Advanced Option Strategies » Options Trading Strategies http://advancedoptionstrategies.net Moving beyond the simple things... Fri, 13 Aug 2010 20:14:58 +0000 http://wordpress.org/?v=2.8.4 en hourly 1 Online Options Trading – Portfolio Measures and Trade Performance Metrics http://advancedoptionstrategies.net/online-options-trading-a%c2%80%c2%93-portfolio-measures-and-trade-performance-metrics http://advancedoptionstrategies.net/online-options-trading-a%c2%80%c2%93-portfolio-measures-and-trade-performance-metrics#comments Tue, 12 Jan 2010 19:34:12 +0000 admin http://advancedoptionstrategies.net/online-options-trading-a%c2%80%c2%93-portfolio-measures-and-trade-performance-metrics The Reward of Profit and the Risk of Losses for retail option trading needs to be managed at 2 related levels of performance: Portfolio and Trade Specific.At the Portfolio level for online options trading, there are 3 types of Targets that must be set, even before you trade.Maximum Return Target: complete achievement of the “ideal” measure. Dream of the “ideal” that stretches you beyond what is practical. For example, earn 2-3 times your monthly living expenses with the monthly trading profit. This is to stretch your imagination well beyond mediocrity. Even if you fail, you just might end up with more than your original target.Minimum Return Target: the lowest acceptable measure, achievable under most conditions, excluding a catastrophic market event. Use the historical annualized return of the S&P 500 between 10%-12% (prior to the 2008 financial pandemic), as the lowest acceptable boundary.  The S&P 500 being a widely accepted benchmark for trading equities is adequate to base the minimum target off, though your portfolio needs to be profitable – being ahead of the $SPX in negative territory does not count.  Below the historical annualized return range of 10%–12%, is the 3 Month T-Bill, presently near zero.  While the T-bill theoretically represents an “absolutely” zero risk investment, even the safest investments will still carry a residual amount of risk no matter how small that risk is.  The point is this.  You got into options and all that Greek terminology, not to make salads; but to beat the performance of equities as an asset class.  If your portfolio’s return is between what is near zero-risk and 10%–12% per annum, you are just delaying reaching a point of pain that marks failure in grasping the base-line ability to control risks.  If the returns of your portfolio are between 0%–12% and you plan to continue trading options, processes within your trading process will need to be re–engineered.”Halt Trade” Target: cumulative losses reach an absolute amount below the Minimum Return, making it necessary to stop trading altogether for a stated period.  10% of [(60% x Cash Balance at the start of the year); or Net Liquidating Value].  Example, for a $50,000 trading account, 10% x (60% x $50,000) = $3,000 of losses in total, is the absolute amount to halt trading.  Why 10%? Blowing up your self-funded capital is final.  There is no bail out package, as a home options trading business does not have access to bank loans; or, shareholders’ equity to finance your personal trades.Now, drilling down to Trade Specific performance measures.Even before you calculate the metrics, characteristically, what makes for a consistently managed portfolio are these traits:

Where can I see this step up function in a consistently profitable portfolio, with these portfolio measures and trade performance metrics? Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that shows these traits.Moving onto the hard metrics.  There’s 2 ways to count the Return on your trading capital.

In both cases, you can minus the Total Cost of Commissions from Total Profit, to get a Total Net Profit number.  The, divide the Total Net Profit by the Start of Year Cash Balance; or, Net Liquidating Value.  Net Liquidating Value is how much your entire trading account is worth, which is equal to Total Cash + Options Value + Stocks Value + Commodities Value + Bonds Value. The Start of Year Cash Balance is straightforward – it is the money in the account at the beginning of that trading year. Cash increases when you are short securities; but, cash decreases, as you get long on securities.To review your performance, calculate these metrics using the Profit (wins) and Loss (losers) from your account:

The Average Win divided by the Average Loss measures how RESPONSIVE you are in taking profits and cutting losses.Combine the Accuracy ratio with the Responsiveness ratio to get your Performance Ratio.Performance Ratio = (Win/Loss Probability) x (Average Win / Average Loss).  Always aim to maintain the Performance Ratio above 1.00. Why?  The commonly known money management rule is to allocate 2%-5% of (60% x Net Liquidating Value of the account) per trade.  What is not commonly practiced is the discipline of moderating a +/- 1% in trade allocation between the 2%-5% allocation.

This is how to achieve a ladder effect in stepping up profits and stepping down losses. This mechanism of stepping up/down is an indispensable tool for rewarding profit and to discipline the risk of losses.  It forces you to improve both ACCURACY and RESPONSIVENESS before raising your position size.

Where can I learn more about portfolio measures and trade performance metrics as part of a total trading system? Follow the link below, for 55 hours of video-based learning of online options trading from home.

]]> http://advancedoptionstrategies.net/online-options-trading-a%c2%80%c2%93-portfolio-measures-and-trade-performance-metrics/feed 0 Stock Option Trading – Fundamental Flaw in Fundamental Analysis and Stock Picking http://advancedoptionstrategies.net/stock-option-trading-a%c2%80%c2%93-fundamental-flaw-in-fundamental-analysis-and-stock-picking http://advancedoptionstrategies.net/stock-option-trading-a%c2%80%c2%93-fundamental-flaw-in-fundamental-analysis-and-stock-picking#comments Tue, 12 Jan 2010 07:28:51 +0000 admin http://advancedoptionstrategies.net/stock-option-trading-a%c2%80%c2%93-fundamental-flaw-in-fundamental-analysis-and-stock-picking Clinging on to Fundamental Analysis and stock picking software, only keeps you stuck in trading equities. Trading this way, compounds concentration risk in one asset class and fails to adequately diversify risks across Equities, Bonds, Currencies and Commodities.  There’s much more to stock option trading, than stock itself.I cite Benjamin F. King’s study, quoted repeatedly since 1966, because it remains valid and has yet to be disproved to the point of dismissing its logic.Market and Industry Factors, Journal of Business, January 1966:  “ Of a stock’s move …

There must be a more compelling reason for you to trade stock other than just for the movement, if only 20% is unique to the underlying equity in question.  Consider this, in context of the Fundamental Analysis or stock picking software that you bought on a per $1 basis.  For each $1 dollar you spend, you “outsourced” the analysis at a cost of 80 cents, only to receive back 20 cents worth of work. Shouldn’t the 80:20 rule of “outsourcing” be the other way round? The problem is that you are still stuck with 80% of the work, to analyze price movement!  Plus, the more you use FA techniques/stock picking software, the more trading capital is stuck in equities alone.Now, you can say “special” research papers help you pick stocks.  Let’s have a look at some of the more common fundamental metrics in these research subscriptions:1. Dividend Yield: the problem is in the variability of yields as firms are in different stages of their business development.  A Mature company that dominates in a well established sub-segment/sector is able to afford a different dividend yield; versus, a Young company in a growth-oriented field; versus, a Small firm in a growing area that may not be able to afford a dividend payout.  Bear in mind there is nothing special about firms that pay a dividend.A company that gives away a portion of it’s retained earnings – which is what a dividend is – effectively gives away part of its valuation, which means it is not worth as much as a company that does need to give investors candy to commit capital to it.  So, a dividend paying stock has to be far superior to a non-dividend paying stock for reasons other than the dividend.  If it is not, there’s no point looking for dividend paying products to trade, there are plenty of non-dividend paying Indexes to trade.2. Price/Book Ratio: the problem is this metric varies across industries and from company to company, as the asset base and capital structures of companies change over time. It lacks cross sector applicability and accounting complexity arises from a firm’s capital structure as it changes due to acquisitions/divestments/CAPEX for new product lines; or, product line cut-backs, as recently seen in the restructuring of major US car companies.3.  Price/Cash Flow Ratio (the cousin of the P/E): accounting laws on depreciation vary across Asia, Europe and US.  As accounting rules are driven by tax codes, which change considerably across regions despite adoption of global accounting standards, there is a lack of uniformity in homogenizing a fundamental ratio that will fit as a common benchmark across geographies. These metrics fail to help you compare say a Dell parented in the US to an Acer parented in Taiwan; but, is listed as an ADR in the US, even though both are competitors in the same sector as computer manufacturers. Furthermore, the current dislocated cost of capital in credit markets, impairs the ability of corporations to optimize the operating cost of their balance sheets.  In essence, corporations are left with the working capital cash flows remaining on their balance sheets, as testament to their financial strength. Do not waste your money on Fundamental Analysis software or research paper subscriptions.As there is a fundamental flaw in fundamental analysis and stock picking, how do you select trades? Trade the options of a broad-based Equity Index to replace single stock exposure.  To replace Fundamental Analysis, use the Relative Strength measure based on Point & Figure methods.What is Relative Strength?  It is nothing more than taking one price as the Numerator, divided by another price as the Denominator, then multiplied by 100.  RS = (Price 1 / Price 2) x 100.  Typically, RS calculations use daily closing prices.  Though simple in its mathematical construction, RS is ingeniously powerful when it is applied not only within a sector; but, across sectors and between asset classes.Let’s start of within a sector.  For example, if you choose 2 semiconductor stocks trading at different prices, how do you know if one stock is outperforming the other in the same sector, when the 2 stocks have price changes at different rates; plus, the sector’s price itself is also changing?SOX = Semiconductor Sector Index, trades up from 452.24 to 467.81.Numerator1:      Price1 = BRCM 33.15    RS1 = 7.33    Price2 = 33.80    RS2 = 7.23Numerator2:      Price1  = TSM 9.91    RS1 = 2.19    Price2 = 13.43    RS2 = 2.87Common Denominator:      SOX  Price 1 = 452.24           Price 2 = 467.81BRCM’s RS1 = (33.15/452.24) x 100 = 7.33. BRCM’s RS2 = (33.80/467.81) x 100 = 7.23.  TSM’s RS1 = (9.91/452.24) x 100 = 2.19.  TSM’s RS2 = (13.43/467.81) x 100 = 2.87.BRCM’s price rises from 33.15 to 33.80 and TSM’s price also rises from 9.91 to 13.43.  Simply because BRCM is a larger stock, does that mean it benefits from the SOX trading up? No, the RS reading (RS1 compared to RS2) shows BRCM’s RS reading dropped (7.33 down to 7.23) against TSM’s RS reading, which increased (2.19 to 2.87).  RS confirms TSM as the outperformer rising in price strength versus BRCM’s weakened price.  RS is constructed on pure price rules.  Using an Index as the denominator, acts as a much more durable benchmark and is structurally more reliable, compared to any “magical” TA indicator; or, combination of income statements, balance sheets and cash flow statements touted in stock picking programmes.You can replace BRCM or TSM with Indexes or ETFs.  Using Indexes with Relative Strength enables a common denominator to compare Equities against Bonds, Commodities and Currencies, to crossover into asset classes other than stocks to trade.  It’s not that Relative Strength is infallible.  But compared to the fundamental metrics cited above, Relative Strength fails the least.  Break the mould on what you learnt about stock option trading.Is there an example of an optionable and consistently profitable portfolio that trades using Relative Strength across multiple asset classes? Yes.  Follow the link below, entitled “Consistent Results” to see a retail online option trading portfolio that excludes the use of single stocks and Fundamental Analysis, using broad based equity Indices, Commodity ETFs and Currency ETFs.  There is no need to trade FX directly. Just trade the options of Currency ETFs.

]]> http://advancedoptionstrategies.net/stock-option-trading-a%c2%80%c2%93-fundamental-flaw-in-fundamental-analysis-and-stock-picking/feed 0 The Stock Replacement Covered Call Strategy http://advancedoptionstrategies.net/the-stock-replacement-covered-call-strategy http://advancedoptionstrategies.net/the-stock-replacement-covered-call-strategy#comments Sun, 27 Dec 2009 07:42:00 +0000 admin http://advancedoptionstrategies.net/the-stock-replacement-covered-call-strategy Back in 2003, (October and November ‘03), the giant biotech Amgen (AMGN) came under some intense pressure, trading down about $12.00 before it found what appeared to be a decent level of support, and began to consolidate. At this level, anyone interested in going long Amgen at a discounted price would be advised to do so. Implied volatility was high coming off this precipitous drop, which caused premiums in the options to increase considerably.
This scenario can be a very attractive for covered call sellers or buy-writers. On Tuesday, December 2, 2003, Amgen was trading at $58.90, the December 60 call was trading at $1.30, and there were only two weeks left until expiration.
Let’s assume that you wanted to take advantage of this opportunity but you would be unable to participate in it due to capital requirements. The stock was trading at $58.90 and you did not have sufficient funds to support buying the stock at that price. After all, the purchase of just 1000 shares would cost $58,900.00.
This is the time to consider using a strategy called stock replacement. In many instances, an insufficient amount of funds in the investors account can mean the loss of a golden opportunity when dealing with high dollar priced stocks.
So, an alternative to purchasing the stock outright is to find a way to replace the actual stock with something else which is not as expensive. In this case, a deep in-the-money call would do just that.
When a call is deep in-the-money, meaning that the strike price of the call is much lower than the stock price, the delta of the call approaches 100. This means that there is close to a 100% chance that this option will finish in-the-money.
Because of this, the option will trade just like the stock; penny for penny, dollar for dollar (in a theoretical 100 delta scenario.) If you recall, the term delta was mentioned when describing the option in question. Delta is the first derivative of the stock and it has a three pronged definition. The first is percentage change.
The delta is given as a percentage change, meaning how much in percentage terms the option price will change with a movement in the stock. A 50 delta option will move 50% the amount the stock does. If the stock moves $1.00, than the option moves $.50. A 30 delta option moves $.30 on a $1.00 movement in the stock, and so on.
Delta can also be defined as percent chance. This is used to describe the percentage chance that the option will end up in-the-money. A 90 delta option has a 90% chance of finishing in-the-money.
Finally, delta can also be defined as hedge ratio which is the amount of deltas needed to properly hedge a position. These concepts will be discussed in more detail in future Options University courses, but for now it is sufficient to just understand these basic concepts.
It was important to explain the meaning of delta to understand that the deep in-the-money call would perform and act just like the stock. One way to determine if the call you will select is in-the-money enough for your purpose is the delta. A delta in the mid or high 90’s is an ideal candidate.
The selection of the proper in-the-money call to use is a critical element in the success of this strategy. In order to obtain an accurate delta of all options under consideration for stock replacement use, you can go to any number of web sites or consult your broker. If all else fails, there is a little trick of the trade that can be used to aid in selecting a call that is deep enough in-the-money to suit the stock replacement criteria.
To do this, check the quote of the corresponding put (i.e. the December 47.5 put if you are looking at the December 47.5 call for stock replacement). If there is no bid quoted for the put, then the call is deep enough in the money to consider it for a stock surrogate. There are several reasons for this being an effective strategy, which we wont cover here, but for the purposes of this discussion, it is enough to know that this method does work.
So, with the stock at $58.90, the December 47.5 calls met the criteria for stock replacement. This call had a mid to high 90’s delta and its corresponding put had no bid. The December 47.5 call was trading at $11.45 or $.05 over parity. By purchasing this option, you would be equivalently buying the stock at $58.95 (the strike price plus the option price).
Let’s say that you bought the December 47.5 call for $11.45. If a total of 10 calls were purchased (an equivalent of 1000 shares), you would lay out a total of $11,450 to fulfill your stock requirement on this buy-write. If you had purchased the stock outright, you would have spent $58,900. The difference between the capital needed to purchase the stock outright ($58,900) and the capital needed to buy the in-the-money call ($11,450) is the key to this trade.
Now that you have your stock (via the calls you bought above), it is time to sell covered calls against this position, which would be the December 60 calls for $1.30. If the stock stays at its present level, you would then capture the $1.30 premium that you sold the December 60 calls for because they finished out-of-the-money at expiration.
The $1,300 profit in this scenario represents an 11.35% return in only two weeks. This well out-performs the return garnished on a $58,900 investment which would only be a 2.21% return in the two weeks, if you purchased the actual stock.
As we know, the maximum profit of $2.35 will be attained if the stock reaches $60.00 or above. This return comes from the $1.30 you received in the premium for the sale of the now worthless December 60 call plus a $1.05 profit from the December 47.5 call you purchased. With the stock now at $60.00, the December 47.5 call is worth parity, which is $12.50.
You purchased the call for $11.45 thus you received a $1.05 capital gain in the option. This profit of $2350.00 represents a 20.5% return in two weeks verses a 3.98% return in two weeks, if you had purchased the actual stock.
As you can see, you are getting the same overall dollar return on much less money – which creates a much higher percentage rate of return. This is one of the positive leverage effects that the proper usage of options can provide. When you initiate this trade, you are buying and selling two different options simultaneously which is known as a spread. A spread is a trade which involves the buying of one option against the sale of a different option simultaneously and will be covered briefly in the next section.
By buying the December 47.5 calls for $11.45 and then selling the December 60 calls at $1.30, you are buying the December 47.5 December 60 call spread for $10.15. This type of spread is known as a vertical spread.

]]> http://advancedoptionstrategies.net/the-stock-replacement-covered-call-strategy/feed 0 Options Trading Mastery: Time Decay and Volatility Trading Opportunities http://advancedoptionstrategies.net/options-trading-mastery-time-decay-and-volatility-trading-opportunities http://advancedoptionstrategies.net/options-trading-mastery-time-decay-and-volatility-trading-opportunities#comments Tue, 22 Dec 2009 19:35:57 +0000 admin http://advancedoptionstrategies.net/options-trading-mastery-time-decay-and-volatility-trading-opportunities When vertical spreads are mentioned, they quite often come with monikers such as ‘bull’ and ‘bear’. This lends most to think of vertical spreads as directional plays which is true. However, vertical spreads can be used to take advantage of two other potential trading opportunities – time decay and volatility movement.
If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. Knowing a little about them now, you will recall that a vertical spread has a limited profit potential but also a limited loss scenario for both the buyer and the seller. So, how do we use this covered trade to take advantage of time decay.
At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays away over time, you could set up a vertical spread by selling an at-the-money option and buying either the out-of-the-money option (creating a credit spread) or buying an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay away at a faster rate than either the in-the-money option or the out-of-the-money option due to the fact that the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.
Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea, but now there are a couple choices. Should you do the put spread or the call spread? Should you buy it or sell it? The decision of what to do from here should first be based on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you can’t expect the stock not to move at all. So even though you are playing time decay, you still want to form an opinion about in which direction the stock is most likely to move. By doing this, you’ve now give yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.
Now that you have picked which at-the-money strike you are going to sell and you’ve picked your anticipated stock position you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember both the vertical call spread and a vertical put spread allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up. For the bears, you can buy a vertical put spread or sell a vertical call spread. For each direction there are two choices to decide from. One is a purchase, one is a sale. The best way to decide which to do, other than your own style or comfort ability is a simple risk/reward analysis.
By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.
Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility. Volatility is a huge component of an option’s extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.
As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less. Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the spread.
So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.
As to how to set it up, you would follow the same guidelines as you would for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.
Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the spread will have to be constructed with the short option being the at-the-money.
As you can see, the vertical spread does not have to be used only in directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to both the buyer and the seller.

]]> http://advancedoptionstrategies.net/options-trading-mastery-time-decay-and-volatility-trading-opportunities/feed 0 Options Trading Mastery: Rolling the Position http://advancedoptionstrategies.net/options-trading-mastery-rolling-the-position http://advancedoptionstrategies.net/options-trading-mastery-rolling-the-position#comments Tue, 22 Dec 2009 07:43:58 +0000 admin http://advancedoptionstrategies.net/options-trading-mastery-rolling-the-position The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In order to close out the spread, an investor would just let it expire. Both options finish out of the money so there is no residual position left over.
If the spread finishes fully in-the-money (at maximum value), meaning both options in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
Investors encounter a difficult scenario when a stock closes in between the two strikes of the spread. This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. When both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. This is not the case here. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
Two actions are possible in this scenario. One involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. This risk is short-lived because you are doing this late on expiration day of the expiring month. If this happens, you will be naked in the residual stock position.
If there is still time, you can always trade out of the option, but that is very risky. If the stock is at a relatively safe distance from the out-of-the-money option, you may want to just close out the in-the-money option and let it expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this takes place at the very end of the day on expiration day. These options only have minutes of life left. The risk is somewhat mitigated, but still there nonetheless.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, it is best to trade out of the spread entirely.
As stated before, if the stock closes either with the spread fully in-the-money or out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position.
We discussed how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
If you have 10 July 50 calls and you exercise them, you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

]]> http://advancedoptionstrategies.net/options-trading-mastery-rolling-the-position/feed 0 Options Trading Mastery: Getting Out or Rolling the Position http://advancedoptionstrategies.net/options-trading-mastery-getting-out-or-rolling-the-position http://advancedoptionstrategies.net/options-trading-mastery-getting-out-or-rolling-the-position#comments Sat, 19 Dec 2009 19:17:44 +0000 admin http://advancedoptionstrategies.net/options-trading-mastery-getting-out-or-rolling-the-position The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence as was used in the selection and management processes.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes that must be addressed. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In this scenario, in order to close out the spread, one would just let it expire. Both options finish out of the money so no residual position will be left over.
If the spread finishes fully in the money, (at maximum value) that is with both options in-the-money, then both options will be exercised. You will exercise your long call and your short call will be assigned. They will cancel each other out and you will be left with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
The difficult scenario is when the stock closes in between the two strikes of the spread. This scenario, the closing of the stock between the two strikes creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money.
When both options expire in-the-money, they are both exercised-one creating a long stock option, the other creating a short position thus canceling each other out. This is not the case here. Here, one option, the one that is in-the-money will leave a residual stock position and since the other option is out-of-the-money, it will not be able to be used to offset the residual stock position created by the expiring in-the-money option.
There are two actions that could be taken. Choice number one involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. Giving up a portion of the profits may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk (albeit short-lived because you are doing this late on expiration day of the expiring month) that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. If that happens, you will now be naked the residual stock position. Of course, if there is still time, you could always trade out of the option then but that is very risky. However, if the stock is at a relatively safe distance from the out-of-the-money you may want to just close out the in-the-money option and let the out-of-the money option expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this is being done at the very end of the day on expiration day. These options only have minutes of life left. So, knowing this, the risk is somewhat mitigated, but still there none the less.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, you would be best advised to trade out of the spread entirely.
Again, as stated before, if the stock closes either with the spread fully in-the-money, or fully out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position. We discussed above how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
Then, if you have 10 July 50 calls and you exercise them you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

]]> http://advancedoptionstrategies.net/options-trading-mastery-getting-out-or-rolling-the-position/feed 0 Options Trading Strategies – Book Review – Sheldon Natenberg, Option Volatility and Pricing http://advancedoptionstrategies.net/options-trading-strategies-book-review-sheldon-natenberg-option-volatility-and-pricing http://advancedoptionstrategies.net/options-trading-strategies-book-review-sheldon-natenberg-option-volatility-and-pricing#comments Sat, 12 Dec 2009 19:31:55 +0000 admin http://advancedoptionstrategies.net/options-trading-strategies-book-review-sheldon-natenberg-option-volatility-and-pricing As with most books on the topic of how to trade options, the amount of material to get through can be daunting. For example, with Sheldon Natenberg’s Option Volatility & Pricing, it is about 418 pages to digest.  There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 418 pages in total, excluding appendices.1  The Language of Options.  12, 2.87%.2  Elementary Strategies.  22, 5.26%.3  Introduction to Theoretical Pricing Models.  16, 3.83%.4  Volatility.  30, 7.18%.5  Using an Option’s Theoretical Value.  14, 3.35%.6  Option Values and Changing Market Conditions.  32, 7.66%.7  Introduction to Spreading.  10, 2.39%.8  Volatility Spreads.  36, 8.61%.9  Risk Considerations.  26, 6.22%.10  Bull and Bear Spreads.  14, 3.35%.11  Option Arbitrage.  28, 6.70%.12  Early Exercise of American Options.  16, 3.83%.13  Hedging with Options.  16, 3.83%.14  Volatility Revisited.  28, 6.70%.15  Stock Index Futures and Options.  30, 7.18%.16  Intermarket Spreading.  22, 5.26%.17  Position Analysis.  32, 7.66%.18  Models and the Real World.  34, 8.13%.Focus on chapters 4, 6, 8, 9, 11, 14, 15, 17 and 18, which makes up about 66% of the book.  These chapters are relevant for practical trading purposes. Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective.4  Volatility. Volatility as a measure of speed in context of price in/stability for a given product in a particular market.  Despite its shortcomings, the definition of volatility still defaults to these assumptions of the Black-Scholes Model: 1. Price changes of  a product remain random and cannot be engineered, making it impossible to predict price direction prior to its movement. 2. Percent changes in the product’s price are normally distributed.  3. As the product’s price percent changes are counted as continuously compounded, the product’s price on expiry will become lognormally distributed.  4. The lognormal distribution’s mean (mean reversion) is to be found in the product’s forward price.6  Option Values and Changing Market Conditions. Use of Delta in its 3 equivalent forms: Rate of Change, Hedge Ratio & Theoretical Equivalent of the  Position.  Treatment of Gamma as an option’s curvature to explain the opposite relationship of OTM/ITM strikes to the ATM strike having the highest Gamma. Dealing with the Theta-Gamma inverse relationship, as well as Theta being intertwined synthetically as long decay and short premium with Implied Volatility, as measured by Vega.8  Volatility Spreads. Emphasis is on the sensitivities of a Ratio Back Spread, Ratio Vertical Spread, Straddle/Strangle, Butterfly, Calendar, and Diagonal to Interest Rates, Dividends and the 4 Greeks with specific attention on the effects of Gamma and Vega.9  Risk Considerations. A sobering reminder to select spreads with the lowest aggregate risk spread versus the highest probability of profit.  Aggregate Risk as measured in terms of Delta (Directional Risk), Gamma (Curvature Risk), Theta (Decay/Premium Risk) and Vega (Volatility Risk).11  Option Arbitrage. Synthetic positions are explained in terms of manufacturing an equivalent risk profile of the original spread, using a mix of single options, other spreads and the underlying product. Clear caution that transforming trades into Conversions, Reversals and Adjustments are not risk-free; but, may raise the trade’s nearer-term risks even though the longer-term net risk is lowered.  There are material differences in the cash flows of being long options versus short options, arising from the Skew bias unique to a product and the interest rate built into Calls making them disparate against Puts.14  Volatility Revisited. Different expiry cycles between near-term versus longer-term options creates a longer-term volatility average, a mean volatility.   When volatility rises above its mean, there is relative certainty that it will revert to its mean. Likewise, mean reversion is highly likely as volatility drops below its mean. Gyration around the mean is an identifiable characteristic. Discernible volatility traits make it essential to forecast volatility in 30 day periods: 30-60-90-120 days, give the typical term to be short credit spreads between 30-45 and long debit spreads between 90-120 days.  Reconciling Implied Volatility as a measure of consensus volatility of all buyer/sellers for a given product, with inconsistencies in Historical Volatility and predictive constraints of Future Volatility.15  Stock Index Futures and Options. Effective use of Indexing to remove single stock risk.  Distinct treatment of the risks for stock-settled Indexes (including impact of dividend/exercise) separate from cash-settled Indices (absent of dividend/exercise).  Explains logic for Theoretically Pricing the options on Stock Index Futures, in addition to pricing the Futures contract itself, to determine which is economically viable to trade – the Futures contract itself or the options on the Futures.17  Position Analysis. A more robust method than just eye balling the Delta, Gamma, Vega and Theta of a position is to use the relevant Theoretical Pricing model (Bjerksund-Stensland, Black-Scholes, Binomial) to scenario test for changes in dates (daily/weekly) before expiration, % changes in Implied Volatility and price changes within and near +/- 1 Standard Deviation. These factors feeding the scenario tests, once graphed, reveal the relative ratios of Delta/Gamma/Vega/Theta risks in terms of their proportionality impacting the Theoretical Price of specific strikes making up the construction of a spread.18  Models and the Real World. Addresses the weaknesses of these core assumptions used in a traditional pricing model: 1. Markets are not frictionless: buying/selling an underlying contract has restrictions in terms of tax implications, limitation on funding and transaction costs. 2. Interest rates are variable, not constant over the option’s life. 3. Volatilty is variable, not constant over the options’ life. 4. Trading is not continous 24/7 – there are exchange holidays resulting in gaps in price changes.  5. Volatility is linked to Theoretical Price of the underlying contract, not independent of it. 6. Percentage of price changes in an underlying contract does not result in a lognormal distribution  of underlying prices at distribution due to Skew & Kurtosis.To conclude, reading these chapters is not academic. Understanding techniques discussed in the chapters must enable you to answer the following key questions.  In the total inventory of your trading account, if you are …

]]> http://advancedoptionstrategies.net/options-trading-strategies-book-review-sheldon-natenberg-option-volatility-and-pricing/feed 0 Lessons in Options Trading Strategies – The Lean http://advancedoptionstrategies.net/lessons-in-options-trading-strategies-the-lean http://advancedoptionstrategies.net/lessons-in-options-trading-strategies-the-lean#comments Tue, 08 Dec 2009 09:06:07 +0000 admin http://advancedoptionstrategies.net/lessons-in-options-trading-strategies-the-lean Professional traders use the term lean to refer to one’s perception about the directional strength of the stock. When you own a stock and intend to hold it for a period of time, you are aware that you will probably be holding it while it goes up and while it goes down.
This means that at any given moment in time, you might have a different opinion of the potential movement of that stock. Knowing this, there is a way to address your present level of confidence or ‘lean.’ You do this by your choice of which option you sell.
While it is true that the at-the-money option has the most amount of extrinsic value, it might not always be the ideal option to sell in every situation.
For instance, if you feel that the stock itself has a very high chance of producing capital appreciation above the potential amount of premium you could receive from selling an at-the-money call, then sell an out-of-the-money-call so you can allow yourself a little more room to the upside on the stock.
For example, let’s say the stock is trading at $27.00. Normally, you would sell the 27.5 calls at say $1.00. If the stock were to rise quickly and eclipse the $28.50 mark, then with the buy-write strategy, your position would have maxed out at $28.50, and you would have a $1.50 one month gain. Not bad, but if the stock went to $29.50 then you would have missed out on
another $1.00 profit. However, if we had sold the 30 calls for $.30 then we would have another outcome. You bought the stock at $27.00 and sold the 30 calls for $.30 and the stock goes to $29.50.
You would have made $2.50 in capital appreciation and $.30 in option premium for a total of a $2.80 return.
So, if you feel the stock has a real good shot at taking a run up, you can lean your position long by selling an out-of-the-money call.
If you have a more neutral view on your stock you would sell an at-the-money-call in order to receive a bigger premium which allows for greater downside protection if the stock trades down and higher potential profit if the stock becomes stagnant.
This strategy also works on the downside. If, by chance, you feel that the stock may trade down a bit during the life of the option, then you can sell an in-the-money-call. The effect of this would be to provide you with a little extra premium to cover more downside risk.
Remember when you sell an option you seek to capture extrinsic value. An in-the-money option not only has extrinsic value but also some intrinsic value.
When you feel that you want to lean your covered call strategy (buy-write) a little short, choose to sell an in-the-money call so you can also have some intrinsic value to cover your downside.
As an example, say your stock is trading at $29.00 and you feel that your stock may trade down a little but still remain in an uptrend cycle. You don’t want to get rid of the stock but you also don’t want to lose any money so you sell the 27.5 call at $2.00.
The stock starts to trade down and finishes at $26.00. If you had owned the stock naked, then you would have lost three dollars since you owned the stock at $29.00 and it closed at $26.00 on expiration.
However, because you sold the 27.5 calls at $2.00, you would only realize a $1.00 loss in the stock. The premium received will offset the loss due to the fact that you identified and adjusted for a likely move.
As you can see, the buy-write strategy can be altered to fit any directional view you have on your selected stock.
Finally, if you intend to use the buy-write strategy
successfully, you generally need to sell the calls against your stock on a consistent, recurring interval, over a period of time.
This means that you will have to be prepared to ‘roll’ your calls out to the next month come expiration. Sometimes, all you’ll need to do is to sell the next month out call.

]]> http://advancedoptionstrategies.net/lessons-in-options-trading-strategies-the-lean/feed 0 How to Trade Options – Book Review – Lawrence G. McMillan, McMillan on Options http://advancedoptionstrategies.net/how-to-trade-options-book-review-lawrence-g-mcmillan-mcmillan-on-options http://advancedoptionstrategies.net/how-to-trade-options-book-review-lawrence-g-mcmillan-mcmillan-on-options#comments Wed, 02 Dec 2009 20:12:47 +0000 admin http://advancedoptionstrategies.net/how-to-trade-options-book-review-lawrence-g-mcmillan-mcmillan-on-options Larry McMillan is an iconic Hercules of the options world.  Few option titans have the depth and range of grounded insights to devote 630+ pages to a publication.  Do not be overwhelmed by what initially appears as a titanic chronicle.McMillan commits extensive effort to clarify the proper use of misused trading terms.  He rectifies inaccurate practices by applying the mechanics of the math that is material and helps you visualize this with graphically rich worked examples.  Every chapter has its own summary, emphasizing specific techniques to refine your own trading methods.There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 630 pages in total, excluding appendices.1  Option History, Definitions, and Terms.  44, 6.98%.2  An Overview of Option Strategies.  60, 9.52%.3  The Versatile Option.  82, 13.02%.4  The Predictive Power of Options.  164, 26.03%.5  Trading Systems and Strategies.  90, 14.29%.6  Trading Volatility and Other Theoretical Approaches.  128, 20.32%.7  Other Important Considerations.  48, 7.62%.Focus on chapters 4, 5 and 6, which makes up about 61% of the book. These chapters are relevant for practical trading purposes.  Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective. 4 The Predictive Power of Options. Within this chapter, focus on these sections: Using Stock Option Volume as an Indicator, Implied Volatility Can Predict a Change of Trend and The Put–Call Ratio.  Here, you are taught to spot trading opportunities where the daily total option volume is more than double the average option volume. For highly liquid Index products, a higher ratio is required.  There are filters to validate the use of volume speculation.  These filters include ruling out the impact of arbitrage, total volume concentrated in too few strikes that are not identifiable as block trades, spread trades concentrated in just two series of strikes and over concentration of daily volume in ITM strikes that does not have the percentage leverage of ATM/OTM strikes.The section on Implied Volatility evaluates the treatment of IV as it moves between its expected ranges towards extreme boundaries.  IV Mean Reversion is involved. Implied Volatility must leave from where it is currently trading at (be it IV for ITM, ATM or OTM strikes), to converge at zero on expiration date.  Though, price can go anywhere (up, down or stay flat).  The boundary analysis of IV is applied to covered call writing, index options, the seasonality of volatility and trading volatility directly using the VIX.  Other volatility companion measures should be used in combination with the VIX, namely the VXO, QQV and VXN as sentiment gauges.McMillan differentiates between a “standard” put-call ratio versus the “dollar-weighted” put-call ratio. There is further refinement on the applicability of specific ratios to equity only put-call ratios, distinct from index put-call ratios and futures put-call ratios.  Weighted ratios accentuate the extremities of overbought/oversold conditions when sentiment has reached its peak or valley to signal impending changes, which is overlooked in using a standard ratio that is not weighted.  Sentiment needs to be sensitized with the weightage.5 Trading Systems and Strategies. Pay attention to these sections, which make up about 68% of the chapter: Intermarket Spreads and Other Seasonal Tendencies. The section covers European options that do trade at a discount to parity, spread differentials between heating oil futures and unleaded gas futures, small-cap outperformance with the January effect, spread differentials between gold stocks versus the price of gold, spread differentials between oil stocks versus the price of oil, the relationship between the utilities sector and 30-year bonds, other relationships between sector indexes/futures and Pairs Trading.  There is convergence and divergence at work in these specific products and asset classes identified. For a unique set of relationships, McMillan clearly explains why some relationships must be treated as cross-correlated dependencies versus independent treatment of non-correlated mutually exclusive events. There is also clarity on how to design your trading system to collectively control the diversification of risks across these distinct linear relationships and inverse interplays.The section on Other Seasonal Tendencies challenges August as a dull month with muted volatility in the pits, alerts you to September-October as months to be long puts but short futures and identifies cyclical periods of rallies in late October and late January. McMillan confronts the conventional reasons for seasonal nuances. For example, the traditional leave periods of floor traders/market makers/institutions who move 85+% of exchange volume does not dampen volatility in the pits and there is no slack during the Labour Day holiday period. He blends the business cycle in with the use of seasonality. For example, companies that are stock components of the S&P 500 with cash rich balance sheets will need to periodically slim down their current asset holdings and redeploy cash into longer-term investments. Firms must maximize shareholder’s equity and cannot just sit on cash.  McMillan explains when and how to position your trades in view of the common market practice of “window dressing”, in context of cash flow contraction and the velocity of money during these periods of fiscal adjustments to the books of corporations.6 Trading Volatility and Other Theoretical Approaches. In brief, the themes covered are: volatility’s role in pricing options, controlling directional risk with delta neutral trading, predicting volatility based on forecasting IV from its current percentile, comparing historical and implied volatility to confirm trading ranges in percentile terms, trading implied volatility recognizing the trade off between being short premium versus long decay, reaffirming the relevance of the Black Scholes model with application of the Greeks, aligning a spread’s strike construction for trading the volatility skew, the aggressive calendar spread that expires within 10 days versus conventional inter-month calendars, using probability and statistics in volatility trading to rank the risk to reward profile of trades and expected return metrics to measure risk per $1 allocated.Of all the focus chapters, Chapter 6 is the heaviest on the use of numerical reasoning. Though, is not beyond anyone who is comfortable with Statistics 101.To complete the review, here’s the background of the author.  Larry is the President of McMillan Analysis Corporation, founded in 1991.  From 1982 to 1989, he headed up the Equity Arbitrage Department at Thomson McKinnon Securities, Inc. He traded the firm’s own money primarily in advanced option spreads and risk arbitrage strategies.  Between 1989-90, he was in charge of the Proprietary Option Trading Department at Prudential-Bache Securities. He traded primarily convertible Euro-bonds and Japanese warrant arbitrage strategies.  Prior to these roles, he was the retail option strategist at Thomson McKinnon from 1976 to 1980, and traded the firm’s proprietary account beginning in 1980.  He initially worked at Bell Telephone Laboratories from 1972 to 1976.  He holds an M.S. in applied mathematics and computer science.In conclusion, McMillan on Options exposes you to the full gamut of how to trade options and the essential methods required to build a sustainable and consistent trading system. Intermarket spreading and Implied Volatility forecasting are clearly the cornerstones of a solid trading system.This is not a criticism of the book but a personal observation. To complete the construction of a total trading system requires the metrics for portfolio diagnostics. I have written a separate article, entitled “Book Review -  Kenneth L. Grant, Trading Risk” that deals with portfolio management.

]]> http://advancedoptionstrategies.net/how-to-trade-options-book-review-lawrence-g-mcmillan-mcmillan-on-options/feed 0 Options Trading Mastery: An Imaginary Spread Scenario http://advancedoptionstrategies.net/options-trading-mastery-an-imaginary-spread-scenario http://advancedoptionstrategies.net/options-trading-mastery-an-imaginary-spread-scenario#comments Wed, 02 Dec 2009 07:58:20 +0000 admin http://advancedoptionstrategies.net/options-trading-mastery-an-imaginary-spread-scenario We are going to put together an imaginary spread scenario and set it in real life events. Consider that, in October, you begin to hear about IJK stock. It looks interesting, so you use a variety of sources to learn about it. (News, charts, outside analysts, Internet research, etc.) From your investigations, you decide that this stock is poised for a strong upward move and you would like to take advantage of it. Each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.
Now is the time to investigate IJK spreads. Since you are bullish on the stock, you look into the bullish plays of the call spreads and the put spreads. You check the pricing of both since you know that implied volatility and time decay affect your purchase and selling price if you decide to sell out the spread before expiration.
Imagine that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide that you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. This is the Nov. 50-60 spread. The spread’s cost is $3.50, which means you pay $3,500 for the trade. This is inexpensive when you consider that 1,000 shares of IJK stock would have cost you $50,000! You will now wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.
If the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you will lose the $3,500 that you paid for the spread. If the stock begins to move up, you will recoup your investment and move into profits. When the stock has moves up to $3.50, you are at the breakeven point. Every money advance after that represents profit.
At any time until expiration, you can sell out of the spread, but what you receive for the price are influenced by implied volatility and time decay. That will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3,500 investment is $6,500.
You paid $3,500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6,500 profit, which is a 186% return. If you had invested $50,000 for 1,000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.
For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

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