry yourself if you don’t understand everything just yet. As with many investment strategies, it will start to make more sense as you work with the trades themselves.
Conclusion: When and Why to Use the Butterfly Spread.
The butterfly spread is a great tool for relatively stable markets that are not suffering large price swings. If there is a lot of uncertainty and volatility in the market, the risks will increase while profits will remain limited. This means that butterfly spreads, like iron condors (LINK), are great when prices are moving sideways, and are either rising or declining at a slow, stable rate.
If there are serious concerns over a financial crisis, or economic downturn, you probably don’t want to use a butterfly. Likewise, if the government is considering a massive stimulus plan that could lead to generally rising asset prices, such as quantitative easing, again it’s best to avoid the butterfly.
Still, when markets are relatively stable, butterfly options offer a great way to profit off of that stability while also limiting yourself to risks. Remember, the most you can lose is what you invest. This makes it easier for you to project your finances and to manage your overall portfolio and its risk composition.
Sun, 01 Oct 2017 13:38:00 -0700.
There are lots of strategies for selling options premium for monthly income. My strategy is outlined here.
Interested in following along with my trades in realtime? My trades are posted to our twitter feed. Don’t forget to follow!!
Don’t forget this is just for educational purposes. Please do not blindly follow along. You will not succeed. Learn from what I am doing. Don’t be afraid to ask questions. You can email me here: [email protected].
One last note — The Profit / Loss do not include commissions I paid via my broker Tradier.
Thu, 28 Sep 2017 11:31:00 -0700.
Historical volatility is just as its name implies. It is a representation of the underlying’s actual past price movement, both up and down. Implied volatility is what the market expects it to be in the future. Now, to better understand how volatility affects premium, let’s take a quick look at the difference between market value and theoretical value. The easiest way to do this is to compare the different components that make up the two.
What Determines An Option’s Market Value Affects Prices.
This is going to sound trite, but there are only two things that determine an option’s market value. They are supply and demand. That’s it. It’s a simple point, but it’s important. The reason that it’s important is because supply and demand are influenced by what traders think. And, what traders think is also a key component of what makes up an option’s theoretical value.
What Determines An Option’s Theoretical Value.
Theoretical value is calculated using six variables. Those variables are the strike price of the option, the market price of the underlying stock, the time remaining until the option expirations, the amount of any dividend the stock pays, interest rates, and implied volatility. Of these, implied volatility is the most important.
Why Volatility Is So Important Options Prices.
The reason that implied volatility is the most important variable in determining an option’s theoretical value is because it is the great unknown in the equation. At any given point in time, the other five variables are easily attainable. They’re either right there staring you in the face on your trading workstation’s quote monitor or are printed in the financial section of your daily newspaper. Implied volatility is a little more esoteric. It’s the market’s estimate of where the stock is likely to trade between now and expiration. Now, think about this in terms of market psychology and the last time you had an option trade go really bad…or really well.
The market’s expectation for how volatile a stock is going to be in the future isn’t always right. Sometimes the market guesses that the stock will be more volatile than it has been in the past. Sometimes it guesses that it will be less volatile.
When the market thinks that the stock will be more volatile in the future than it has been in the past, then it’s implied volatility will be a bigger number than its historical volatility. When traders think that the stock will be less volatile going forward than it has been, then it’s implied volatility will be a smaller number than its historical volatility. It’s this mismatch between historical volatility and implied volatility that’s important.
When the market gets it wrong, then implied volatility will move relative to historical volatility. If the market guesses too high, then implied volatility will shrink relative to historical. If the market guesses too low, then implied volatility will expand.
Now, remember that implied volatility is the great unknown in the equation used to calculate theoretical value. So, if implied volatility rises, so does theoretical value. And, if implied volatility falls, then theoretical value falls too. This is the reason that volatility is so important and how it affects option premium.
Tue, 26 Sep 2017 14:02:00 -0700.
But after diving into Warren’s investment strategy, you quickly realize it’s not for you. We want riches today—not when we’re 80. We want a quick buck! Next stop, Day Trading! We all have visions of facing a wall of monitors while we sit at a desk pressing buttons, making thousands of dollars day after day. So you start day trading.
Day trading here I come.
People all over the internet claim to make riches day trading. You want to be like them. Heck, some of them sell you books and courses. Maybe you also buy a few new computer monitors. Now you’re ready to day trade. On your first day you nearly double your money. You’re crushing it! Maybe you crush it for an entire year. Maybe even a few years. Warren Buffett is a chump compared to you!
(Do you really want to be like this guy?)
And then the day comes. You thought you were too smart for this to happen to you. You really thought this day would never come. But it did. You blew up your account. No more trading capital. The arm candy you had been dating just took off. No money, no love :). Rock bottom. Well, maybe not true rock bottom. Let’s hope you only day traded with a small portion of your savings.
You have seen how you can get rich trading the market. It’s in your crawl. But how can you do things differently so that you always crush it and never blow up your account? You scour the internet looking for the holy grail of trading. And then it happens—you discover options trading!
Options trading is my new arm candy.
When I say options trading I don’t mean directional options trading. Directional options trading is nothing more than using options as a way to leverage your day trades. Buying stock in Apple and hoping it goes up by the end of the day is the same thing as buying options in Apple and hoping it goes up by the end of the day. With directional options trading you can use far less capital to make the same return, but at the end of the day it’s the same form of gambling.
Options trading is, for me, probability-based options trading. Using probability and statistics to determine the expected move of a particular underlying asset (aka stock).
Before we get too deep, let’s set the stage. This type of trading doesn’t involve 12 monitors mounted on your wall. It doesn’t require you to sit in front of your computer every day for hours on end. It’s a nice hybrid between Warren Buffett’s buy and hold approach and adrenaline-filled day trading. Sounds pretty good to me—more free time and more money!
How the most successful options traders trade.
As I said, some of the best options traders use probability and statistics to form a trading strategy. They don’t place directional trades, trying to gamble on if a stock will go up or down. Most options traders place trades where they don’t care if the stock goes up or down. Though they might care if the stock moves up or down in a big way in a short period of time—more on that later.
Most successful options traders use volatility and options greeks to determine the likelihood of a particular underlying asset performing in a particular way. Then, instead of jumping on the directional bandwagon this type of options trader places trades that profit from the expectation of the move.
Before going into the nuts and bolts of this type of trading, let’s explore an analogy—take insurance companies, for example. Typically you pay your car insurance company a monthly sum in exchange for coverage should something bad happen. Of course, insurance companies are in business to make a profit. They need to collect more in total monthly payments than the total they have to pay out. They are banking on the fact that they can predict the percentage of their customers who will get into an accident—and the percentage who will not.
Say you send your car insurance company a $100 check for a month of coverage. If you make it the entire month without any accidents the insurance company wins. The insurance company knows, based on models of past performance, that most of the time they will win and every so often they will lose. They price the insurance they offer to account for this calculation. As an options trader you can mimic this type of transaction. You can become your own little insurance company.
Use fear to sell premium in the options market.
Say you’re a big hedge fund with billions under management and you’re unsure where the market is going. You can’t simply sell all your stock and go to all cash (too much to sell—the selling would move the market). One option (no pun intended; maybe) would be to buy some insurance in the form of put options.
In accordance with the concept of supply and demand, the cost of buying put options will increase as big hedge funds start buying them to protect their portfolios. The more managers reach for protection, the more the put options will cost.
No one knows the future—if anyone did they would be even richer than Mr. Buffet. So the insurance buying from big hedge funds is often precautionary and overdone. From the price managers are paying for these put options, in addition to some other factors, we can gauge what investors are expecting the market to move. This measure is often referred to as volatility . The VIX, aka the fear index, is a measure of the volatility of the stock market as a whole.
So what does this have to do with you? You’re just a small retail investor—for now at least. Well, you can take advantage of the big hedge funds’ eagerness to buy insurance. You can sell it to them. Just like the car insurance companies sell it to you.
As I mentioned, through supply and demand options pricing can get out of whack. Here is how you take advantage of that. Let’s say options pricing is suggesting the market will move 5% in the next 30 days. You sort of know that’s out of whack. Implied volatility is way overdone. Why not sell puts based on this 5% implied move? You sell a put option contract and collect some premium just like an insurance company would.
How does this work? Let’s say you sell (or write) a put options contract on the SPY (ETF that tracks the S&P 500). You write this contract 5% out of the money (the current price of the SPY). This options contact expires within the next 30 days. If the SPY closes down more than 5% in 30 days you lose money. In our analogy this is the equivalent of what happens when you crash your car and the insurance company pays to settle the claim. If instead the market stays above a 5% loss in 30 days, you keep the premium you collected when you sold the put option on the SPY.
Pretty simple right? In this example the SPY could go up in value, stay flat, or go down in value less than 5% and in each case you win.
To put some context to this idea let’s look at my post How Often the SPY Falls More Than 5% in a 30-Day Period and Why You Should Care. In this missive I show that during any 30-day period from 1993 through 2014 the SPY closed down 5% or more 11% of the time . Using this historical information, if you sold a put 5% out of the money 11% of the time you would lose the trade—meaning the SPY closed down more than 5% in a 30-day window.
Just like car insurers have a model to estimate how many people will place claims in a year you can estimate how many times you will lose a particular put selling trade.
An options strategy that will gain you monthly income.
It’s time to put all of this together. There are lots of strategies you can use to leverage the concepts I highlighted in this post. What I am about to share is how I like to trade put credit spreads on the SPY over and over again. I do not suggest blindly copying what I do. I suggest exploring different ideas and find the strategy that suits you best.
Earlier I talked about selling put options on the SPY and collecting a premium—most likely selling to those sucker hedge funds :). There is one downside to this approach. The losses can be pretty big. Think about it this way: if you get in a fender bender your auto insurance might have to shell out thousands in repairs. But if you total your car, your insurance company might be buying you a new car (maybe $40,000?). That’s a big range. Selling a naked put option can be the same way. The more the market tanks the more you pay out.
Did you know insurance companies buy something called reinsurance? Your insurance company has an insurance company of its own. Your insurance company buys insurance to cap its losses. So if you total your car and your insurance company buys you a new car, its insurance company might be paying half of that bill. So why not buy a form of reinsurance on your put option?
To insure a naked put position I often buy a put option (my own reinsurance) further out of the money. In the example above we sold a put option 5% out of the money. I might go and buy another put option 8% out of the money so I would only have to cover losses between 5% and 8% out of the money. If the SPY dropped 12% I would pay the first 8% and the put option I purchased would pay the remaining 4%. This trade is called a put credit spread.
By placing a put credit spread I am limiting my maximum loss, but I am also limiting my profit. I have to take out of my profits the cost of the put option I purchased.
By placing these put credit spread trades over and over again I generate monthly income that’s similar to day trading profits. The difference is I’m not gambling the way I would have to with day trading. I predict that 11% of the time I will lose and 89% of the time I will win. I limit my losses by buying protective puts.
My rule of thumb is this: whenever there is a put credit spread on the SPY that expires within 45 days and gives me a credit of $20 per lot or more, I place that trade. Often this strategy works out to 2 trades a week. In a good year this strategy returns 90+%, and over time this strategy returns 20 to 30% CAGR (that is CAGR, not pure return). I have never seen a day trading strategy that does this well year after year. Though yes, day trading might beat this strategy for a few years.
Conclusion.
I had one very simple goal in this post: convince you that there are better alternatives to day trading. Most people do not succeed at day trading long term. You can get wrapped up in the idea of big percentage gains month after month. But take a moment to do one simple exercise. Put all the gains you think you will make month after month day trading into a spreadsheet. My guess is you’ll be a billionaire within a few years, right? Now look at the Forbes richest people list. Did any of them get rich day trading? Nope. If it was easy someone would have figured it out by now.
This type of options trading only became possible for the retail investor in the last 5 to 10 years. It’s pretty new, which is why you haven’t heard much about it. I am not saying probability-based options trading will make you a billionaire. What I am saying is the odds of long-term success are much more in your favor.
I will add that there is a time and place for day trading. Heck, I’ve even blogged about it. Day trading should be for a very small amount of your capital and mainly used to stay engaged in the market and have a little fun. I don’t think day trading should be the bulk of your trading strategy.
Wed, 20 Sep 2017 19:22:00 -0700.
You decide that a short butterfly strategy has a high probability of profiting from the impending news, whatever it may be. The stock is trading at $50, so you purchase two put contracts with $50 strikes. You simultaneously sell another put contract with a $51 strike, while writing a fourth put option with a $49 strike. All four contracts have the same expiration dates.
The two center options cost $75 each, for a total of $150. The upper contract earns $30, while the lower contract, which is out-of-the-money, earns a very nice $140. The total amount received is $170, while the total spent is $150. The net credit is $20, which will be reduced by any commission paid.
After a week, you hear in the news that Abbott Labs has cancelled the study, because several patients developed severe side effects from the drug. Investors send the stock price down to $43. The two options you purchased are worth $700 each at expiration, while the short contract with the highest strike is worth $800, and the lowest-strike contract has a value of $600. You can exit these last two positions by buying to close. Doing so costs $1,400, and you have the other two long contracts that are worth a total of $1,400. The contracts obviously offset each other, leaving the $20 credit obtained at the outset.
Maximum Loss and Gain.
The $20 earned is the maximum gain for our example. Because there are two shorted contracts with two long contracts in the butterfly spread, the options will always negate each other if they are in-the-money, assuming that the strike prices of the butterfly’s wings are equidistant from the center strike, which they should be.
If the stock moves in the opposite direction, all derivatives will be out-of-the-money with no value. This also leaves the $20 net credit earned at the start of the trade. If the stock hovers around the center strike value, one of the shorted contracts will be in-the-money. Upon exercise, this will decrease the net credit or produce a loss on the trade.
Equations.
Looking at what we have learned in our example with Abbott, the following equations are revealed:
Because the short butterfly play has these caps, only limited gains can be made with it. But the limits also create an inherent safety mechanism that makes the short butterfly safer than many security investments, including equity trading.
Tue, 19 Sep 2017 21:00:48 -0700.
Given all of the risks associated with investing, it’s important for investors to pay close attention to what they are doing, to be conscious of risks, and to constantly stay up to date on the market. For investors who are new to the game, one great way to get started is with “paper trading”, which refers to simulated investing with fake money. Paper trading is especially great for traditional investors who want to learn about options trading.
A variety of stock brokers and other organizations now provide a variety of trading simulation tools and paper trading options. These tools allow you to execute trades based on up-to-date market data, but instead of risking real money, you use fake money. You can then monitor your performance based on real-world market data. In other words, paper trading is very similar to actual investing, but you don’t have to risk your money.
Where Can I Find an Options Paper Trading System?
There are many great paper trading options and simulators available on the Internet. Some of them specialize in certain assets, such as futures or options. Others allow you to trade a variety of assets. Let’s briefly highlight some of the more popular paper trading platforms:
Investopedia- this popular investing education platform also offers a great paper trading platform. You can paper trade stocks, options, and other assets on Investopedia, making a great choice for people who want to try various investments.
OptionsXpress- this website offers a great platform for paper trading options. You start out with $25,000 dollars in fake money, and can start trading right away.
MarketWatch- features a bare bones and perhaps difficult to use interface. However, their Virtual Stock Exchange simulator offers great opportunities for paper options trading.
There are many other stock and option simulators out there. If none of the above suit your fancy, go ahead and search around for other options. So long as the paper trading system allows you to make a variety of trades and is based on real-time information, you’ll be afforded plenty of opportunities to learn.
Who Should Use Paper Trading and Why?
Paper trading is a fantastic choice for people who are new to investing, or are trying out a new type of investment vehicle, such as options. For example, if you’ve been steadily building up your retirement and stock portfolio, and want to expand into options, starting with paper trading makes a lot of sense. You’ll be able to learn how investing works and can also tinker with various strategies. While reading blog posts from thought leaders like Tasty Trade is a great way to increase your investing knowledge and skill, at the end of the day experience is also essential.
Quite simply, picking up knowledge is one thing, while implementing it is another. There are tons of fantastic option trading strategies that can help traders reduce risk and increase the potential for profits. Options Cafe and other websites work hard to provide as many insights and opportunities as possible. Yet at the end of the day, you as an investor must put that knowledge to work. You have to conduct the trades and you have to manage your portfolio. Paper trading offers a great way to test theories and learn the ropes, while not exposing yourself to unnecessary risks.
Paper trading is especially important for options because premiums, fees, and time decay will all play a big role in your investment strategies and will impact your profits or losses. With stocks, many trading strategies allow you to simply focus on price. With options, there are more considerations that you have to pay close attention to. Paper trading options will help you learn how to focus on these different aspects and variables.
However, there are some downsides to paper investing. Most importantly, it’s simply not real. Even if you start making a lot of “money” off of paper trading, you’re not really making any profit at all. Further, many traders do great with paper trading because they are unencumbered by fear. Without real money at stake, investing can be a relaxing and feel more like a video game rather than wealth management. Making big, bold trades is easy, and often those bold moves will produce big “profits.” Once real money comes into play, however, many investors tighten up, and their trading strategies change, even if subconsciously, and often for the worse.
Let’s jump into how you can properly utilize paper trading options, while also digging deeper into the limitations of simulations and how you can overcome them without exposing yourself to too much risk.
Putting Paper Trading To The Best Use.
Not ready to jump into options trading with live money? That’s okay. Paper trading options offers an excellent way to get started. With paper trading, markets are live but the money you invest isn’t. This means that the simulations are highly accurate and will reflect real world conditions.
When you invest the fake dollars, treat it like a real trade. If you’re a risk averse trader, then you should focus on making paper trades that mitigate risks. If you’re willing to expose yourself to more risk, go ahead and do so. Just make sure you’re being honest.
Of course, with paper trading you can also test new ideas, higher risk trades, etc. in order to learn new strategies. You might be intimidated by the risks involved with options trading, but after paper trading you might quickly find that you actually have a knack for it. The same is true of individual strategies. Some options trading strategies are much lower in risk, but generally have restrained profit potential. Other strategies offer great profit potential, but also carry higher risks.
In order to learn, it’s important to think through each trade. Why are you buying an option for this stock? How can you use an iron condor in that market? Don’t just throw darts at the wall and hope that your trades bear fruit. Be strategic. As you conduct paper trades with options, some of them will undoubtedly turn sour. Don’t get discouraged, take it as an opportunity to learn! Sit down and try to figure out why that particular options trade didn’t turn out well.
While paper trading options offers a great way to get started and to learn, nothing beats real, live experience. Of course, investing can be intimidating. With opportunities come risks, and it is possible that you will lose some money. This is true of any investment vehicle, including stocks, bonds, futures, Forex, options, and all the rest. Options tend to have a higher risk profile, but also a higher profit potential. Further, various options strategies can be used to mitigate risks.
Regardless, many investors get nervous when they start options investing. The transition from paper trading to real-live options investing is often bumpy for investors. Yet if you’re serious about making money, you have to get serious about investing real money. That’s why Options Cafe recommends transitioning from paper trading to real trading as soon as you’re comfortable with both options trading basics and the options strategies you plan on utilizing.
Before betting the house, however, we recommend that you start with a smaller amount of “risk capital”. Let’s jump into what that means.
Start Options Trading With a Small Amount.
Don’t want to risk your retirement portfolio with options trading? That’s a wise idea. While options trading has a fantastic potential to produce profits, there is a risk of losing money as well. If you’ve learned all that you can learn from paper trading options and are ready to jump into options trading, it’s smart to start investing with a smaller amount, say $2,000 dollars.
This way, you will limit your exposure. Yes, you’ll also limit your profit potential, but that’s okay for newer investors. Obviously, no one wants to lose or even risk $2,000 dollars if they don’t have to. However, you can think of this initial investment as an educational opportunity as well (more on that later).
When you first start investing in options, you should limit yourself to “risk” capital. This refers to money you can afford to lose. No one wants to lose money, of course, but many people can afford to lose a certain amount before it starts to really affect their life style.
For example, you might start by trading with $2,000 dollars. When it comes to options trading, fees, commissions, and all the rest mean that you will generally produce limited profits with only $2,000 dollars invested. However, by limiting your exposure, you won’t be putting yourself at serious risk.
Even if the nearly inconceivable happens and you lose all $2,000 dollars of your investment, you likely won’t lose your home or vehicle. Yet by investing with real money, even a small amount, you’ll start to see how you react to the pressures of a live market and live risks. Often, you will find your reactions to be different from when you were paper trading options. This is normal, but do take note.
If your trading is detrimentally impacted, which quite frankly is common, you need to sit down and take a deep breath. What strategies produced results when you were paper trading options? How can you implement them now? Remember, you’re only trading risk capital, so it’s okay to take some risks.
On the other hand, it’s usually a bad idea to overexpose yourself when you are just beginning to trade options. Even if you’ve enjoyed a ton of success with paper options trading, it’s not a good idea to jump in with large investments right away. By easing in, you’ll reduce risks and set yourself up for a higher chance of long-term success.
The Best Platforms for Small-Capital Options Investing.
So you’re ready to invest some risk capital in options trading. You’ve already managed an account on Investopedia or another options paper trading simulator. Now you want to jump in. Which options broker should you use? There are tons of options brokers, and many of them have their own unique advantages and disadvantages.
We don’t want to discourage you from shopping around for an options broker, but in our experience Tastyworks.com is the best broker for newer investors who are trading with smaller amounts. They are great for options trading with large amounts as well, but when it comes to limited capital investing few platforms offer as competitive of fees and commissions.
Newer Investors Should Think of Their Investing as an Educational Experience.
There’s no getting around it: when you start investing in options there is a risk that you will lose some money. It’s possible, even if unlikely, that you could lose all $2,000 dollars or whatever your initial investment is. Don’t let that intimidate you, and remember that even Warren Buffet and other world-class investors make bad investments from time to time.
Further, every time you invest you are creating an opportunity to learn. There’s an old saying, “practice makes perfect”, and that’s true for investors as well. Every time you invest, you are creating an opportunity to learn, and as you learn you can improve. People always say education is invaluable, and that’s true. However, we can put some hard numbers to it as well.
Think about how much tuition at a university is. In-state tuition at many public tuitions is now above $15,000 dollars per year. Private schools (many of which have the best investing and finance programs) can top $40,000 dollars per year! Each year, hundreds of thousands of students and their families fork over their savings accounts for education. In the long run, however, it’s usually worth it. A bachelor’s degree along can equate to $2.3 million dollars or more in lifetime earnings, on average, over a high school only degree.
In that context, options investing is actually quite cheap, and the education can be just as valuable, and for some options traders, even more so. Of course, paper trading options is free, so even if you’re a bit skeptical, give it a shot. There’s no risks. Having trouble producing profits? Recalibrate your trading strategies. With time, effort, and patience, you’ll all quite likely start producing profits.
Wed, 13 Sep 2017 00:05:15 -0700.
Next Look at The Greeks.
Because this is a vertical spread I’m long some Delta and I’m short some Delta. I’ve circled this as # 1 in the image above. When you do the math, you’ll see that I’ve got hardly any net Delta at all; just 6.93. That means that for every 1 point move in AAOI stock, this spread is going to advance less than 7-cents. Doesn’t sound like much, but when you consider that we put on this spread for just 58-cents, that’s not a bad move – especially for this high-beta stock.
How The Options Greeks Could Go Wrong?
So, the next thing to look at is # 2, Theta. Here again, it’s a net number. And, between now and the close of business tomorrow this puppy is going to lose 0.83-cents of its value to time decay. The important thing to remember is that Theta is right now as low as it’s going to be for the rest of this contract’s life. It’s only going to get bigger, and bigger, and bigger from here. And, it’s going to get bigger at a faster pace every day for the next 37 days. So, again, I better be right on the direction of this stock or this baby is going to expire worthless!
Now, let’s look at # 3. You’ll notice that there are two circles labeled # 3. They are related. Look at the circle to the left. That’s the one over Vega. Here again, we see that because we’re long one strike and short the other, Vega is a net number. It’s 1.26. This tells me that if implied volatility increases one percent (or one point) then my net premium is going to go up 1.26-cents. If it goes down one percent, then my premium shrinks by 1.26-cents.
What Could Go Right?
Now look at the # 3 on the right. Here we’re looking at implied volatility. I’m not concerned about netting these two numbers. I’m more concerned about where they are in relation to historical volatility. Take a look at the image below to get a sense for that.
The blue line inside the yellow oval shown in the image above is historical volatility (HV). The red line is implied (IV). When I took this screenshot HV was at 167.11. IV was at 67.65. I’ll talk more about this in the weeks ahead, but the relation between these two is so out of whack, that I think that IV will increase rather than decrease from here. If that happens, then my net premium is going to expand right along with it. This, oh by the way, is why I put on this trade today.
As you can see there are lots of factors in trading option greeks understanding how they work is key to successfully trading options. Greeks drive the decisions of most options traders.
Mon, 11 Sep 2017 00:00:00 -0700.
Why do I post my trades every month?
I am a big fan of trading options as a form of monthly income. I think selling premium in options over and over again far out performs any other investing / trading strategy that I know of. Yes, we all can make big wins day trading but it never lasts. Almost everyone blows out their account at some point. When placing probability based options trades you know how successful you should be month after month.
With that said — the reason I share my trades is to spread the success of these types of strategies. My goal is to convince people looking to become day traders to move away from those ideas and embrace these ideas.
There are lots of strategies for selling options premium for monthly income. My strategy is outlined here.
Interested in following along with my trades in realtime? My trades are posted to our twitter feed. Don’t forget to follow!!
Don’t forget this is just for educational purposes. Please do not blindly follow along. You will not succeed. Learn from what I am doing. Don’t be afraid to ask questions. You can email me here: [email protected].
One last note — The Profit / Loss includes commissions I paid via my broker Tradier.
Sun, 10 Sep 2017 12:02:00 -0700.
Because there are two short options and two long options, if the stock makes a move that causes the two short options to gain intrinsic value, the other two options, which are of the same type, will also increase in value. Thus, this strategy always negates losses.
Example of a Long Butterfly Spread.
Suppose you noticed that General Mills (ticker GIS) has been moving sideways for some time. You expect this trend to continue based on your technical and fundamental studies. Although you don’t have a lot of risk capital, you decide to use a butterfly derivative strategy to earn a little extra income, knowing that the investment is limited in risk.
The stock is trading at $60. You sell two call options, each with a strike price of $60. You also buy one call with a strike of $55 and another call with a strike of $65. All four securities have the same expiration date.
The written calls produce a revenue of $1.50 each. Because there are two contracts of 100 shares apiece, the profit is $300.
The contract with the lower strike costs 80¢ per share, while the upper-strike contract is priced at $2.60 per share. The cost of the long contracts is $340. Subtracting this amount from the revenue generated from the written contracts produces a $40 cost for the entire trade.
If GIS stays at $60 and ends there on the expiration date, the two written contracts will be worthless, and so will the call contract you hold at $65. The final contract with a strike of $55 has $5 of intrinsic value per share, producing a profit of $500, which is the total gain from this butterfly strategy. Subtracting $500 from the $40 net debit produces a net gain of $460 for the butterfly investment, not calculating any commissions paid.
On the other hand, if General Mills had reported above-average earnings and the stock price went to $70, all four contracts would have intrinsic value. The two short contracts would be worth $1,000 each, producing a total loss of $2,000. The contract with the lower strike would be worth $1,500, while the higher-strike call would have a value of $500. Clearly, the long and short contracts cancel out, leaving just the cost of entry as the total loss.
Butterfly Equations.
Looking at the numbers in the General Mills example, we can determine the following equations, which show the breakeven points:
Notice that the more you pay in commissions and premiums, the narrower the range of profit.
Mon, 04 Sep 2017 00:00:00 -0700.
Right off the bat, I’m going to tell you that I don’t pay any attention to Rho. Rho tells you how premium is going to change with a 1% move, up or down, in interest rates. Now, the likelihood that you’re going to see that big a move in rates before a contract expires is not very high. This is especially the case if most of the trades you make go out fewer than 60 days. So, unless your trading methodology centers around buying or selling LEAPs, I suggest that you don’t need to pay much attention to Rho.
Now, with that said, some day interest rates may be higher than they are now. You never know. So, just in case that happens, here’s how Rho affects premium. If interest rates rise by 1%, then a call’s premium will decrease by the value of its Rho. Call premium will increase by the value of Rho when interest rates fall by 1%. The exact opposite is true of put premium. The reason a change in interest rates will affect premium is because it costs money to maintain an open options position. When interest rates rise the cost to carry a position becomes more expensive. When rates fall, the cost to carry becomes less expensive. Rho compensates for this and adjusts premium accordingly.
Gamma, Gamma, Gamma!
Another one of the Option Greeks that I don’t consider when setting up a trade is Gamma. Gamma tells us how much Delta is going to move with each one-point change in the underlying. If Delta is at .50 and Gamma is at .10 and the underlying moves up by one point, then Delta will move to .60. If the underlying declines by one point, then Delta will go to .40. Gamma affects puts the exact same way it affects calls. But, bear in mind that this assumes you’re long. When you’re long Gamma is a positive number. When you’re short, it’s negative. Gamma is at its zenith when the option is at-the-money and trails off the further the option goes in-the-money or out-of-the-money.
The reason that I don’t factor Gamma into my decision making when I model out a trade is because if I’ve gotten the other components right, then Gamma will just be along for the ride. And, if I’m in a trade that goes south, then it’s because something else went wrong. Gamma won’t be the cause of either a winning or a losing trade. Winners and losers will be much more affected by Delta, Theta, and Vega.
The Big Three – Delta, Theta, and Vega – The Must Know Greeks.
Delta.
Delta tells you how much premium is going to change with every one-point move, up or down, in the value of the underlying. It’s expressed as a decimal number. So, for example, if an option you’re considering has a Delta of .50 the ramification of a one-point move in the underlying is a 50-cent move in premium. Traders also use Delta as a predictor of the likelihood that a given option will be in-the-money at expiration. So, traders say that an option with a .30 Delta has just a 30% chance of expiring in-the-money. But, one with a .80 Delta has an 80% chance.
Each Delta lies on a continuum numerically between 0 and 1.00. Call Deltas are positive; put Deltas are negative. When an option is at-the-money, a call’s Delta will be at .50 and a put’s Delta will be at -.50. As you set up trades you should be using Delta to help you model your exit strategy (assuming the trade goes to plan) based on an assumed price target for the underlying. The other Greek that you want to pay close attention to is Theta.
Theta – What You Need To Know.
Time value is an option’s excess premium over and above its intrinsic value and the rate at which an option loses time value is represented by its Theta. Time value wastes away at an exponential rate. The closer the calendar gets to expiration, the more rapidly an option loses time value. On any given trading day, Theta represents the amount of premium that will be lost to time decay by the close of business tomorrow. And, then tomorrow, it will do the same thing all over again, except that Theta will be a bigger number.
Losing premium to time value is good if you’re short. When you sell a position, you’re looking for it to expire worthless. So, Theta is your ally. The opposite is the case if you’re long. Being long Theta requires that you pay close attention during trade setup.
The reason for this is that you’ll want to know how much your trade is at risk if the underlying doesn’t go in your direction pretty quickly. The longer you have to sit around and wait for the underlying to move, the quicker that contract is going to lose value. Even if the underlying is moving higher the contract will still lose premium unless the option is deep in-the-money.
Vega – Volatility In Da House.
So, when setting up a trade you want to make sure that you avoid strikes that are ridiculously out-of-the-money and that you give yourself plenty of time to have the underlying make the move you anticipate. And, that brings us to the last Option Greek you need to pay attention to: Vega. This is the most important one in my opinion.
For me, trading options is really all about trading volatility. The one variable that has the greatest impact on premium is implied volatility (IV). If it expands, premium expands; if it contracts, premium contracts. The rate at which this expansion or contraction will take place is revealed to us by Vega. It tells us how much our premium is going to change with every one percent move in IV.
So, when you set up a trade you want to make sure that you understand how Vega sensitive your position is. For example, if you’re long and Vega is a big number, then you want IV to expand. If it does, then your premium will increase by the percent change in IV multiplied by Vega. If you’re short and Vega is a big number, then you want IV to shrink. That will also shrink premium in the exact same manner; percent change in IV multiplied by Vega. Understanding Vega will help you to understand how much volatility risk you have in a position as well as help you model out possible exit points and stop losses.
Paying attention to Option Greeks as you set up new trades will help to make them more successful. And, in the next installment of this blog I’ll show you the things I look for from them when I set up a trade.
Sat, 02 Sep 2017 00:05:44 -0700.
One downside to utilizing high probability of profit (POP) trades, especially credit spreads, is that they can turn very ugly if the underlying stock moves against you. The maximum loss in high POP trades is often much larger than the maximum profit. Most of the time, these trades work out great, and are reliable and consistent. What can we do to minimize our losses on a losing credit spread?
Never Follow Your First Instinct.
It is the first instinct of many traders to panic and close the position when they see a large loss. This is a big mistake. Holding onto to profitable trades hoping for more profit and closing losing trades while they are still losers will result in poor returns. So, should you just hold onto a losing position and pray the stock moves in your favor? Of course not! It is important to consider that in addition to closing or holding, you can add more options to your positions.
Example Of How To Trade Delta Focused Options.
Lets imagine you’ve opened up a put credit spread on a stock. Some bad news comes out, and the stock plummets. You are now at a loss, and it appears that the stock shows no sign of stopping its fall. What can you do? Well, instead of closing, you can simply reduce your delta. By nature, put credit spreads have a positive delta. To reduce your delta, you simply have to enter an option position in the same underlying with a negative delta. This could be selling a call spread, buying a put spread, or even simply buying a put. I personally recommend selling a call spread, therefore creating an iron condor. This will help to reduce your losses should the stock continue to plummet. Just ensure your positions delta is overall positive, that way if the stock recovers you will make back a portion of your money.
Keep in mind that adding more options to your position does increase your max loss. It doesn’t eliminate the potential for further losses, it simply helps your position if the stock continues to move against you. It does increase your maximum potential profit as well, especially if you go the credit spread to iron condor route.
Increasing Delta Is Another Way To Manage A Position.
Reducing delta isn’t the only way to manage a position. You can also increase your delta if you believe the stock is going to reverse, rather than continuing to drop. This is achieved in the same way that reducing delta is, but instead you simply add more options with positive delta. This way, it will require a smaller upwards correction for you to break even. I would advise against this in most cases, as if you are wrong you will lose even more than if you just held the position. As always, there is always a time and place for certain strategies. Keep your personal portfolio goals and risk toleration in mind.
Delta in individual positions is one way to manage your delta. Options traders should also keep in mind the delta of their overall portfolio. Your portfolio delta is the sum of the delta of every option in your portfolio. If you want to collect credit and use theta as your main driver of profit, you should try to keep your delta close to zero. While you may have temporary success timing the market and making big gains, nobody can time the market forever. If your portfolio delta is very high during a bear market, you can say goodbye to your profits. Keeping your delta close to 0 ensures that you can collect money from time decay and directional moves will have less impact.
Keeping Delta To Zero.
So what is the best way to keep your portfolio delta 0 while making money trading delta options? This is up for debate, but uses the same principle as editing position delta. If your portfolio delta is very negative, add a long position with positive delta. One strategy I like to employ when my portfolio delta gets very high is selling a call spread on an index. I choose an index that contains the underlying stocks my long positions are associated with. For example, if I’m long a lot of tech stocks, I’ll sell a call spread on the Nasdaq index, QQQ. If I’m long a lot of retail stocks, I’ll sell a call spread on a retail ETF such as XRT. Do some research to find out what ETF’s and indexes include your longs/shorts in order to reduce your delta and hedge your bets.
Even if you are an options seller who relies on theta, it is important to study delta. Delta is not important to directional trading exclusively, and it can be used to edit positions and hedge your bets. Stay profitable and happy making money trading delta options.
Wed, 30 Aug 2017 00:16:09 -0700.
The price of an option is determined by six variables, five of which are known values based on pretty straightforward measures. There’s no guesswork about them. For example, the intrinsic value of an option is determined by the market price of the underlying. It’s a very black and white measurement. Nobody’s opinion is involved. It’s pure mathematics, plain and simple. That’s not the case with implied volatility.
Implied volatility is the market’s estimate as to how much a stock is going to move – up or down – over a set period of time. Sometimes the market gets it right. Sometimes it doesn’t. Sometimes it estimates implied volatility too high and sometimes it pegs it too low. So, today, I’m going to walk you through a couple of trade setups you can use when implied volatility is higher than historical volatility.
In each setup I’m going to use GameStop Corp ( GME ) as my example. I’m going to show you how to trade volatility when you’re a bull and when you’re a bear.
Step One – Should We Be Long Or Short?
Take a look at the image below. Here we’re looking at a graph comparing implied volatility (the red line) to historical volatility (the blue line). When I took this screenshot 30-day implied volatility was at 54.43 and historical volatility was at 23.27. That’s huge!
That’s the biggest mismatch we’ve seen in more than a year. Since implied volatility is so out of whack with historical, I think that a trader has a better chance of winning by selling premium rather than buying it. And, that’s the case whether the trader is a bull or a bear. Let’s say you’re a bull.
The Bull Case – Trade Setup.
If you’re a bull and you want to make a directional trade to profit from an up move in the stock you have two choices. You can go long calls (or a call spread) or you can short a put spread. There’s no naked writing in my methodology. And, as I suggested above, with implied volatility so high, I’d be awfully shy about going long. There’s just too much risk of volatility shock. So, I’m going to suggest that in this circumstance the upside move is a bull put spread.
Let’s look at what GME is offering the bulls. The expected move is about 2.2 points and the stock is at 20.93. That means the market thinks the stock could go to 23.13. So, if I write a credit spread and GME moves as expected, both of the strikes I’ve chosen should expire worthless and I’ll max out my profits. My credit spread is long the 21 strike and short the 22-half strike.
That will generate 97-cents in premium.
Now let’s look at what the bears might expect. I’m going to keep this simple and use the same strikes and follow the same logic, that there’s just too much risk being long premium with volatility so high.
The Bear Case – Trade Setup.
To make this call spread a credit spread – and therefore a bear spread – I’m going to sell the 21 and buy 22-half.
That’s going to bring in 56-cents of premium income. Using the expected move of 2.2 points, the market is suggesting that on the downside GME could trade to 18.73. So, being short the 21 strike is well within that move. If the stock did trade there, then both options would expire worthless and I’d get to keep my 56-cents.
Volatility Trading Is Opportunity.
The examples above are some of the simplest ways to trade volatility. There are plenty more strategies that a trader can use to take advantage of a mismatch between implied volatility and historical volatility.
Many of those strategies are pretty complex. But, the best part about them is that you don’t need to make a bet one way or the other. You don’t have to make a directional play for those other strategies to work out. You can be completely neutral and still make profitable trades.
This is one of the main reasons that I believe that trading volatility is where all the opportunity is!
Sun, 27 Aug 2017 09:23:00 -0700.
I know what you are thinking: if the market is so random how can you rely on S&P 500 statistics? A fundamental reason for this long-term trend is that the U.S. stock market is the primary place people invest money for long-term growth (think retirement funds). New money tends to flow into the market consistently because most people have X dollars taken out of their paycheck every month for retirement investing. It is a supply and demand dynamic—as long as new money flows in, the market should have a bias not to tank.
Am I being emotional about the foundation of my own trading strategy (the S&P 500 dropping over a 30-day period)? It’s true that I must apply some judgment to my strategy, and where there is judgement there is emotion. So I concede I can’t avoid emotional trading altogether, but I make a decision after hours of research and backtesting and I do not revisit the decision unless my strategy starts to fail. What I want is to avoid day-to-day, in-the-moment emotional trading decisions.
Check Your Emotions at the Door.
As I said, I trade put credit spreads on the SPY and I expect to lose money 11% of the time. And when trades go against me I lose money in a big way. In general on a one lot trade I make around $23 before commissions—but if the trade goes against me I can lose up to $177. Because I need 8 winning trades to make up for one loss, I need to place as many of these trades as possible to have a nice yearly return. I need to trust my trading strategy and place trades regardless of how scary the market is. Every so often the market tanks for good reason (think the 2001 tech crash or the 2008 real estate crash). During these times it’s tempting to sit on the sidelines, but my strategy obligates me to check my emotions at the door and continue to trade through wild times. And over time I have learned that wild times can be some of the best times to trade.
When I design a trading strategy I make sure it does not rely on emotional trading. I base my strategy on a foundation validated through backtesting. Then I execute my strategy over and over like a robot. Sometimes I even try to automate it. Because my trading decisions require no in-the-moment judgement there is no room for emotions to skew my returns.
Fri, 25 Aug 2017 00:00:00 -0700.
By writing two contracts instead of one, you collect two premiums. Taking a double position creates greater sensitivity to time decay than single options. The short straddle will be more profitable if time passes while the stock has little price action. These are the primary advantages of the strategy. There are significant downsides.
Risks Associated With Short Straddles.
The ideal situation is for the stock price to reach the strike price at expiration. This is where the maximum profit would be achieved, and no contracts are assigned. If a contract is in the money by a penny or more, it will automatically be exercised on the expiration date.
If the equity price is higher than the strike price, the call option will be assigned, and you’ll have to first buy the stock in the market and then sell it at the strike price to the counterparty. On the other hand, if the stock price is lower, the put option will be assigned. This will force you to buy shares of the underlying stock at a higher price than what they are selling for on the open market.
Short Straddle Example.
Suppose you expect Wal-Mart to have neutral price action in the next few months. You sell one call option for $1 and one put option for $3. Both have a strike price of $80 and the same expiration date. The most you can make on the trade is $4 minus any commissions you paid for the trade. If you want to make more money, just sell more contracts, keeping the number of puts equal to the number of calls. In this case, 10 contracts on both sides would generate $4,000 of revenue (10 contracts per side × 100 shares per contract × $4 credit), not taking into account trading fees. The further the price of the underlying equity moves from the strike price, the more money is lost on the investment.
Short Straddle Equations.
Scrutinizing the numbers in the above example will reveal the following break-even equations:
Using the numbers from the Wal-Mart example produces a trading range of $84 to $76. You need the stock price to stay in this range. If it breaks out, you will begin to lose money. You could hold until expiration, hoping the stock re-enters the break-even range and you don’t get an early assignment. Or you could cut your losses by buying option contracts to offset the ones you wrote. Doing so would take you out of the position.
A potential loss can be estimated using these equations:
Because of the high risk and low return potential of the short straddle position, it is recommended only for experienced traders.
Wed, 23 Aug 2017 00:00:00 -0700.
Equity (stock) Based Options.
Equity Options are the most common and popular type of option. Equity options are based on underlying stocks. When you buy a call equity option, you gain the right but not obligation to buy stocks at a certain price. When you buy a put option, you gain the right to sell.
Equity options are sold in lots of 100, meaning you gain the right to buy or sell 100 stocks. You don’t have to actually own the stocks in question. You can simply buy the options. This is true for both put and call options. When you do own the underlying stock and also buy put options, that’s actually called a “married put”.
Stock Index.
Besides individual stocks, you can also buy options based on a stock index. A stock index is an indicator comprised of numerous different stocks. Usually, stock indexes are created so that traders and economists may quickly and easily monitor the overall market.
For example, the S&P 500 is made up of 500 of the largest publically traded companies in the United States. These companies are spread across a wide range of industries. As such, the S&P 500 provides a good indicator of how markets are doing in general.
You can buy options that are tied to the point value assigned to each index. This way, you can “bet” on which way markets will move. Will markets rise, or will they fall? Many options traders like index-based options because they can focus on macro-trends rather than individual company performance.
Commodities Options.
Options can also be tied to commodities. What is a commodity? A commodity is a basic good that is interchangeable with other basic goods of the same time. Consider barrels of Brent Crude Oil. Each barrel of Brent Crude is equal in value to another barrel of Brent Crude. However, West Texas Intermediate Crude Oil (WTI) is a different type of oil, and so a barrel of WTI will not necessarily be of the same value as Brent. In fact, WTI is normally a bit cheaper.
Commodities are most commonly traded through “futures” contracts. Like an option, a futures contract is a derivative. Futures also feature an expiration date. Unlike options, however, when you buy a future, you are obligated to buy the asset and the seller is obligated to sell. Let’s say you purchase a future for one barrel of Brent Crude oil in May of 2018 for $50 dollars. Come May, you will be obligated to buy that barrel of oil for $50.
Options based commodities are generally based on futures, making them derivatives of derivatives. You could buy an option based on the futures contract for Brent Crude oil come May of 2018. Unlike a future, you wouldn’t be obligated to buy the barrel of crude, but you would have the option to do so.
Foreign Exchange Options.
Do you know what the biggest financial market in the world is? If you’re thinking the New York Stock Exchange, or even stocks in general, you’re wrong. The biggest market is actually the Foreign Exchange, or FOREX markets. These markets run 24 hours a day, 365 days a year, and are the largest, most liquid markets in the world.
Forex markets are the global currency exchange markets that allow governments, companies, and other entities to quickly and easily convert currencies. You can buy options based on Forex markets. With these options, you will have the right but not obligation to exchange one currency at a specified rate with another currency at a future point in time.
A Quick Look At Binary Options.
With so many different types of options one we can not ignore is called “binary” options. These options are gaining some popularity in Europe, but aren’t as commonly traded in the United States or by Americans in general. They offer a simple “yes” and “no” proposition. With binary options, you simply state “yes” or “no” regarding whether an asset will rise above a certain price. Binary options are often set up to expire in mere minutes or even seconds.
So let’s say you by a binary option for Acme Motors, which is currently trading at $25.50. There’s a yes or no binary option that expires in five minutes with a strike price of $25.55. In this case you can either vote “yes” or “no” that the stock price will be at or above $25.55. If you vote no, and stock prices rise to $25.54, or any price below $25.55, you’ll earn a predetermined pay, which is usually expressed as a percent. Get it wrong, and you’ll lose whatever you invested.
American Options Versus European Options.
On a final note, you may sometimes hear traders talking about “American options” and “European options.” This doesn’t have anything to do with the underlying assets. European stocks can still be the underlying asset for American options, and vice versa. The difference instead comes down to the setup of the option contract itself, and it’s a very important difference.
With American options, you can exercise your option at any point before the expiration date. With European options, you can only exercise the options at the moment they expire. In other words, if you buy a call option for Apple Inc. stock, with an American option you can buy those Apple stocks at any point before the option expires. With a European option, you only have one chance to buy the Apple stock, and that’s at the exact moment the options expire. This makes American options much more flexible, and as a result, most traders prefer to trade with them.
Sun, 20 Aug 2017 19:16:00 -0700.
So, we know delta is a number, and we know that delta corresponds to an options price, but how? Put simply, delta is a ratio. The delta ratio represents how the price of an option will change for every $1 the stock moves . This can be confusing to think about, so let’s use an example. Let’s say I purchase a call option on stock ABC. This call option has a delta of 40. If stock ABC moves $1 higher, my call option will gain $40 in value. Similarly, if stock ABC moves down $1 tomorrow, my call option will lose $40 in value.
Options can have a negative delta as well. Put options always have a negative delta, because they gain value when a stock moves downwards. Call options always have a positive delta, because they become more valuable when a stock moves upwards. However, Delta does have a cap. A single call option can have a delta value ranging from 0-100. A put option can have a delta value ranging from -100 to 0. This makes a lot of sense when considering options correspond with 100 shares of underlying stock. Options that are in the money will have a delta closer to 100 or -100. Options that are out of the money have a lower delta value closer to 0. Now that we understand the mechanics of delta, let’s examine how to make profitable trades by using delta as our main vehicle.
Long Delta Strategies vs Other Strategies.
Because delta is associated with the direction of a stock’s movement, we will look to use delta to profit when we have a strong opinion that a stock will move up or down. This is also called directional trading. A large majority of options traders tend to stray away from directional trading, and instead opt to make most of their money by selling options to collect cash. They then wait for the options they sold to expire worthless, or buy the options back for a lower price. These are called long theta strategies. Good examples of long theta strategies are short put spreads, and iron condors. These strategies usually have a higher probability of being profitable. For what reasons would we want to enter a trade that has a lower chance of being profitable? Certain long delta strategies, such as the long call spread, have notable benefits over long theta strategies.
Benefits of Long Call Spreads.
One benefit of long call spreads (aka: long delta strategies) that will be attractive to many new options traders is that it is a much cheaper position to enter than a short put spread. These are both bullish positions that will benefit when the stock rises in value. However, the long call spread will tie up much less of your buying power, and additionally generate more profit from a directional move. Let’s use a real world world example to demonstrate.
American Airlines, stock ticker AAL, reported their earnings after hours this past Friday. Imagine that I am a bullish on AAL this earnings, I think they will surpass expectations and the stock price will rise. A common strategy would be to sell a put spread. The stock is currently trading at $50.49, so I’ll choose some options near the current price. Imagine I sell a 48/50 put spread expiring in two weeks. By all means, this is a decent trade. It has a 60% probability of profit, I’ll collect a 32$ premium, and the stock can stay flat or even go down a bit and I’ll still make money. It has a delta of about 21. The real downside here is that if the stock really trades downwards, my maximum loss is $168. For a new trader with not much capital to work with, that risk/reward profile can be pretty unacceptable. Let’s examine the alternative, a long call spread. I’ll choose similar strikes, a 50/52 call spread, with the same expiry. This trade has a lower probability of profit at 45%, but let’s examine the risk/reward profile. The delta is 27, so more money will be made if our directional prediction is correct. We pay an $81 debt, so that is our max loss. The maximum profit on this position is 119$, larger than the maximum profit of the put spread, while boasting a much lower maximum loss as well. So, what’s the downside? When trading a short put spread, the stock can go up, flat, or even down a little bit and we can still collect our max profit. The main mechanism of profit in a put spread is typically time decay. With the long call spread, the stock must go up for us to realize our maximum profit. This is why I personally love trading long call spreads around binary events, such as earnings. It puts less money on the line while still giving us a high payout in the event that our prediction is correct.
Another great use of long call spreads is simulating stock positions. Many new investors want to long a stock, but do not have the capital required to make a profit that is worth the investment. If I want to buy 100 shares of a 100$ stock, it would require me to invest 1,000$ in cash. That ties up a lot of buying power, and in small accounts this can lead to less diversified risk. Alternatively, one could buy a call spread that has a delta of 100. An options position with a delta of 100 will act almost exactly the same as purchasing 100 shares, but will require a much smaller initial debt, enabling those with smaller accounts to spread their capital into multiple positions. The main downside with going long a stock with this strategy is that your initial debt will disappear much faster in the event the stock moves against you. On top of this, you will be forfeiting any dividend you would receive if you had held the stock. Options positions also expire, where as stock can be held forever. This creates a limit on the amount of time you can go long on the stock. Finally, long call spreads have a maximum profit whereas stock positions have unlimited profit.
Many options traders will try to avoid long delta strategies in favor of more time tested strategies. Overall, I suggest all traders do their own research, and learn what ways long delta strategies can benefit your portfolio before ignoring them entirely.