Trading Option Greeks

Vertical Spreads and the Blurred Line Between Delta and Theta: Part II

2009-09-28T11:21:00.003-05:00

My last post (Part I of this same topic) discussed debit spreads and credit spreads, both members of the vertical spread family. It was shown how, because of synthetic relationships, a debit call spread is essentially the same as a credit put spread and a debit put spread is essentially the same as a credit call spread. The only real difference is the cash transaction--debit or credit--at the time when the spread is initiated. The potential risk and reward, however, is the same once interest and dividend issues are taken into account. This concept can have an important impact on the psychology of managing an ongoing vertical spread trade.

The Psychology of Trading Verticals
Imagine that a trader buys an out-of-the-money debit call spread, say a 50-55 bull call spread with the underlying stock at $49. This trader gains positive delta, positive gamma, negative theta and positive vega. Specifically, in this example:

Out-Of-The-Money Call Debit Spread
Delta = + 0.35
Gamma = + 0.09
Theta = - 0.01
Vega = + 0.04

The positive delta results from the call with the closer-to-the-money strike being purchased. Positive gamma, negative theta and positive vega result from the underlying stock being closer to the long (50) strike than the short (55) strike.

The trader wants the stock to move higher, to or through the short strike, and fast. Why? To avoid the impact of negative theta.

Now imagine that within a short amount of time, the underlying stock does, in fact, move up to, say, $56 a share. What are the trader’s new greeks?

In-The-Money Call Debit Spread
Delta = + 0.35
Gamma = - 0.09
Theta = + 0.01
Vega = - 0.05

Note the delta is still positive; however, the signs of all the other greeks are reversed. That is to say that now there is negative gamma, positive theta and negative vega.

Positive delta still results from the 50s having a higher delta than the 55s. But now the short strike is the dominant influence. With the stock closer to the 55 strike, negative gamma, positive theta and negative vega prevail. At this point, the trader will have made some of the maximum profit that resulted from the long delta, but will still have to wait it out to reap the remainder in the form theta. These greeks would incidentally be about the same as they would be for a 50-55 credit put spread.

The Blurred Line Between Debit Spreads and Credit Spreads
The new goal (presuming the trader doesn’t close the position to take a partial profit) is to wait it out and hope the stock remains above $55 a share until expiration. The trader would, in fact, need to manage this trade as if it were a 50-55 bull (credit) put spread.

This can be a big psychological leap for some traders. It’s not a credit spread; it’s a debit spread. But imagine for a moment, that the trader did not have the debit spread in inventory. If the trader believed the stock (again, now at $56) would stay flat or continue higher, he might consider selling a 50-55 credit put spread. The trader would monitor the trade and wait out time decay and perhaps hope for some gain from the positive delta if the stock continues higher. This is effectively the same position the trader holds with the ITM debit call spread.

Further, think back to the box. It has been shown in Part I of this two-part series that the two spreads are synthetically the same. It becomes a matter of recognizing the flip-flop that can occur from debit call spread to synthetic credit put spread that can help a trader manage the trade accordingly and see more clearly how to view the trade after the stock moves higher.

See more of Dan's blogs at www.tradingoptiongreeks.blogspot.com

Vertical Spreads and the Blurred Line Between Delta and Theta: Part I

2009-09-03T15:26:00.002-05:00

Vertical spreads are one of my favorite subjects to teach. On the surface, they appear to be rather straightforward but, in fact, they are not. The overly simplistic view of vertical spreads held by many traders can lead to poor trade management and ultimately a heap of losers that should have been winners.

Vertical Spreads
Vertical spreads can be divided into two categories: debit spreads and credit spreads. Debit spreads, of course, are called such because when they are established, the trader’s account is debited; that is, the trader pays for the spread upfront in hopes it will gain in value and can be sold at a higher price later. Credit spreads, on the other hand, are called such because they are done for a credit; the trader receives cash upfront, hoping to buy the spread back later at a cheaper price.

While these two spreads seem to be very different animals, and are often traded as such, debit spreads and credit spreads are really not that different. In fact, they are essentially the same thing. To understand this, let’s look at another option spread called a box.

Understanding Boxes
A box is a four-legged strategy involving a call spread and a put spread on the same stock in the same month sharing the same strikes. A long box is established when a trader buys both a debit call spread and a debit put spread (again, sharing the same month and strikes). A short box is established when a trader sells a credit call spread and a credit put spread. Let’s look at an example.

For this example, a trader will buy the 40-41 box. To complete the box, the trader will:

Buy 1 40 call at 1.12
Sell 1 41 call at 0.60
Sell 1 40 put at 0.86
Buy 1 41 put at 1.34

Notice the first two legs of the spread listed here — buy 1 40 call at 1.12, sell 1 41 call at 0.60 — form a debit call spread. The second pair of legs — sell 1 40 put at 0.86, buy 1 41 put at 1.34 — forms a debit put spread. Both debit spreads.

The call debit spread is purchased for a total of 0.52. Let’s look at the maximum gain and loss of this spread at expiration.

Stock above 41: Max profit 0.48
Stock below 40: Max loss 0.52

The put spread was bought for 0.48. Let’s look at the put debit spread if held until expiration.

Stock above 41: Max loss 0.48
Stock below 40: Max profit 0.52

So if a trader bought both of these spreads for a total of $1 (that’s 0.52 for the call spread plus 0.48 for the put spread — incidentally the distance between the two strikes) and the stock settles above 41 at expiration, the gains on the call spread would be offset by losses on the put spread. Below 40, the losses on the call spread would be offset by gains on the put spread. And, in fact, if the stock ended between the two strikes at expiration, any gains on one of the spreads would be directly offset by comparable losses on the other spread.

(Please note, dividends, interest, the bid-ask spread, exercise style, and hard to borrow issues are all factored into the arbitrage of boxes. Because of this, it is common for boxes to trade at a price other than the distance between the two strikes as shown here with this $1 box.)

Looking at the box another way, the trader is buying synthetic stock at the 40 strike (buying the 40 calls, selling the 40 puts) and selling synthetic stock at the 41 strike (selling the 41 calls and buying the 41 puts) for a total debit of $1. The trader would be paying $1 for an asset that is worth, in arbitrage terms, $1.

While most active individual traders don’t trade boxes, an important lesson for vertical spread trading can be gained from this exercise. It has been illustrated, that buying a call spread is an exactly opposite position from buying a put spread — they offset each other (again, once interest and other influences are factored in). Therefore the logic must follow that buying a call spread must be synthetically the same as selling a put spread. And, indeed, it is.

Consider buying the call spread vs. selling the put spread.

Debit call spread at expiration:

Stock above 41: Max profit 0.48
Stock below 40: Max loss 0.52

Credit put spread at expiration:

Stock above 41: Max profit 0.48
Stock below 40: Max loss 0.52

Likewise, between the two strikes will show an identical arbitrage P&(L) at expiration. To be sure, the P&(L) diagrams of the two strategies — debit call spread and credit put spread — would be identical too for this example.

With this in mind, we can now study the psychology of a vertical spread trader, and how the trader must adapt as the spread moves more in- or out-of-the-money. This will be discussed in the upcoming Part 2 of this series.

MTM Facebook Page

2009-06-02T01:48:00.003-05:00

Hi, friends. Long time, no blog! Sorry. Busy, busy, busy. Market Taker Mentoring LLC has a facebook page! you can interact with fellow traders, share trade ideas, and learn more about trading. Visit the page today and meet like minded traders.

Market Taker Option Trading and Trading Education

Knowledge is power! Learn option trading techniques from each other.

Educational Option Trading Webinars

2009-05-06T11:55:00.004-05:00

Generally I like to offer some free educational option trading tips. But this time I wanted to inform my readers that through my company, Market Taker Mentoring LLC, I'll be offering in-depth, interactive, educational option trading webinars.

These educational option trading webinars will cover a variety of topics. The first series, starting soon, will address the option greeks in a very hands-on way. The webinars are for option traders of all experience levels. Even basic-level traders can benefit greatly from the information in these presentations.

For more information, and to learn how to begin your educational option trading webinars, visit MarketTaker.com.

Dan Passarelli

Entering a Trade

2009-04-16T09:37:00.015-05:00

Nickels add up. It's true. If you're an option trader you realize this by now. Each nickel you make (or save) on an option contract is $5 in your pocket. That's $50 on a 10-lot; $500 on a 100-lot. Over the weeks and months and years, nickels are big money. Interested in learning how to save some nickels? Your method of trade entry may make a difference.

Bids and Offers
Typically, off-floor traders buy offers and sell bids. That is the nature of being a retail trader. But, what if you could get a better trade price? With some trades, I like to "middle the market". That means try to buy below the offer (but above the bid) or sell above the bid (but below the offer). That means, if I get filled, I get filled at a better price--sometimes saving the coveted nickels. But it doesn't always work. There's a trick to it. Here is one tip on middling the market on trade entry.

Middling the Market
Market makers like to reduce risk. It's their job. If they are making a trade, they'd prefer to make a less risky trade. In fact, they would be happy to put on a trade at a less favorable price if it has less risk. Spread trades have less risk. In many cases, market makers are willing to trade a spread between the market [i.e., buy (from you) above the bid or sell (to you) below the offer], in the process giving up precious nickels.

For example, imagine a call spread that you want to buy is .70 bid, offered at .85. Instead of taking the .85 offer, a trader may opt to bid .80 (above the bid but below the offer). In some cases, market makers will accept the bid shy of their offer. Sometimes not.

While there's no way to know for sure if your bid will trade, one guideline is that it is closer to the offer price--you have to meet them more than half way. The same would go for you trying to sell. Your offer needs to be closer to the bid than the market maker's offer.

But there is some risk in this technique. The market can change. If you bid .80 (a nickel away from the offer), and the market for the spread rises to being .90 offer, your chances of getting filled just got worse. Now, if you really want the spread, you have to pay up.

There's a knack to entering orders; and there is certainly a bit more to it than what is discussed here. But it's a start! Good luck trading. And if you haven't visited MarketTaker.com in a while, check it out. I've made a few changes.

Dan

Fact or VIXion

2009-03-19T22:00:00.005-05:00

The CBOE Volatility Index®, or “theVIX®”, has been at historically high levels for a while now. The question for today is: How long can it stay this high? To answer, let’s first examine what the VIX is and why it rises or falls.

Basically, the VIX is a measurement of the implied volatility on the S&P 500. More specifically, the VIX measures the implied volatility of hypothetical 30-day options listed on the SPX, which is the index contract that represents the S&P 500®.

Implied volatility, as many of us know, is the volatility component embedded in option prices. When option-market participants buy up options—usually in expectation of future volatility—implied volatility (and therefore the price of the option) rises. Likewise, when market players sell options—usually in expectation of waning volatility—implied volatility (the price of options) falls.

A comparison of the “market volatility” of fluctuations in the S&P 500 index and the embedded “option volatility” or the VIX can be easily done mathematically. These figures are both stated in terms of annualized standard deviation of daily price changes. The actual standard deviation of the S&P index is calculated by past price fluctuations, while the implied volatility represents expected price volatility.

For example, if the annualized standard deviation of the value of the S&P 500 is, say, 43 and the VIX is 43, that means over the next 30 days the volatility of the SPX is expected to remain constant. If the VIX is higher than the calculated standard deviation of the S&P, the market expects volatility to be higher in the future. If the VIX is lower, expectations are for lower actual volatility in the S&P.

For the VIX to remain at this lofty level, the S&P 500 needs to remain volatile. Otherwise, the options will be mispriced creating an arbitrage scenario. The moral to the story: when the market stops moving as much as it has been, the VIX will fall.

Dan Passarelli
Market Taker Mentoring LLC

The Battle of the Brain

2009-03-01T20:18:00.003-06:00

No matter how long you've been a trader, it's easy to slip into bad habits. Among the worst habits for traders new and old is to be undisciplined.

Though there are many different trading philosophies, strategies and methodologies, all traders need to have a plan, and just as importantly, they need to follow it. It's easy to forget the plan when you're in the thick of it. But when you deviate from the plan, emotions can get in the way, clouding judgment and leading to bad decision making. It's the age-old battle of the right brain versus the left brain.

The left brain is the mathematical, logical side. It's the side of your brain that crunches the numbers in your analysis that lead up to a trade. It can methodically lay out the quantifiable steps that make sense to follow. And measure potential profits and losses and deduces ways to curtail losers and make the most out of your winners. The left brain is a trader's friend.

The nemesis of the left brain, however, is the right brain--creative, qualitative and, oh yes, emotional. This side of your brain tries to wreak havoc on your trading every chance it gets. "Hey, maybe we can make a little more on this trade if we just hold it a little longer," it may tell you. Or, "For God's sake! I've got to get out right now. I just know it's going lower, "it may say at other times. Knee-jerk reactions to fear and greed are all a product of the evil right brain sneaking into your trading trying to topple the even-keeled left-brain trading machine.

Don't listen to it! When that right brain starts speaking up, play it some music, take it to a movie, a museum, maybe. But when it comes to quantitative trading decisions of picking your entrances and exits for a trade, leave it up to the professionals. Let that left side of the gray stuff do it's thing. Keep it tight. Logically map out the smartest course, and follow it unwaveringly. Stick to the plan.

Black Gold, Texas Tea

2009-02-12T19:39:00.005-06:00

A friend of mine emailed me today inquiring about oil. "it's at it's lows", he said, "looks like it bottomed out; gotta rally from here". Well, I don't know if he's right or wrong, but (for our purposes) that's not important right now. What IS important (and interesting regardless) is how one capitalizes on such an outlook.

There are a few ways, all different in their own right. First--and for a lot of securities options traders, the one that comes to mid initially--is to buy calls on or shares of an oil-services fund-of-sorts like OIH, the oil-services HOLDR. (BTW, a HOLDR is similar to an ETF with small [for most people, insignificant] differences).

While putting a bullish position on an oil-services HOLDR seems like an obvious play for a bullish-on-oil trader, it may not be a perfect trade to match the bullish oil-play objective. Why? First, buying an oil-services HOLDR--by definition--is a position in the stocks of companies in the oil services industry. Among the highest weighted stocks in OIH are Transocean, LTD (RIG), Schlumberger Limited (SLB), Haliburton (HAL), and Baker Hughes (BHI). While these companies have a strong interest in the price of oil (crude), they are companies with costs and revenues and strategies that can effect profits independent of the price of oil. For a more pure, speculative play on oil, just buy the future.

A crude oil future is about the next best thing to filling your garage with barrels of the black stuff. A long futures contract is technically a contract to buy the "spot" (in this case crude oil) at a specifies point in the future. (Don't let this intimidate you. Simply selling the contract to close it eliminates the obligation to buy. This way, you don't end up with a garage full of barrels of crude!) If a trader is truly bullish on the price of oil, buying a futures contract is the most practical way to do it. Of course, practicality doesn't come without problems.

Securities and commodities are governed differently. Securities (and securities options) are overseen by the SEC--Securities and Exchange Commission. Commodities (and their options) are overseen by the CFTC--Commodity Futures Trading Commission. So, your broker may not be able to offer you both. In order make a commodities trade you either need a broker who can do both, or in addition to your online securities broker open an account with an FCM--Futures Commission Merchant. For those with online securities accounts, first look into your firm's offerings. Do they allow futures? If not, do some research. Talk to your investing friends. See if they can recommend an FCM. You can even do commodity options through them.

Dan
http://www.markettaker.com

What to do? What to do?

2009-01-28T16:20:00.004-06:00

What do we do when it turns around?: A great question that is on the minds of many traders these days. But I've got a better one: When what turns around? Many traders focus (maybe too much) on the obvious. Yes; the "market" (i.e. the S&P 500 index) is down at a relative extreme low. This, arguably, presents an opportunity for long-term investors who believe that one day, the market/economy will turn around and erase its recent problems. But there is another index that is sitting at a relative extreme as well: the VIX.

The VIX is the CBOE's volatility index which (in a round about sort of way) measures the market's expectations for future volatility in the S&P 500. Specifically, the VIX measures the 30-day implied volatility of the SPX (the tradable option index on the S&P 500). The VIX has been over 50 lately, which is a very high level at which to be spending so much time. In years past, a more typical level for this index was in the low 20s.

Implied volatility buffs often refer to "reversion to the mean". This is the situation in which implied volatility makes a move away from its typical range and then reverts back to its "normal" level. Looking at the VIX now, it's hard not the think, "what goes up, must come down". To profit from falling implied volatility, one must sell options.

But it's a little bit tricky, this volatility game is. First, We don't know when implied volatility will decline. To be sure, it could be months. With the wily market we've seen lately, most traders don't want to be short options for an extended period of time.

Second, probably, after it's all over, the VIX will not return to the levels seen earlier in 2007 and 2008. It will likely remain a bit higher for a while as the sting felt by traders remains at the back of their minds.

Bottom line: the VIX will likely fall (one day) but it's not likely to collapse. To take advantage of this decline, traders need to be proactive, but careful. Cautious traders will watch volatility closely and wait until just before it looks like it is starting to wane to sell. And then, traders must monitor positions closely looking to exit if their wrong. Capturing a downward move on implied volatility can be profitable, but the risk of being short (naked or covered) can outweigh the potential gains.

Face it. If trading was easy, everybody'd do it! To succeed, one must look for opportunities, where others don't. Implied volatility is something that common traders often overlook. But this trader says it's worth keeping an eye on.

Dan
Market Taker Mentoring LLC

Living on the Edge

2009-01-07T21:31:00.003-06:00

Edge. "What's edge?" you ask. Basically it's like crack for option traders. It is what you just can't resist! Experienced option traders trade when (an only when) they see edge. They just can't help themselves.

It's like this. None of us has a crystal ball. As much as many of you may like to think you know where a stock is going, you simply don't. Face it. Trading is statistical. So what makes for a good trade? Having the odds are stacked in your favor. Edge. So we look for the fine details of the trade that indicate trader edge. Alas, these are the details that are tough to find!

Any hack trader can look at a chart of a stock, see it's in a trend and jump on the band wagon (and half the time they will be wrong). But the traders who have the real potential to out-shine their peers go a step (or maybe a few steps) further and study option premiums and other market data to swoop in on the good trades and skip out on the traps.

Much of the edge in an option trade can be found by studying its volatility. Option volatility isn't a predictor; it's better. It helps indicate whether an option is cheap or expensive. This is truly useful information.

Want to maximize your trading performance? Learn to recognize (and trade on) edge.

Holiday Shopping

2008-12-21T17:51:00.006-06:00

It's bad enough fighting the crowds at the mall, but try shopping for option trades this time of year! Trading options can be a little trickier during the holiday season because of some unique seasonal anomalies.

First, it can be slower. Professional traders take time off. There are less market players, which means less business transacting. This has two seemingly contradictory implications. On the one hand, the market tends to have fewer big moves because, traders with an ax to grind are using it on the Christmas goose and not on knocking out 10,000 lots in the market. But, because there are fewer liquidity providers, the small moves that occur can be more erratic because there is less size on the bids and offers in both stocks and options.

Second, there is the fabled Santa Clause rally. Traders cite the Santa Clause rally whenever the market runs up this time of year. Do I believe in the Santa Clause rally? Hmmm... If I don't, do I stop getting presents? Maybe it's better to believe than not!

But lastly, and most importantly is the theta risk of having the market closed for two extra days. These are days in which options loose value from time decay, but there is no trading that might lead to potential profits--very bad for longs. We tend to see traders taking the day out early this time of year as options get cheaper faster as traders anticipate the holiday.

Have a safe (and, hopefully, profitable) holiday season.

Dan

The Golden Age of Option Education

2008-12-09T18:48:00.005-06:00

Remember about seven or eight years ago when the bid-ask spread in a typical option contract was so wide you could drive a proverbial truck through it? When I was a market maker on the CBOE trading floor back then, most of my bids and offers were around 20 cents apart. I must say, it was a good time to be a market maker.

But as the late George Harrison once said, all things must pass. Changes in the industry forced markets tighter and tighter. Market makers had to take on more and more risk for less and less reward. It got to the point where the options market was more liquid than the underlying market (this is still the case in some securities options). That is when I left the floor and stopped being a market maker in favor of trading as a market taker. And I wasn't alone. Lots of traders left the floor at that time. I believe it is still a great time, comparatively, to be a "retail" trader.

But tight markets aren't the only benefit of this exodus of professional traders from the trading floor. A handful of ex-market makers--present company included--have moved into option education. Now anyone serious about learning options can reap the benefit of years of experience from the trading floor.

When my peers and I were learning options, formal education administered by professionals was not commonplace. We had to earn our education in the school of hard knocks--on the trading floor--and the price of success was often high. Now potential traders can arm themselves with formal option education from an ex-market maker and learn how to avoid costly and painful trading mistakes.

I encourage my readers to visit my Web site, MarketTaker.com, and consider the benefits of personalized one-on-one option mentoring from a floor trader.

Dan

Remembering Theta Bara-ly

2008-11-20T13:08:00.006-06:00

A theta trade? What's that? There was once a day when 80 percent of the traders I'd talk to at my trading seminars traded nothing but credit spreads, iron condors, time spreads and butterflies: i.e. theta spreads. With the volatility in the market these days, theta spreads have gone the way of long forgotten silent film stars, like Theda Bara. Theda Bara, the infamous sexy vamp of silent film is barely remembered by movie goers today. She never made a film with sound; she had her time and place.

Theta spreads, while sexy in their own time and place, have been usurped by the new stars of this golden era of trading, like volatility plays. Theta spreads involved selling options and were attractive for two reasons: 1) They profit when stocks DON'T move, and 2) They usually produce more winners than losers. The problem, though, occurs when stocks DO move. This is when losers are produced. And when theta spreads lose, they can lose big. In fact, with many theta spreads, often $4 or $5 is risked for the chance to earn $1. Sometimes that ratio is even higher like $10 or $20 risked to make $1.

Traders who were introduced to options in the less volatile periods thought these strategies were manna from heaven. They'd have profitable trades month after month, never seeing a loser. Nirvana! But, when the volatility kicked in everything changed. The first losing month came as a shock to many newbie traders. "How could this happen!?!" It can. And, it does.

To be good at trading options requires versatility. One-trick ponies don't last in the long run. A deeper understanding of options helps traders adapt to ever-changing market conditions. This is the most important thing that I try and instill in my students at Market Taker Mentoring LLC. Understand the product. Don't just try and get good at one trick, even if it's a good one.

Though silent film and theta strategies are both fun nostalgia, their eras are over. Time to move on.

Dan Passarelli
http://markettaker.com

Bull Call Spread to Hedge Volatility

2008-11-17T13:47:00.005-06:00

On the one hand, it seems like a good time to be an option buyer: limited risk, leveraged reward, etc. But on the other hand, they're just so darn expensive! Right now implied volatility is at historic highs. That means, when you're buying a call or a put for a directional bet, you're paying up because of volatility.

One way to combat high implied volatility is to trade a spread. A spread involves buying one option and selling another. Rationale? While you're buying an expensive option, you're also selling an expensive one, too. That means it's possible to net out some of the potentially adverse effects of high implied volatility.

In terms of greeks, with spread trading all the greeks are lower. But vega is usually much more reduced than delta. That means there is still a fair amount of the wanted directional sensitivity without as much implied vol risk.

There are a couple of tricks to this technique. First, it should go without saying, that since this is a directional play, you have to be right on direction to make money. But what's important in setting up the trade is strike selection--especially on the short strike. The short strike should coincide with the price point in the underlying conducive with expectations. That is, sell the strike that is as high (low) as you think the stock will go.

Example:
A trader thinks XYZ stock will go from 50 to 60 over the next month but wants to hedge implied volatility risk. He'd buy 1 30-day, 50-strike call and sell one 30-day, 60-strike call. This is what traders call a bull call spread, or a debit call spread. Here the trader retains a lot of the directional sensitivity (delta) but spreads off most of the implied volatility risk (vega). If he's right and the stock goes to 60 in 30 days, he reaches his maximum profit (in this case $10 minus the cost of the spread). If the stock exceeds $60 a share, though, profits are limited. If, however, the stock falls, the trader can lose up to the amount paid for the spread.

In times like these, where volatility rules the market, traders need to trade smart and use everything they can to gain as much edge as possible. Spreading off volatility risk is one technique that all traders should consider.

Dan
markettaker.com

Taken Aback by Backspreads

2008-11-12T13:13:00.010-06:00

A backspread is an option trading strategy that enables a trader to profit when the underlying security is volatile. Though these strategies are fairly simple to construct, they are complex to trade. Unless a trader has a good feel for this option strategy, it is hard to make money trading backspreads.

A backspread involves selling one option and buying two or more options on the same underlying in the same expiration month, but with different strike prices. For example, in IWM a call backspread could be established by selling 1 December 45 call at 4.25 and buying 2 December 50 calls at 1.85. Here, the trader would collect a net of $0.55 when putting on the trade (a credit of $4.25 from the 45 call and a debit of $3.70 from the two 50 calls).

Most non-professional option traders tend to think about their position in terms of what happens if the option position is held until expiration. This is easily visualized with the help of a profit and loss [P&(L)] diagram like the one shown along with this blog.

Here, if both calls are out-of-the-money at expiration they expire and the trader makes $0.55. If just the 45 calls are in-the-money at expiration, the call acts like short stock and becomes more of a loser as IWM approaches $50. Above $50, with both options in-the-money, the trader ends up net long one call which acts like long stock. The higher the underlying, the higher the profits. In this two-dimensional representation, the backspread looks easy--you don't want IWM around $50 at expiration. You'd prefer it rallies sharply. You're OK with it falling sharply.

Though a picture may say 1,000 words, this picture doesn't say enough to fully explain the backspread. First, unless IWM really rises a lot (it was at $46.14 when I created this example) it's not a great trade. In fact, with IWM at $50 at expiration, the trader loses $4.45 ($50 minus $45 minus $0.55 credit). That's a lot more than the $0.55 that can be made if IWM is below $45 at expiration. The only way this makes sense is if the trader is strongly bullish. And the fact of the matter is a superior position can usually be created just by buying a call.

So, why do traders fancy backspreads so much? When backspreads are traded successfully, it is usually by a gamma-scalping professional trader. This means the trader scalps the underlying by hedging the position delta thereby locking in profits to offset time decay. For most retail traders, that last sentence might as well have been written in Greek. And that is (if you'll excuse the cutesy pun) what the trader needs to focus on with backspreads: greeks. Unless you are fully boned up on option greeks, you're probably better off leaving backspreads to the more experienced traders.

When Buying Puts, Timing Is Everything!

2008-11-06T12:02:00.005-06:00

There is a knack to buying puts. The key is to buy the option before the stock falls. Easier said than done. Surely no one knows with certainty whether a stock will fall or not. (If they did, the wouldn't need to hedge with options!) So how does one know when to buy puts?

There are two factors.

1) Your level of concern. Research and good old fashion gut feel play a key role here.

2) Value. This is the trickier endeavor. Once you decide that you have a stock that is causing enough concern to consider buying puts for protection, you must ask, "Is it worth it?"

Yesterday Research In Motion (RIMM) closed at $52.97. If you wanted to buy a 44-day, 50-strike put you could have lifted the offer of 5.35. That's more than 10 percent of the value of the stock. And RIMM would have to be more than 5 percent lower at expiration for the put to kick in. Unless you are really concerned about a huge drop (more than another 15 percent from the current price) this insurance is hardly worth it.

Protective puts need to be chosen selectively. Pick your spots. Puts tend to be especially expensive in volatile markets. Remember, once the move has happened, it's over. There's nothing you can do about it. Buying overpriced puts after the fact is often a fool's errand.

Dan
Market Taker Mentoring LLC

Selling Puts at the Bottom

2008-10-30T21:05:00.007-05:00

I don't have many favorite option trading strategies, but one of them has to be selling puts at a market bottom. Now don't get me wrong, the term "market bottom" can really only be used with accuracy when talking about what has happened in the past. None-the-less as a trader, that's what we do. We speculate on whether or not we've reached a market bottom. We can't help ourselves: it's our plight. For the purposes of the educational nature of this discussion, let's say we get to a point where we think we've reached a market bottom and we're ready to put our money where our mouth is.

What does a market bottom really mean to us? If you really think this is a bottom, are you willing to buy here? If you, again, are willing to put your money where your mouth is I think the answer is "yes". And, what does it look like going forward? For the year the market is down, what, around 30 percent give or take? What do we think will happen over the next month? Can we make back that 30 percent in 30 days? Maybe; but it's not likely. More likely we'd have a small, but respectable rally of maybe 5 percent.

That brings us to our option strategy. Selling puts has a few benefits when you get ready to call a market bottom. Not that it's without risk; but it can be a smart way to play this trading scenario.

When you sell puts, if the underlying security in question (for our purposes an ETF such as SPY, IWM or QQQQ) falls, you might get assigned on puts, in which case you buy shares of the underlying ETF. This, of course, is totally conducive the trading plan. That is, "if I think it's cheap (i.e. a bottom) I'll buy it". (Again, not saying you can't be wrong, but if you want to get long the market, here's a way).

Now, let's say the market rallies after selling puts. If it rallies a small but respectable amount, you have a winner on your put. The only caveat is that if the market does, in fact, stage a huge comeback, your profits are limited to the credit received for the put. That is (kind of) OK, too. Leaving money on the table might make you swear, kick and scream; but let's face it, no one ever went broke taking a profit.

The real benefit here, though, is two fold. Not only are the (perceived) odds in your favor with an upside bias with the stock market at its lows, but implied volatility is through the roof! Selling puts after the panic is like selling fire insurance after the fire--and people are paying up!

Selling puts is a strategy that the faint hearted tend to use on stable "safe" underlyings to collect premium on a likely-to-win bet. Here, there's theoretically more risk since there is high volatility. But when you're ready to go ahead and take a stance, this can be one of the smarter ways to do it.

Dan Passarelli
Market Taker Mentoring LLC

Delta Concious

2008-10-23T20:05:00.005-05:00

Lots of option traders buy calls hoping to profit from a bullish move in a stock. It is a leveraged trade that can create huge percentage profits when the trader is right and, of course, potentially pretty big percentage losses when wrong. But when option traders get used to seeing these big p&(L) swings from long calls they are sometimes surprised (either pleasantly or unpleasantly) by the size of the gain or loss. That's why I ALWAYS look at the option delta of my trades.

Delta is the rate of change of an option's price relative to a change in the underlying security. Option deltas are stated in percentage terms. So if an option has a "50 delta" (sometimes stated as a ".50 delta") it will move 50 percent as much as the underlying stock.

For example, lets say a trader buys 10 December 50 call options which have a 35 delta. That means if the stock rises by $1 a share, the trader would anticipate gaining $350 as a result of the option's delta. Why? each call would change in value 35 percent of the change in the stock. In this case, the stock gained $1, so each call would gain 35 cents (or $35 of actual cash). Because the trader owns 10 calls, that's a $350 profit. And remember, it works both ways. If the stock would have fallen, it would have cost the trader a $350 loss.

Effectively, an option delta is a measure of trading leverage. If the stock moves by X, what do I make? It is important for a trader to know the option's delta on every trade so he understands his trading exposure.

For more option trading education, download a free excerpt from my book here. This is an excerpt from chapter 6 of Trading Option Greeks, which discusses put-call parity.

Dan

New Philosophy

2008-10-12T18:34:00.005-05:00

It has come to my attention that my previous blogs have been blogger-esque rants about the wrongs of Wall Street and the government affecting traders and the population as a whole, when they should be about option trading, and more importantly, option education. Option education, after all, is the world in which I live (with Market Taker Mentoring and my previous collaborations). So, I decided to talk a bit about my area of expertise, Trading Option Greeks, in terms of options education for option traders.

My thought was that the main problem for traders--aside from the corruption of Wall Street and the government (can you say $150 billion in earmarks???[couldn't resist])--is that most option traders focus on delta. It has been (to most traders I know) nearly impossible to call direction from one day to the next. And, for the record, I'd argue that that is typical in trading. Volatility traders and academics alike will say that it is very difficult (some extremists say impossible) to call direction. So why focus on the difficult game of directional (i.e., delta) bets at all?

In trading it's funny. The more sophisticated a strategy, the easier (arguably) it is to trade because there is more edge in the trade. In times like these, I like to focus on volatility trading. Volatility trading--whether gamma/theta or vega--is a completely different philosophy. I've talked to lots of traders lately who have thrown up their hands and simply given up calling market direction, but just about all of them have had opinions on market volatility. It seems to me this is where traders ought to pay more attention.

Of course, the roadblock for many traders is that option volatility is an esoteric concept. To learn option trading at a deeper level, however, requires an understanding of option volatility and option greeks. To really learn options trading requires a stiff dose of options education. Going forward, this is where I will attempt to concentrate my efforts in my blog. I will also try to add some free options education to my Web site, markettaker.com. Until next time, good luck trading.

Dan

What's $700 Billion Among Friends?

2008-09-25T14:40:00.004-05:00

When I invest I tend to look for solid investments with a track record of solid management, growth and longevity. That is one of the tenets I teach students of Market Taker Mentoring who are interested in investing. And really, I don't think I should even have to teach this concept. It's what you might call common sense.

Well, "friends," you (by proxy) are considering such an investment. That's right. That is the proposal the people in D.C. managing OUR investments are looking to institute on our behalf. Let's just call this investment fund our collective discretionary account.

Now, to be fair, something needs to be done to prevent an all-out collapse of our financial stability. But let's not oversimplify. Let's fully understand the subject at hand (which is more than I can say about the managers of our collective discretionary account).

It appears that our investment managers are looking to buy mortgages under the assumption that they are riskless investments--that they will be paid back. Perhaps not an entirely reasonable assumption, at least not for all these loans. Certainly, some of them will be defaulted on. Typically, what investors do when faced with such a dilemma is to assign a risk factor to the investment. That is, they discount the price they are willing to pay by a certain percentage based on the perceived risk of default. So, unless our discretionary account managers think there is no risk of default, they ought to be recommending we drop our bids. Maybe the government needs to step in (maybe not), but why remove all the risk after the fact to keep afloat companies that made bad (very bad) investments (maybe even knowingly, but that is for the feds to determine)?

And one more bit of conventional wisdom that ought to apply. Usually when an investment manager does a really poor job, he or she gets fired. Some of those at LEH, AIG, et al, are suffering that fate (although "suffering" may not be the right word when getting fired means walking out the door with more money than most poor suckers ever make in their lifetime). But we now have the opportunity (make that civic duty) to watch our collective discretionary account managers very closely to see how they do. Their performance is up for review every few years.

Dan Passarelli
markettaker.com

Lent Over a Barrel

2008-09-17T21:30:00.001-05:00

A few years ago, I had a friend who asked me to be a co-signer on a car loan. Fast forward 6 months and I then became the proud owner of a Ford Focus worn and aged beyond its time. A few years later, the same friend asked to borrow money from me--"it's just a short-term loan!" Unfortunately (for him anyway) I had to say no. He's a nice guy (and still my friend) but he proved that he couldn't manage his checkbook. I figured (based on experience) I wasn't likely to see that cash again no matter how good his intentions were.

Haven't our friends at AIG suggested to us that they have a rough time balancing their checkbook? $85 billion? The Fed is willing to loan that amount to these guys. Isn't that how all this trouble started? Lenders were encouraged (read: mandated) by the government to give home loans to people who were likely to have a hard time paying the loans back. Sadly, the Fed hasn't learned from these mistakes, as we see with the AIG bailout. It's only a short-term loan! But what happens when the loan isn't paid back? In that event, the government (really I mean you and me, but it's less frightening to say "the government") would be out a mere $85 billion. Fortunately, we have that kind of cash to throw around.

But in this case, it's actually much worse. It's not just a loan; it's an investment. An $85 billion investment in a money pit of a business. In actuality "the government" (we) can lose more--much more--than $85 billion. And that's not even counting the systemic fallout of such a debacle.

But, really, if there is a lesson to be learned here, it's in where to point the finger. It's not really the government or mortgages or bridge loans or anything the talking heads are telling us. It's people. People at these companies making bad, irresponsible decisions and then leaving us holding the bag. Remember: Mortgages don't kill corporations, people do ... with the help of the government.

Financial Fiasco? Thank you very much.

2008-09-13T09:27:00.003-05:00

Maybe it's the end of the world, but I feel fine. On a popular business news channel (that would be CNBC) one of the personalities talked about how it would be a horrible weekend for traders, what with the Lehman (LEH) debacle and all. And, to be sure, I've heard other traders express the same gloom. To me the logical question is: why? The job of a trader is not to commentate or cheer for the good guys (or bad guys as it were). The job of a trader is to observe and subsequently act. We take notice of what is happening and figure out how to make money on what we see. If you think LEH is on its way to Hades in a handbasket I have one word for you: puts! If you think the government (ours or otherwise) will come to the rescue, you should welcome the opportunity to scoop up this giant for cheap.

The market offers trading opportunities daily. In fact, the existence of the options market specifically offers opportunity in perpetuity. Whatever the market or any individual stock is doing, there is a way to trade it. Bullish, bearish, high volatility stocks, sleepers, and even Lehman can all be traded with a little creativity.

So if this 158-year-old fixture in our financial landscape falls out of bed Monday morning I won't shed a tear. I won't have time. I'll be too busy trading it.

DanPassarelli
Market Taker Mentoring
markettaker.com

New on the blog scene...

2008-09-08T11:39:00.003-05:00

Welcome to the Trading Option Greeks blog! I will time to time add thoughts, tips, and musings about option trading. I'll discuss topics from my book, Trading Option Greeks, as well as more timely market thoughts. Of course, I welcome comments from my readers. So, enjoy and be part of this community.