Kennynah's Options Strategies

Option Strategy During Earnings Season

2010-02-25T03:29:00.001-08:00

Option Strategy During Earnings Season

Very often, stock prices can gap up or down on the next opening session, immediately after quarterly earnings are announced. Such directional risk can be largely mitigated by using the underlying Options.

For example, AAPL is announcing its quarterly earnings today after bell. You had earlier Shorted 100 shares of AAPL at $200. Of cos, if you now have an opinion that AAPL may release a set of sterling earnings, you may choose to close off your Short position and that would totally remove all risk. But with no risk, comes no possible rewards.

Since you are already Short 100 shares of AAPL, you want to maximize your potential for profits but remove as much directional risks as possible. Just in case, AAPL gaps up on open the next morning, as a protection, you can establish the following Option position :

200 of Long $200 Call Options

By having Long Calls, any upside gaps next morning will protect your Short stock positions.

Hang on... you only Shorted 100 shares of AAPL, so why buy 200 of AAPL Call Options when 100 seemingly would suffice?

The answer lies in one of the Option Greeks, namely Delta.

At-The-Money options possess 0.5 delta, whereas 1 Short share of AAPL has -1 delta. Therefore, you need 2 ATM options (2 x 0.5) to equal 1 stock share.

Portfolio Recap :

Short 100 shares AAPL @ $200
Long 200 $200 Call Options

GREEKs Profile :

Delta : 0 (Short 100 shares = - 100 deltas, Long 200 Call Options = +100 deltas)
Gamma : +0.06
Theta : - 0.24
Vega : +0.40

Note that Delta is 0, which means you will not gain or lose no matter how AAPL price moves the next morning. You have effectively removed directional risks arising from earnings announcement. At least this is how it will appear.

In reality, Delta of these 200 Call options will change, when AAPL price moves away from $200 mark. The Delta will change because of Gamma. The overall value of the Long Call will also be affected by Theta and Vega, which are also NOT zero.

If you were Long 100 shares of AAPL, then by going Long 200 options of $200 Puts, will achieve the same direction neutrality to your portfolio. The overall Delta will be again 0, and the remaining GREEKS will largely be the same as above.

We can discuss the impact the remaining Greeks have on this portfolio later. Please feel free to chuck in at any time.

But for now, you can appreciate that using Options, you can immediately remove a chunk of directional risks, without having to liquidate the stock position.

Stock Dividends and Its Impact on Options

2010-02-25T02:42:00.001-08:00

Stock Dividends and Its Impact on Options

Although dividend is not a Greek component of any Option, it has a direct impact on the values of Calls and Puts. For this reason, it is important to understand how dividend payouts positively or negatively impact Option values.

I will refrain from a lengthy post on this topic, in part because I'm still struggling to understand the technicalities myself.

Aside from the actual reasoning and explanation of how dividend payouts affect Calls and Puts, it is at least important to note this general phenomenon.

On Ex-Div Date (commonly known as XD to Singapore traders/investors) :

a) ITM Call values will be lower
b) ITM Put values will be higher

Deep OTM Calls and Puts will largely be unaffected by dividend payouts.

It is also for this reason that a day before XD, open interests and trade volume for these ITM options will see gigantic spikes. It has nothing to do with market place opinion on direction of the underlying price movement. Thus, trying to decipher the directional bias based on open interests of the Calls and Puts in especially just before XD will be misleading and inaccurate.

If there's anyone who can succinctly explain this phenomenon, please post here. My brain is all jammed up putting together the details of this outcome. Thanks in advance.

Why Conversions and Reversals Cause Stock Volume Spikes on Expiration Days

2010-02-23T22:41:00.001-08:00

to truly understand the cause of volume spikes on Option expiration days, we must comprehend the Put-Call Parity structure that is associated with Conversions and Reversals.

recall an earlier discussion about Put-Call Parity equation. in a gist, a Put is a Call and a Call is a Put. if this sounds confusing, you are on the right track 8-)

[u]Put-Call Parity[/u]
Call = Put + Stock - Strike + Interest - Dividend

and by rearranging this formula,

Long Stock = Long Call - Short Put + Option Strike Price - Interest (carrying cost) + Dividend (of stock)

in otherwords, any Long stock position can be synthetically created by using Options and using some combination of Options, Long or Short stock positions can be synthetically created. now, this is a powerful tool and knowledge.

Market Makers (MM) seize this knowledge to their advantage. In fact, Conversions and Reversals are strategies utilized by market makers every trading day. they have to do so, because they have to accept all orders, both buy and sell. in order to make a profit, they cannot always choose only to buy or sell. almost all market makers will buy and sell throughout the trading session. one of their primary functions is to provide liquidity and get rewarded. however, at times, they find themselves too Long or Short, and risks mount. to defray risks, they "convert" their stock positions into synthetically opposite trades. by doing so, they remove directional bias without having to liquidate existing stock positions yet.

so, if a MM is uncomfortable being too Long XYZ at $100, he/she will immediately Long 100 Put and Short 100 Call to form that Conversion. the MM "converted" his Long stock position into synthetically short stock position, removing his directional risks.

now, come that Friday expiration, the synthetic Short stock (Long Put and Short Call) position could well need to be exercised, if XYZ falls below $100. the market makers does so and automatically, that Long XYZ stock gets sold in the open exchange. even if XYZ price was higher than $100, the fact that those options are expiring, exposing the MM with Long stock directional risks, these Long stock positions will be liquidated. this action contributes to the increase stock volume transactions. MMs are in the business of speculating market directions.

the same can be explained about Reversals, which is

Short Stock + Long Synthetic Stock (ie. Long Call + Short Put)

on Option expiration day, if those Long Calls are exercised, the relevant Stock will be purchased.

retail players do not usually enact Conversions and Reversals. only MMs do so, in order to profit from

a) buying the Bid and selling the offer
b) arbitraging the difference in price of direct stock purchases/selling and synthetic shorts/longs
c) interest rate outlook; conversions are interest rate bearish and reverses are interest rate bullish strategies

these advantages above are very tiny, sometimes less than 5 cents but due to the size of their transactions and very low to near zero commissions on trades, they can make substantial profits if they get them right.

MMs are by far the single largest contributor to stock volume transactions...retailers, commercials and in-house traders trade with them.

so, please don't try Conversions and Reversals unless you are fully aware of the intricacies involved...

and so, now we know the reason for the consistent Stock volume spikes on Option expiration day...because Conversions and Reverses are closed off by MMs.

What is a Conversion?

2010-02-23T22:40:00.001-08:00

simply explained, a Conversion is a Long stock AND a synthetic Short position; for example :

say AAPL is at $200 now.

Long AAPL @ $200 (this is the Long stock position)
Short AAPL 200 Call + Long AAPL 200 Put (this combo is the Short synthetic stock)

If stock price moves up, the Long stock position profits but the Short synthetic stock position loses about the same amount, resulting in very little fluctuation in the P/L.

Conversions are as good as flat positions (not totally, but very close). Hence, there is no directional risk in Conversions.

since Conversions can hardly make money (not that it can't, just rather difficult), the question that is begging to be asked is "why would anyone establish a Conversion?"

answer: no retail player in the right mind, except to temporarily mitigate all directional bias risks, should establish such Conversions.

but this doesn't yet directly explain why Conversions and Reversions cause stock markets activities to spike on expiration days...

Conversions and Reversals

2010-02-23T09:59:00.001-08:00

Conversions and Reversals
every last but one Fri of the month, across the board, stock volume transactions rise above average daily transactions. why does this happen?

most people will cite that it is because it is this day that equities and index Options and sometimes Futures expire... but so what that these derivatives expire?

why is it that when these derivatives expire, the overall trading volume of equities markets rise? aren't these derivatives separate classes of assets that can be traded independently from stocks, nevermind the existing relationship? who is to dictate that i must buy or sell stocks when i trade options? for most options traders, they take positions in Options without accompanying stock positions; such as Long Call, Short Put, etc and hence liquidating those options on expiration day should have no material impact on volume of stocks traded. of cos, those who BUY/SELL-Write (eg, Covered Calls, married Puts) will likely close off their stock positions as they square off their Options as well. but these are arguably a significantly smaller group in the Options trading space. consequently, their overall trades should not consistently rake up the increased volume that we witness on every expiration day.

so, then, why do stock market transactions volume spike on such expiration days?

the answer lies in Conversions and Reversals....

Explaining Risks through Greeks

2009-12-22T22:05:00.000-08:00

let's use SPY trading at $108.20 with 11 days to expiration....the following Greeks for a Long Nov 109-strike Call are :

Delta : +0.41
Gamma : +0.1
Theta : -0.06
Vega : +0.08

we move on to more specific Greek talk..

the above is a Bullish directional option position, which was established by paying a premium of ~$1.91 or $191 for 1 contract size.. this is evident from Delta, which is +ve 0.41.. this also represents the position's biggest risk..

Delta Risks
why is this +ve 0.41 delta, the biggest risk? for one primary reason; if SPY moves up or down 1point, this position gains or loses $41 (0.41 x 100)respectively. this is a 21.5% fluctuation in the P/L; a significant % by any measurement.

therefore, before anyone goes Buying single directional options, whether Long Calls or Long Puts, the trader MUST understand Delta risks... which is most prevalent for Long Calls and Puts.

Gamma Risks
a +ve gamma is always associated with any Long options. remember, +ve gamma has nothing to do with directional bias. this means, one can Long Call or Long Put, such positions will always yield a +ve gamma. as long as you BUY an option, you will be +ve gamma; and conversely, as soon as you are Short(sell or write) an option, you will be -ve gamma.

gamma is best explained vis-a-vis delta. they are a pair of Siamese twins...because delta of an option position changes ONLY because gamma changes it. if gamma is 0(zero), no amount of movement of the underlying will change the delta value of that option !!!

in this example above, this Long SPY 109 Call assumes a +ve 0.1 gamma risk. how so? recall that gamma changes delta. gamma either makes a delta bigger or smaller. in this example, if SPY moves up 1 point, this Long 109 Call delta becomes +ve 0.51 (0.41 + 0.1) and if SPY drops by 1 point, the same Call option value will drop by +0.31 (0.41 - 0.1). of cos, this is a simplified calculation, becos gamma itself changes as SPY moves about. but we will keep it simpler here.

hence, if SPY moves up by 1 point, gamma helps the 109Call value tremendously by pumping the delta value up by ~24%(from 0.41 to 0.51),making this an even greater delta risk play. similarly, if SPY drops by 1 point, the option value will drop by ~23%..

therefore, if you are very bullish and decide to purchase a Long Call option, you want a large enough +ve gamma, to help you increase your +ve delta. BUT you had better be right on your directional bias, because if you were wrong, a large +gamma can also quickly erode your +ve delta of your Long Call option position, making it less sensitive of subsequent upward price movement of the underlying.

this, in a gist, is what gamma risks is all about...

Theta Risks

Theta is defined as the Rate of "Decay" of any option's extrinsic premium.

A side note on option premium. All options value are composed of intrinsic and extrinsic values. For example, recall that this Long SPY Nov 109 Call is valued at $1.91, when SPY was trading at $108.20. This is an OTM Call. This $1.91, the value of this Call option, consists of $0 Intrinsic value and $1.91 of Extrinsic value.

All OTM options contain only extrinsic values. ONLY ITM options contain intrinsic values.

Thus, when you purchase this 11days to expiration Long SPY Nov 109 Call, and paid $1.91, all of this is "time" fee. This is "fair" because option is a leveraged instrument, allowing you to gain control of 100 SPY shares at a fraction of the cost of actually buying SPY shares. The tradeoff, is that you pay such extrinsic value, build into the SPY options. Option trading epitomizes the saying "There ain't never a free lunch in this world !!".

Theta affects ONLY the option extrinsic value, NEVER the intrinsic value. In this example, there is $191 worth of premium to be decayed.

So, as with the above example, with a -ve 0.06 Theta, with every passing day, this option decays by $6 (0.06 x 100). You would have noticed an anomaly by now. Given that this option has only 11 days to expiration, doesn't it mean that there is only $66 ( $6 x 11 days) of decay, but with an extrinsic value of $191. So how is this possible? This is possible, because Theta does not decay in a Linear fashion. In fact, the rate of decay (aka Theta) becomes larger as time to expiration nears. It accelerates very aggressively in the last days and last moments of the option's life !!!

A very important lesson about Theta is this...

Supposing you did purchase this Long SPY Nov 109 Call and paid $1.91 and on the final day of expiration, SPY settles at $110. One would imagine making a profit from this position. This cannot be further from the truth. In fact, if SPY had ended at $110 at expiration day, this position would make a loss. By how much?

Value of 109 Call option on expiration, with SPY trade close at $110, will have a value of exactly $1. That Long SPY Nov 109 Call can be exercised into 100 shares of SPY shares at $109 and immediately be sold off in the open market for $110, profiting $1. Of cos, this Call option will be valued at $1 exactly, no more, no less..."No free lunch mantra, remember"....

So, with this SPY Call worthy of $1, and yet you paid $1.91 for it 11 days ago...tell me, how could be be a profitable trade? It is a bigger-than-burger-king-big-whopper loss of 48% !!!

But wait...just when you think this is bad...I've got worse news...Supposing SPY on expiration day closed off at $109, that Long SPY Nov 109 Call would be worth $0 !!! All of that $191 paid for that Long Call option, miraculously vanished into thin air. Talk about frustration! You've got your market direction right, no doubt about that. You entered the trade when SPY was $108.20, and 11 days later, SPY did rise to $109, and yet, you lost 100% of your capital on this trade. Ain't this a sucker trade !! Bitch it all on -ve Theta.

Now, I believe Theta has your attention and respect (sing that song...R-E-S-P-E-C-T by Donna Summers) .......this is what Theta risks is all about.... in this case, contrary to popular saying, time is not money...instead, time is your foe, when you are -ve Theta...

Bull Call Spreads with Positive Theta

2009-12-22T21:44:00.000-08:00

Bull Call Spread

We know that a Bull Call spread is a bullish position, with limited profit potential and losses. It this sense, credit Call spreads are limited risks positions...

A Bull Call spread consists of Long Call and Short Call of a higher Strike price.

Let's take AAPL as a case study....with AAPL price trading at ~$196

Some traders like to establish

A) Long 200 Call + Short 220 Call and pay $5.41 premium
vs
B) Long 180 Call + Short 200 Call and pay $15.38 premium

P/L for A)
Max Profit = $14.59 ( $20 - $5.41)
Max Losses = $5.41

P/L for B)
Max Profit = $4.62
Max Losses = $15.38

A) has a lot of profit potential and losses are much lesser, when compared to B). Moreover, it costs less to establish A) than B).

QUIZ :

Which of the 2 positions is a better trade, if indeed there's any difference, given the following Greeks:

GREEKS of A)
Delta +43
Gamma +1.5
Theta -7
Vega -11.6

GREEKS of B)
Delta +37
Gamma -1.7
Theta +4.9 >> most are mistaken that Bullish option positions will always yield -ve theta.. clearly not true
Vega - 11

Covered Call Variety

2009-12-22T21:43:00.001-08:00

Covered Call

We all know that the term, Covered Call, implies a position consisting of Stocks and Short Call options...

example: 100 shares of AAPL (Apple) at $196.40 and 1 contract of Short AAPL Jan $210 Call (whose premium today stands at $2.15)...

The 2 primary reasons for having such a WRITE Buy are :

a) Income generation from the premium collected for selling the Short Call option
b) Cushioning price decline

this position roughly requires a capital outlay of $19,425 (100 x $196.40 - 100 x $2.15)...

Max Profits = $1575 (trust me here)
Max Losses = $19,425 (if AAPL bankrupts and price zooms to $0)

now...consider the following alternative :

naked 4 x Short AAPL Jan 195 Put ...whose premium is currently $350 per contract

this position requires margin of ~ $15,600 to be set aside

a) Max Profits = $1400 ( 300 x $3.50)
b) Max Losses = $78, 000 (400 x $195) >> (if AAPL bankrupts and price zooms to $0)

now, if AAPL does indeed collapse and stock value goes to $0... i guess, i would throw in the towel and admit, i am not cut out for this business... ie, this scenario is remote...not impossible...but very slim chance...

this said, look at the 2 trades... would you not say, they are about similar.... they both have limited profit potential and very large potential losses..

QUIZ :

so, why would anyone be interested to purchase Covered Call vs Naked Short Put, given that they 2 are synthetically similar (they are...trust me)....

assumption : NOT a dividend paying Stock...

Result of GS Trade

2009-12-22T21:41:00.000-08:00

but alas...i didn't establish the above trade (refer to this link >> http://optionsstrategies.blogspot.com/2009/11/trading-options-on-goldman-sachs.html )....if i had, it would have been a winner...on both counts...

Long GS Dec09 165 Put and pay $5.60 >>>> GS did lose value to a low of ~$161 on 17Dec09
Short GS Dec09 170/175 Call and receive $1.14 >>> this option expired worthless on 18Dec09, thus I keep all of $1.14 premium

but this is only how it looks like on the surface....

QUIZ :

In reality, how much profit did I make if I held 100 shares GS and 1 contract of that Short Call spread until option expiration last Friday, 18Dec09?

Delta Neutral Discussion

2009-12-22T21:40:00.000-08:00

Delta-Neutral Trading

Selling a Strangle, such as Short V 80Call and Short V 80Put in our example, results in 0 (zero) Delta. Recall, that value of options with a 0 Delta position will not be affected by underlying price movement.

Perhaps by relating options to stocks, Delta can be better explained...

Long 100 shares of V = 100 Deltas
1 contract of Long V 80 Call (this is ATM Call) = 100 x 0.5 = 50 Deltas (1 option contract = 100 shares)
=> 2 contracts of Long V 80 Call = 50 x 2 = 100 Deltas

Therefore, Long 100 shares of V = 2 contracts of Long V 80 Call

(sidetrack : 100shares of V @ $80 = $8000 of capital. 2 contracts of V 80 Call will cost only a few hundred. such is the leverage nature of options)

802 is correct to suggest that if we Short 80 Call/Put, yielding a 0 Delta, which means that however V price swings, we just milk the Theta dry (read : profit from premium decay)... this is the intention !!!

Although such Short Strangles have 0 Delta, it doesn't mean that this Delta will stay totally unchanged. Given sufficient movement in V's price, this Delta will become more +ve or -ve; the reason? Gamma. This old faithful Gamma is at -0.14

Delta-Neutral trading is the process of ensuring that the overall option position is immune to price swing in either direction. It aims to profit from either Theta or/and Vega movement....

I'll leave it as such for now...and open this for further discussion...

Trading Options on Goldman Sachs?

2009-11-28T10:19:00.000-08:00

GS - Goldman Sachs

As I looked at GS chart, I cant resist wanting to go bearish on this stock.

GS is currently trading at $164.16 and has a current Historical Volatility of ~33%.

Using options, I can construct a bearish play, like so :

Long GS Dec09 165 Put and pay $5.60
Short GS Dec09 170/175 Call and receive $1.14

This position will cost a trader $446 and require a margin of $386.

The maximum losses is $946, if at option expiration, GS trades above $175; ie. GS goes past the Long 175Call option. If this happens, all of the premium paid, $446, for Long 165Put will be lost. The Short 170/175 Call spread will cost $500. Hence, the total damage = $946.

This position has unlimited profits. Although it is enticing to add a "unlimited" profit potential position, the trader must have a reasonable chance of it actually happening. In this case, we need to know how much GS price needs to weaken in order to make enough profits to justify the potential max loss of $946 !

To be able to achieve ~$950 of profits, GS must trade at $151 in 20 days time. GS must drop by some 8% from its current ~$164 price tag. Is this reasonable expectation? Let's get scientific about it.

Take a look at GS Option chain appended below. It shows that 150Put has a -0.14 delta. Ignore the -ve polarity. This is telling us that there's roughly 14% chance of GS price settling at or below $151 at expiration. Restating, GS has ~86% of staying above $151 in 20 trading days. Delta is a trader's rough gauge of an option expiring In-The-Money.

A more scientific way is to actually calculate the de-annualized Implied Volatility. Right now, averaged ATM option is showing about 31% annual IV. To calculate the potential move of GS price in 20 days, do this :

square root (20/365) x 31% = +/- 7%

There's a 68% chance of GS price fluctuating 7% up or down within 20 days. This makes GS price having a 2/3 chance of trading between $152.60 and $175.65. Now, this position makes ~$950 if GS price trades at $151 at expiration day. This calculation suggests that this is outside the 2/3 chance; ie. this trader has only 1/3 chance of making $950 or more but yet has 2/3 chance of losing $946.

Now, it is apparent that the risk/reward is not so enticing anymore.

Thus, as much as this trader likes to establish a bearish position on GS using options, current option chains do not offer the trader any meaningful way of doing so. It would be wise to find another trade.

Formulating Option Trade by applyng GREEKS

2009-11-28T10:14:00.000-08:00

TLT - iShares Trust Barclay's 20 Plus Yr Treasury

Remember that Option Trading is no more different than stock trading, in that one needs to first formulate an trade opinion, as part of an overall trading plan.

In this example, using TA, I see a possible bullish setup at this juncture. Obviously, one can include FA into consideration or use both TA and FA to decide if TLT will move up, down or sideways in the next 3 weeks.

As my trade opinion is that TLT will move higher than current price, I need to adopt appropriate Option Strategies that can offer an acceptable potential profits for some known associated risks of this position.

Note that Historical Volatility for TLT is now ~13%. It is at the low end of its HV. Option chain of Dec09 TLT also shows a similar Implied Volatility.

This is one possible setup employing ONE contract size :

Long TLT Dec 96 Call and pay a premium of $1.25 (known risk).

Short TLT Dec 96/94 Put and receive a premium of $0.67.

This entire position requires a capital outlay of $58 ($125 - $67) + commissions + $133 ($200 - $67) of margin requirement.

The maximum loss of this trade = $258 ($58 paid for this position + maximum loss of the $2 wide Short Put spread)

The maximum profit is unlimited !

GREEKS for this trade :

Delta = + 77.05
Gamma = + 11.45
Theta = - 1.40
Vega = + 7.09

Clearly, this is a +ve Delta setup, a Bullish position, which reflects the bullish opinion. If TLT moves up by $1, this position makes ~$77 and loses the same if TLT drops by $1. Of the remaining GREEKS, Gamma is the next most significant risk factor. It will fluctuate Delta more or less by ~15%; ie. quite quickly with TLT's price swings.
A short note on Implied Volatility. As TLT is now trading with HV of only 13%, TLT options are also relatively cheaper now than when TLT was at 36% volatility. Remember that option values are positively correlated to Implied Volatility. The lower the IV, the cheaper the option. It is unwise to buy options when IV is very high, such as those just before an earnings report.

The main reason that this delta is large is because of the choice of ITM 96 Call. Since TLT is currently at $96.40, this ITM 96Call has a delta of +0.54. The Short 96Put is also very near ATM and so yields another +0.47 deltas. Both these options combine to form ~ +1.00 delta.

You should realize now that Long 96Call + Short 96Put = a synthetic Long TLT stock !! You paid $58 capital to establish a position that almost mimics a Long TLT stock position, which otherwise would have cost $9,640 to buy the 100 shares.

This is the power of option leverage. But it is not free. There are trade offs.

a) this option expires in 20 days
b) $1 move in TLT yields ~$77 vs $100 if 100 shares of TLT was bought
c) this overall option position has a maximum risk of $258 ($200 + $58) vs maximum losses of $9640 if TLT stock price drops to $0. of cos, we dont expect this to happen. but even if TLT drops off $10, the losses would be $1000 if 100 TLT shares were purchased. in other words, the downside losses can be very damaging. but using this option position, the losses is capped at $258.

If you believe that TLT will move significantly to the upside within the next 3 weeks, then consider establishing this position, instead of outlaying $9640 to buy 100 shares of TLT when all you need is $258 to put on this option trade.

Greeks - Theta Explained

2009-11-17T04:25:00.001-08:00

let's use SPY trading at $108.20 with 11 days to expiration....the following Greeks for a Long Nov 109-strike Call are :

Delta : +0.41
Gamma : +0.1
Theta : -0.06
Vega : +0.08

Theta Risks

Theta is defined as the Rate of "Decay" of any option's extrinsic premium.

A side note on option premium. All options value are composed of intrinsic and extrinsic values. For example, recall that this Long SPY Nov 109 Call is valued at $1.91, when SPY was trading at $108.20. This is an OTM Call. This $1.91, the value of this Call option, consists of $0 Intrinsic value and $1.91 of Extrinsic value.

All OTM options contain only extrinsic values. ONLY ITM options contain intrinsic values.

Thus, when you purchase this 11days to expiration Long SPY Nov 109 Call, and paid $1.91, all of this is "time" fee. This is "fair" because option is a leveraged instrument, allowing you to gain control of 100 SPY shares at a fraction of the cost of actually buying SPY shares. The tradeoff, is that you pay such extrinsic value, build into the SPY options. Option trading epitomizes the saying "There ain't never a free lunch in this world !!".

Theta affects ONLY the option extrinsic value, NEVER the intrinsic value. In this example, there is $191 worth of premium to be decayed.

So, as with the above example, with a -ve 0.06 Theta, with every passing day, this option decays by $6 (0.06 x 100). You would have noticed an anomaly by now. Given that this option has only 11 days to expiration, doesn't it mean that there is only $66 ( $6 x 11 days) of decay, but with an extrinsic value of $191. So how is this possible? This is possible, because Theta does not decay in a Linear fashion. In fact, the rate of decay (aka Theta) becomes larger as time to expiration nears. It accelerates very aggressively in the last days and last moments of the option's life !!!

A very important lesson about Theta is this...

Supposing you did purchase this Long SPY Nov 109 Call and paid $1.91 and on the final day of expiration, SPY settles at $110. One would imagine making a profit from this position. This cannot be further from the truth. In fact, if SPY had ended at $110 at expiration day, this position would make a loss. By how much?

Value of 109 Call option on expiration, with SPY trade close at $110, will have a value of exactly $1. That Long SPY Nov 109 Call can be exercised into 100 shares of SPY shares at $109 and immediately be sold off in the open market for $110, profiting $1. Of cos, this Call option will be valued at $1 exactly, no more, no less..."No free lunch mantra, remember"....

So, with this SPY Call worthy of $1, and yet you paid $1.91 for it 11 days ago...tell me, how could be be a profitable trade? It is a bigger-than-burger-king-big-whopper loss of 48% !!!

But wait...just when you think this is bad...I've got worse news...Supposing SPY on expiration day closed off at $109, that Long SPY Nov 109 Call would be worth $0 !!! All of that $191 paid for that Long Call option, miraculously vanished into thin air. Talk about frustration! You've got your market direction right, no doubt about that. You entered the trade when SPY was $108.20, and 11 days later, SPY did rise to $109, and yet, you lost 100% of your capital on this trade. Ain't this a sucker trade !! Bitch it all on -ve Theta.

Now, I believe Theta has your attention and respect (sing that song...R-E-S-P-E-C-T by Donna Summers) .......this is what Theta risks is all about.... in this case, contrary to popular saying, time is not money...instead, time is your foe, when you are -ve Theta...

Greeks - Delta and Gamma Explained

2009-11-16T03:47:00.000-08:00

let's use SPY trading at $108.20 with 11 days to expiration....the following Greeks for a Long Nov 109-strike Call are :

Delta : +0.41
Gamma : +0.1
Theta : -0.06
Vega : +0.08

a quick reference to this and then we move on to more specific Greek talk..

the above is a Bullish directional option position, which was established by paying a premium of ~$1.91 or $191 for 1 contract size.. this is evident from Delta, which is +ve 0.41.. this also represents the position's biggest risk..

Delta Risks
why is this +ve 0.41 delta, the biggest risk? for one primary reason; if SPY moves up or down 1point, this position gains or loses $41 (0.41 x 100)respectively. this is a 21.5% fluctuation in the P/L; a significant % by any measurement.

therefore, before anyone goes Buying single directional options, whether Long Calls or Long Puts, the trader MUST understand Delta risks... which is most prevalent for Long Calls and Puts.

Gamma Risks
a +ve gamma is always associated with any Long options. remember, +ve gamma has nothing to do with directional bias. this means, one can Long Call or Long Put, such positions will always yield a +ve gamma. as long as you BUY an option, you will be +ve gamma; and conversely, as soon as you are Short(sell or write) an option, you will be -ve gamma.

gamma is best explained vis-a-vis delta. they are a pair of Siamese twins...because delta of an option position changes ONLY because gamma changes it. if gamma is 0(zero), no amount of movement of the underlying will change the delta value of that option !!!

in this example above, this Long SPY 109 Call assumes a +ve 0.1 gamma risk. how so? recall that gamma changes delta. gamma either makes a delta bigger or smaller. in this example, if SPY moves up 1 point, this Long 109 Call delta becomes +ve 0.51 (0.41 + 0.1) and if SPY drops by 1 point, the same Call option value will drop by +0.31 (0.41 - 0.1). of cos, this is a simplified calculation, becos gamma itself changes as SPY moves about. but we will keep it simpler here.

hence, if SPY moves up by 1 point, gamma helps the 109Call value tremendously by pumping the delta value up by ~24%(from 0.41 to 0.51),making this an even greater delta risk play. similarly, if SPY drops by 1 point, the option value will drop by ~23%..

therefore, if you are very bullish and decide to purchase a Long Call option, you want a large enough +ve gamma, to help you increase your +ve delta. BUT you had better be right on your directional bias, because if you were wrong, a large +gamma can also quickly erode your +ve delta of your Long Call option position, making it less sensitive of subsequent upward price movement of the underlying.

this, in a gist, is what gamma risks is all about...

ITM vs OTM Covered Calls

2009-11-11T22:16:00.000-08:00

Let's superficially address the choice between ITM and OTM Covered Calls...

We must remember that when the option is american stye, such option are exercizeable even before its expiration date. european options can be exercised only on expiration date. most stock options are american style and several indexes options are european style.

So, if CROX is at $8 and I choose to Sell $7 strike Call, an ITM Call, I risk being early exercised; which means, at any time before option expiration date, my existing Long CROX shares can be "called away"; ie, I am "forced" to sell my shares away at $7. If this happens....the Covered Call play is over even before it can reap any benefits...

The choice of any option strategy is usually decided by the intention of the trade. Thus, we must clearly understand the purposes of Covered Calls... In my mind, these are the main few :

a) Attempt to generate consistent income from existing Long stocks (this can be achieved by Selling either ITM, OTM or even ATM Calls)
b) Provide some downside cushion in stock price (the premium from Selling Calls mitigates small losses from price adverse movement)
c) A predetermined profit exit point (usually with Short OTM Call)
d) Achieve a higher Return on Investment, when the Short Call is exercised and existing stocks are "called away" ("If called" ROI is always higher essentially due to extra premium earned)

I am hoping that we can use GREEKS to explain and decide on why Covered Calls strike should be ITM, ATM or OTM ? and whether to use nearer or further dated options?

A Trvia Quiz

2009-11-11T22:13:00.000-08:00

a trivia quiz.... to keep this blog active....

Assuming today, an option position's Greeks profile is as such:

Delta : + 0.7
Gamma : + 0.018
Theta : - 0.02
Vega : + 2.15

Question :

In order to be profitable, do you want your underlying's price :

a) To move or stay rather stagnant? Why?
b) To move in which direction? Why?

Enjoy

Answers will be posted by 16Nov09

Rho Rho Rho Your Boat

2009-10-13T10:59:00.000-07:00

Put-Call Parity Concept helps to explain several phenomenon in the options world. Particularly in what seems to be a disparity in values of Calls and Puts of the same Strike and same expiration month.

For example, given the following scenario :

ABC Stock Price = $80
Interest Rate = 5%
Dividend Payout = $0.25

A 3-month Call - 80 Strike could be $3.75 and yet
A 3-month Put - 80 Strike could be valued at only $3.00

Question : Why is the Call more expensive than the Put, when they both have exactly the same probability of making or losing money?

The answer lies in none other than the Put-Call Parity Concept. Let me elaborate, by defining mathematically the Put-Call Parity. In essence, the formula can be gracefully expressed in the following manner :

Call + StrikeValue = Put + StockPrice + Interest - Dividend

==> Put = Call + StrikeValue - Interest + Dividend - StockPrce

Intuitively, when Interest component rises; such as the Fed Rates, then Call values INCREASE !! and at the same time, Put values DECREASE !!!

By now, it should be clear that if one is anticipating Fed Rates to increase, then, the market will start pricing Call options higher and everything else being equally, Put option values will drop.

And now, let's get back to the original question on why Calls are more expensive than Puts at the same Strike and same expiration month... It should be clear when we jiggle the Put-Call Party formula :

Stock = Call + StrikeValue - Put - Interest + Dividend

Using the above scenario, the formula easily translates to :

80 = 3.75 + 80 - 3 - 1 + 0.25

{Interest of $1 s calculated as 80 X 0.05 X [90/360] = 1}

If Call value was $3, just like the corresponding Put value, then the Stock price will be <$80, thus making this stock overvalued. This cannot be the case.

Incidentally, this Interest component that influence the values of options, is represented by the Greek - RHO

In summary, both Interest and Dividends components cause the disparity between Call and Put option values of the same Strike and expiration month....In the absence of dividends, then ultimately only the Interest component is responsible for the difference.

The Sobering Truth about Options Trading

2009-09-27T09:13:00.001-07:00

after a while, options traders will come to a sobering realisation...

that in a long run, if options premiums are always fairly priced, then the options trader should result in breaking even in all his options trades (exclude commission fees)....but only theoretically, because in reality Options premiums are almost always skewed to the disadvantage of the retail options traders...

to cement this phenomenon convincingly across, let's use the SPX options position (see link) to explain...

recall that theoretically, it has a 70% chance of winning that $100. conversely, it has a 30% chance of losing $400. in other words, if one establishes such conceptually equivalent options positions over 100 months, one can expect to win 70 times and lose 30 times. in $$ terms, one can expect to win 70 x $100 = $7000 and expect to lose 30 x $400 = $12,000

the net result is that the Options trader loses money...

but why does this happen?

there can be many reasons for this....

let me postulate just one reason here (actually, i can't think of any more than one reason...wahahaha)...please feel free to share your thoughts...

a) Mispricing of and especially of OTM options due to inflated Implied Volatility (ie artificially skewed IV by market makers)

so, then why would anyone entertain the thought of trading options, if indeed retail options traders are constantly disadvantaged? the answer is in knowing when to trade options and when to stay away.... and i dare say that the key lies in spotting mispriced options premiums...known otherwise as "the edge"..

without having a meaningful edge, very few options traders can last too long in the market place...

Low Risk - Premium Generating Option Proposition on SPX

2009-09-27T08:38:00.002-07:00

Basic Assumptions
Capital Base = $5K
Each position will NOT risk more than $500 of maximum losses
Target Rate of Return of Capital = 2% of Total Capital Investment
(means, making $100 for $5K total capital)

Given current SPX level of ~1045, we opine that index will not make a sudden and large downward movement, even though we are not sure if SPX will rally from current level. All that we are "predicting" is that SPX will not drop below 1005 by Oct09 expiration...Incidentally, given current VIX, we have some ~75% chance that SPX will remain above 1005 come Oct09 expiration...

Our Trade Position

1 x Short SPX Oct 1005/1000 Put vertical spread

Max Profit = Premium Received = $100 (excluding commission fees)
Max Loss = $400 (this is below our $500 losses we are prepared to accept)
Risk/Reward Ratio = $400/$100 = 4:1
Probability of Success = ~70% (it would have been better if this was closer or better than 75% given the risk/reward ratio). The inference here is that the market makers are under pricing the option premiums, and understandably because VIX has stayed comparatively low for some months now. Another inference is that there are insufficient Put buyers to drive SPX Puts higher in premium... This is an important judgement for traders who look into option chains for clues on directional bias of SPX index.

Possible Consequences of this Trade
Win $100 or 2% monthly or 24% annualized profits on Total Capital
or
Lose $400 or 8% of Total Capital, which is rather acceptable for most people
[u]
Will One Become a Millionaire using this Strategy?[/u]
Yes...over a long time....but it makes sense because this is a relatively low risk proposition...and so, it is realistic to expect only moderate compensation...

My Question
Does this look like a good trade? Does this look like a plausible strategy to achieve 24% annual income to you?

The New (Thrash) Paper Article on Options dated 20Aug2009

2009-08-20T00:08:00.000-07:00

my take on what's written (in blue)... please feel free to offer your thoughts as well.. thanks in advance..

*********
Thu, Aug 20, 2009
The New Paper

Forget the fast money

By Larry Haverkamp

I WAS drinking iced tea at a Burger King outlet the other day when a woman sitting nearby showed me the course she was studying: Options trading.

She told me: 'It's like stocks, but you can make money even faster.'
Read related:
» Back to basics to grow money

Options were also featured in last week's issue of The Sunday Times. It isn't easy. You have to learn about delta, gamma, vega and theta.

As the woman told me, the appeal is leverage. You can trade 10 to 20 times your capital, which amplifies the profits and losses by 10 to 20 times. It is life in the fast lane.

this is a factual statement..options is a leverage tool

Futures and structured warrants are similar to options. All are traded on the Singapore Exchange (SGX) but the trading volume is low, almost zero.

Futures is in many ways NOT similar to options... the only similarity is that Futures and Options are Derivatives... but so is a whale and a human...both are mammals... but do we say whales are similar to human beings??? Futures positions can be constucted using Options.. but the 2 instruments have stark differences. Futures prices are NOT determined by option GREEKs.

Structured warrants - a type of option - solve the problem by permitting the issuing bank to act as a market maker. It stands ready to buy or sell to anyone who wants to trade.

It is accurate to state that Structured Warrants are similar to exchange traded options, BUT the one and CRUCIAL difference, is Structured Warrants are offered by issuing banks and the being the market maker can very easily manipulate the price of these warrants, and I opine that they do to the disadvantage of retail traders. Structured Warrants are NOT to be traded by small fish...they are to be AVOIDED at all cost...

That's a plus, but the downside is that issuing banks conceal their fees in the warrant's price. There is no way to know the charges and many traders assume there are none.

This is only but one of the main disadvantanges of trading Structure Warrants..

Another solution is to trade futures and options on the major exchanges in Chicago, New York and London. Commissions are low and the volume is high.

This above is a fair statement...

The big question is: 'Can you make money?'

The same question aplies to any form of investment/trading... it is another trading instrument like any other... employ it smartly, and it gives an equal chance of winning and losing...

Courses, brokers and exchanges say you can but their livelihood depends on your trading. In fact, you can't win trading options, futures and warrants.

Flaw 1: Predicting the unpredictable

The first problem is that fancy terms like delta, gamma, vega and theta won't help if you don't have the correct 'view' of the future.

Is that hard to achieve? After all, prices move in only two directions: Up and down.

While they claim it is easy, I have asked trainers and other experts: 'Show me.'

The author is ignorant... price actions consist of not just 2, but 3 main categories; ie...up, down and stagnant...and it is exactly during a stagnant market that only Options trading offers anyone the chance of making money from the market..

when trading stocks or futures, one has theoretically only 33% of winning...that is when it moves in your desired direction....if price stays stagnant, you have just lost on opportunity costs... options on the other hand, can be deployed to make money n a directionless market...NO other instrument allows for this...NONE...I challenge you to name me one other than options...

Simply predict the price of any stock, index, option, warrant or future's contract for any date in the next 12 months. None has taken up the challenge.

I don't blame them. Markets already include all information in the price. You can outperform the market only if you have special or insider information.

It is hard to come by and may even be illegal if it gives you an unfair trading advantage.

armed with a deeper understanding of options, one can have an edge... only unknown to the uninformed...

The good news is even without fortune-telling or an expert view of the future, you can still win.

All you need is to buy and hold a diversified portfolio of stocks, bonds and property for the long run.

You can't do that with options, futures and warrants, since they are short-term trading instruments. Nearly all expire in a year or less.

There are options on stocks, options on futures, options on indexes, options on commodities, options of properties, options on softs, options on hard, options on soiled panties, options on pancakes, options on anything... the author is an ignorant fool....

options was first created as a hedging tool... it is in its very nature to offer protection to an investment portfolio...

Flaw 2: Zero-sum and worse

this entire section is NOT worth your time reading...it is not relevant to options as a trading tool...

Options, futures and warrants are not assets but promises written into contracts. If you make a short-term bet that the market will go up, an unknown counter-party takes the other side to bet it will go down.

Your win is their loss and vice-versa, making it zero-sum.

When you include the trading costs, it becomes negative sum.

It is like flipping a coin with a friend. You pass money back and forth between each other and the average return is zero.

Suppose a third person - George - enters the room and takes a fee for overseeing the coin flipping. This makes a big difference and the game becomes negative-sum.

You and your friend will eventually lose ALL your money to the middle-man, George. It is only a question of time.

Options, futures and warrants are also zero-sum and become negative-sum when you include commissions. While returns are low - negative, in fact - leverage keeps the risks high.

A better choice is non zero-sum investments like stocks, bonds and property. These appreciate in the long run as the economy grows.

They also have the advantage of paying higher returns for riskier investments. Stocks and property, for example, are more risky and earn higher returns than bonds.

It isn't true for options, futures and warrants where risks are always high while average returns remain negative and produce losses.

This article was first published in The New Paper.

When Things Go Wrong - Repair Strategy

2009-01-21T05:55:00.000-08:00

The Repair Strategy

If, whenever you puchase a stock and it rises, all is well and this post is redundant. On the other hand, like some of us mere mortals, you have purchased stocks that had the audacity to fall in price, this Repair Strategy may be useful.

Let's randomly choose a stock, Citibank, for purpose of illustrating this Repair Strategy.

Supposing, during the recent mini rally, you were convinced that C was poised for better days and hence better prices and purchased 500 shares of C at $7. We know that C settled for less than $3 as of 20Jan09. Ouch !!! This is >50% decline in value of the stock.

Ordinarily, investors who are bent on believing that, maybe in the long long term, C will be priced at a higher value, maybe tempted to add on positions at a lower price; a method described as Dollar Cost Averaging (DCA). There are several disadvantages and flaws to this approach. Namely :

a) By purchasing more of C at a lowered price, represents further capital outlay.
b) The downside risk exposure is also compounded by the amount of shares added on.
c) The initial reasons for going Long C is clearly not working out, so why add on to a trade that is not reaping rewards?

Therefore, it would be more sensible that should an original opinion, translated into some trading/investment positions, is no longer valid, it would be better to accept those losses and move on.

However, life as a I/T is hardly all that straight forward. There are multitude of reasons that people hang on to C even when the investment has devalued by >50%, as is the case in our example. So, let's not dwell into the whys and wherefores of such behaviour. What's done is done and the purpose is therefore to "Repair" a damaged situation.

Since it is a repair technique, it is no longer a "profit oriented" approach, but one that centres around "getting your initial money back". This is an important notion, that one who's adopting this repair strategy will benefit dearly to remember.

Also, it is very critical to understand that this repair method is based on the assumption that C shares will increase in price over time. If the view is that price will continue to drop further, then this is NOT the correct strategy to adopt.

Let's get into the specifics now.

500 shares of C bought at $7
C is now at $3
Call Options..................Premium
Sept 3......................$1.15
Sept 4......................$0.86
Sept 5......................$0.66

Instead of purchasing another 500 shares of C at $3, which will immediate deficit your trading account by another $1500, do this.

Purchase 5 contracts of Sept 3 Call. 5 contracts is equivalent to possessing the right to buy 500 shares of C at $3 anytime until Sep09 expiration. This purchase will cost 500 x $1.15 = $575
Sell 10 Sept 5 Call and receive 1000 x $0.66 = $660
Net result, you receive $85 (660 - 575)premium.

What did you achieve by doing this?

1) You do NOT need to pay out $1500, which is what will cost you if you had purchased outright the additional 500 shares of C at $3
2) You receive $85, to establish Long 5 Sept 3 Call and Short 10 Sept 5 Call. Effectively, no outlay at all. AND you acquired the right to purchase 500 shares of C at $3 anytime from now until Sept09. It means, if you want to, you could exercise your 5 Long Sept 3 Call and buy up 500 shares of C at $3 at anytime before expiration. So, why buy now? Buy only when C has gone up in price. If C doesn't rally, then forget this whole entire trade. It cost you nothing, but in fact, you got paid $85. In my books, there's no better deal than this.

Going forward in time....

C rallies and by Sept09 expiration, price goes above $5. What happens?

a) You exercise your right to purchase 500 shares of C at $3, thereby lowering your cost of C to $5 (1st buy at $7 and 2nd buy at $3. Average = (7+3)/2 = $5)
b) Since C has gone beyond $5, that Short 10 Sept 5 Call, will have become ITM. You will likely get exercised and 1000 shares of C will be called away from you. Perfect !!! You got out of your position at a lowered price of $5, broke even and cost you nothing (except some commissions).

C drops further. Well, you would not be any better off having enacted this "ratio spread" of +5 ATM Call and -10 OTM Call, but neither would you be worst off, if you had just let things be. Restated, you cannot do any worse off using this repair strategy than if you did nothing to your existing 500 shares of Long C.

Making it even plain simple...you have everything to gain and nothing to lose using this Repair Strategy. Compare this to DCA method, which compounds your risks, and cost you more capital outlay.

Finally, I will make a brief point about Volatility. For this Repair Strategy to work, the stock in question must possess a relatively higher Volatility. For stocks that are quiet for most parts of their trading cycle, implying lower Volatility, it may not be possible to obtain +ve net credit when trying to enact the Ratio Spread (eg 5 Long Sep 3 Call and 10 Short Sep 5 Call). If so, this Repair Strategy may require payment upfront. The I/T must then decide if it is meaningful to go down this path.

All men (and women) are created equal in the eyes of God. But not all markets are made equal. Many Asian bourses do not offer american options to retail investors. This greatly inhibits achieving creative profits or mitigation of losses. I don't see why we should not consider trading other exchanges that provide more value for our investment money, other than mere convenience or sheer ignorance.

FXE - A Gap Up Play

2008-12-12T03:44:00.000-08:00

A Short Dec 137/138 Call Spread (with 7 days to expiration)

81% chance of success and a risk/reward of ~ 7 : 1

Taken into consideration is also that 138 has a higher IV than 137...giving an edge in this position

Bull Spread - Long OTM Call Condor

2008-09-24T07:47:00.000-07:00

Bullish Spread - Long OTM Call Condor

Like the Long OTM Butterfly, the Long OTM Call Condor involves 4 option positions, which means, it can be costly in terms of commissions.

The easiest way to understand this bullish spread is to view it as :

Long OTM Call Spread and Short even further OTM Call Spread

The Short position helps to fund the cost of the Long OTM Call Spread.

When to use : Mild Bullish Trend
How to establish : LONG OTM Call Spread and SHORT a higher strike Call Spread
Debit or Credit : Debit
Margin Requirement : No
What is the Maximum Profit : The distance between the LONG and SHORT Strikes (limited) - debit paid
What is the Maximum Loss : Amount paid (the debit) for the spread (limited)

Example :

Amgen (AMGN) is at $58. Long 60/62.5 Call vertical is trading at 66cents. The Short 65/67.5 Call vertical is trading at 14 cents. This Long OTM Call Condor is established with a 52 cents (66 - 14) debit.

Profit/Loss Explanation :

Debit (means you pay) for Long 60/62.5 Call Spread = 0.66
Credit (means you receive) for Short 65/67.5 Call Spread = 0.14
Total Debit = 0.52

Maximum loss = 0.52
Maximum Profit = 1.98 ( 62.5 - 60 - 0.52)
Breakeven points = 60.52 and 66.98
Profit Range = anything between the breakeven points
Probability of Success = ~25%

Risk/Reward Ratio = 0.52 / 1.98 = 0.26; ie you risk 0.26 for a profit potential of 1.00

Now, note that is a limited risk position and a limited reward one as well. The risk commensurates with the chance of success almost 1 to 1 relationship; ie 25% of success and a risk of 26cents to win $1. Very fair indeed.

Remember this is a Bullish Position, minus the risk of unlimited losses on a simple LONG AMGN stock position. The trade off is that it comes with a limited profit potential. That's trading and some say, life.

P/L Chart of AMGN Long 60/62.5/65/67.5 Call Condor

I have decidedly show the GREEKS to explain this condor.

Delta
It has a +ve 7.86 delta, which is good becos we always want a +ve delta for a bullish position, which this condor is.

Gamma
What is not good is the -ve 0.32 gamma. This is not good becos the -ve gamma will shrink the +ve delta position as AMGN price rallies. However, do note that this -ve gamma will turn positive at some time in the life of this condor position, provided AMGN rallies as desired. On the flip side, this -ve gamma will help this position from losing too much value should AMGN price drop. This is bcos the -ve gamma again will shrink the delta and with every dollar drop in AMGN, this overall condor option position will also drop lesser becos of the shrunk delta.

Theta
It has a +ve 0.09 theta, small though, but always very good becos as time passes, this condor position will gain from time decay rather than lose value, which happens for option positions that have -ve theta

Vega
It has a -ve0.21 vega, which is not necessary good. This is becos AMGN is currently at $58 and you will want the price to be somewhere between $60.52 and $66.98, which means you want AMGN price to MOVE. You want a +ve vega to help move the price of this condor position with increased volatility rather than a stationary AMGN volatility. Nevertheless, vega will change its polarity depending on what AMGN price is at.

About Rho

2008-09-12T21:41:00.000-07:00

Rho

Rho, is the least mentioned among the greeks; delta, gamma, theta and vega.

Rho measures the impact the change in 1% risk free interest rate has on the value of the option.

In a gist, when Rho increases, the values of all Call options will increase and the values of all Put options will decrease.This occurs to every strike and expiration month options For example,

CSX : $61.61
35day 60Call : 5.10
35day 60Put : 3.40

The current risk free IR is 2%. Suppose, we increase that risk free IR by 1% to 3%, the revised Call and Put values will change. This change is caused by Rho.

35day 60Call : 5.13 (increased from 5.10)
35day 60Put : 3.37 (decreased from 3.37)

Explanation:

The reason that Calls become more expensive when IR increases, is because of "cost of carry". Remember that Call buyers have the right to exercise their Call options at any time before expiration. Supposing a trader had Long +10 6-month 55Call and is now ITM.
He could exercise this 55Call option and take delivery of CSX at $55/share but he will have to fork out $55,000 for this transaction immediately. He will still have the right to exercise his ITM Call option the next day, next week, next month or even right at the end of that 60day period. Why exercise it now, fork out $55,000 when he can deploy his $55,000 into a risk free instrument and obtain an assured interests for the next 6 months?
Of cos, if he feels that CSX will not rally any further from that juncture, he would be better just to close off this 55Call, take his profit and move on.
Hence, when risk free IR goes up, the less motivated a ITM Call option holder will be to exercise his call option. Since more people will be unwilling to do so when IR goes up, this premium is then reflected in the call option value. This is called the Cost of Carry.

Conversely, if a trader had a 60day ITM Put option, eg 60day 90Put, he will have the right to sell CSX at that strike price. Better for the trader to sell CSX at $90/share, quickly take his cash and put into a risk free instrument and earn the increased interests when holding onto those Put options earns no interest whatsoever. Hence, when Rho increases, more Put option holders will exercise their Put. Put values will drop as a consequence of increased Rho.

It would have to take a huge and sudden movement in risk free IR to have any significant impact on option values. And when such IR changes drastically, we have bigger issues to worry about.
Afterall, should the Fed Reserve Bank, decide tomorrow to raise IR from 2% to 5%, i doubt you will be rushing out to buy Call options, even when theoretically, the call values will rise.

Rho is primarily used by market makers when they hedge their positions against clients' and to price option premiums. Since they normally have very large, complex and constantly changing positions, they will take advantage of Rho to the maximum. Not so applicable for retail traders.

It is for completeness of Greek discussion, that I briefly elaborate on Rho.

About Vega

2008-09-12T12:50:00.000-07:00

About Vega

The fifth brightest of all stars, and the third brightest in the northern sky. It will be the north polar star in about 12,000 years. In moving through the Milky Way Galaxy, the Sun is generally heading toward the position now occupied by Vega. At a distance of 7.8 parsecs (25.3 light-years, or 2.4 × 1014 km, or 1.49 × 1014 mi), Vega, or α Lyrae, is the prototypical star of spectral class A0V, indicating that it has an effective surface temperature of 9600 K (16,800°F) and derives its energy from the thermonuclear burning of hydrogen in a stable core region.

And so, Vega is really a name of a star.

But surprisingly, Vega affects option values, even when it is 25.3 light-years away. So, we best give it some attention.

Vega is an option model parameter that affects the value of an option, by the indicated amount, when Implied Volatility (IV) changes by 1%.

We will illustrate the concepts surrounding Vega by using Apple(AAPL) options. AAPL currently trades at $150.20

Sept145Call has a value of 7.20, and a vega of 0.08. The IV of this option is ~ 49%. If IV increases by 1% to 50%, this Sept145Call value will become approximately 7.28 (7.20 + 0.08). If the same call option's IV increases by 10%, thus making it 59%, then the Sept145Call will have a value of 8.00, because the vega will have increased by 10 times, from 0.08 to 0.8, as a result of 10% increase in IV.
Therefore, increasing the IV, increases the vega, which in turn increases the values of all options.
Conversely, should AAPL's volatility drop, say by 1% from 49% to 48%, that very same Sept145Call, whose original value was 7.20, now becomes 7.12 (7.20 - 0.08)
Now, you get the macro picture that IV affects option pricing via Vega (and other greeks, like Theta).

Why is Vega important?

It is important because if you were Long an option, whether a Long Call or a Long Put, you want your value of these options to go up. One way, in which these option values can increase, is by having large +ve Vegas. So that in the event, the IV increases, that large +ve Vega will also increase significantly enough to cause your option values to go up.
But, if you had WRITE Calls of Puts, you will want the value of those options you short, to decrease in value (sell high, buy low concept). One way for these options to decrease their values, is to possess -ve Vegas. In fact, when you have a NET Short position, that will automatically generate -ve Vegas.
-ve Vegas can hurt your overall portfolio, if IV spikes.

Note also that vega is smaller in the front months as compared to the further out months. This means that when IV changes, the further out months option values are more impacted because they possess larger Vegas as compared to the nearer months options.

Most traders do not to focus on Vega becos it is arguably more important to know how the IV is behaving. Afterall, what changes the vega is IV. Vega is just a resultant figure.

When IV increases all option values increase (it is so critical that it warrants repetition), for all Calls and Puts. And conversely, when IV drops, all option values drop, both Calls and Puts.

Look at the Theoretical Price (highlighted within green box)of both Calls and Puts when IV is adjusted up by 10%.

They are all higher than the "mark" value, which is the current traded value. You can easily imagine that when the IV drops by 10%, the values of all options, in each strike of each month, and every month, will decrease in value.

There is absolutely no need for AAPL share price to move 1 cent, for IV to cause option value to change drastically. This is the power of IV. So, Asian traders, the next time you buy a Call or Put warrant, remember, don't get suckered by the issuer adjusting the IV upwards. Once you buy, they turn down the IV, and without price changes to your underlying, the warrants can still lose a heck lot of value. Now, you know why warrants offered for trading in asian bourses, are ONE-sided trades, and you ain't the banker.

This is yet another reason, why you should be looking to Long options only when IV is comparatively low and Short options when IV is exceptionally high. Historical Volatility is used as a comparison. However, this is not always to be taken at face value. Some stocks' have increased volatility for extended months to years. On the flip side, some stocks which have low volatility, can remain non volatile for a good number of years as well.

Hence, you should not base your decision to go Long or Short by simply looking at Implied Volatility, although, all astute options traders will know IV of their underlying very well.

So, in summary, Implied Volatility rules...which is why no option trader will survive this game without having a very clear understanding of IV. I tell my friends that my mistress' name is Ivy.

About Theta

2008-09-12T10:39:00.000-07:00

It's Time for Theta

Theta means Time Decay.

All options will expire one day, sooner or later. As time passes, each option will lose a little of its value due to the theta value that is attached to it. Particularly, all Long option positions value will suffer from such time decay, including weekends and public holidays, with no exception. Long options value decrease over time, because of Theta, even when the underlying stays absolutely still.

Let's review Google(GOOG), which is trading at $437.60. Its option chain is shown below.

Let me just digress a little and highlight a key ingredient; the Implied Volatility (IV) circled in green. The Sept08 options have all but 7 days to expire, the Oct options have 35 days and Dec, 98 days. Their respective Implied Volatilities :

Sept08 = 37%
Oct08 = 46%
Dec08 = 41%

Note that Oct08 has the highest IV. Please note that this is not to say that there is an error in the pricing model. The market is almost always perfectly efficient; especially when one is looking at such a liquid counter as GOOG. No one can tell the reasons for sure why the Oct's IV is higher than Dec's IV. What reasons accorded, can only be speculative, just as it speculative as to why a stock dropped 10% on a given day, without any apparent reasons. However, one can positively conclude that there exists a great deal of interests in GOOG's Oct options. The demand for these options, whether the buy or sell side, is the reason for this increased IV. It is simple economics 101. Mooncakes are most expensive becuase there is a higher demand for mooncakes during the Mooncake Festival and cheaper outside this period. Anticipated events can cause IV to increase.

However, there are always suggestions of market makers being responsible for artificially pumping up the next month's IV for all the reasons one can think of.

Now back to Theta.

Let's compare and contrast :

Within the same month, Theta exhibits this pattern

ATM options will have the highest theta assigned, as are the cases with Sept430 Call and Sept440. The reason is that, the best chances of success of any purchased options to get ITM (of cos other than those already ITM), will always be the ATM options. So, it is fair for options pricing model to allocate most premium to them, and that includes making the buyer of that ATM options, pay more for time decay. The seller of their ATM options, obviously, taking all the risks of writing, will demand a higher premium for ATM options.
Therefore, those ITM options, such as Sept400 Call, and OTM options like Sept470, will always contain comparatively lesser amounts of extrinsic value. Extrinsic value means, the additional premium an option pays for having the right to those options. With most extrinsic values attached to ATM options, correspondingly, Theta is highest always at those ATM options, both Puts and Calls.

Between Different Months, Theta Behaves in Discernable Pattern

Look at Theta for all Sept and Dec options. Across all strikes, Theta is smaller in Dec options than in Sept. For example, Sept 400 Call has a - 0.26 theta and Dec 400 Call has a - 0.18 theta. The reason that further out month has lesser theta attached to the options, is because there are many more days before those options expire.
Theta, or time decay, is experienced most when the options nears expiration. The effect is accelerated 30 days before expiration. So, in this Sept400Call, where theta is - 0.26, theoretically, ceteris paribus, theta will decay the option value by 26cents with every passing day and will decay the option value even more aggressively come closer and closer to the final expiration date.
At expiration date, all ITM, ATM and OTM options theta will revert to ZERO value. The value that time accords to these expired options, are no longer in existence. Hence, all options will lose their extrinsic value at the final second on expiration date.
In short, Theta is totally decayed at expiration date.

Now, if further out months options are supposed to have smaller theta, than why do Oct's options (being further out) have higher theta values across all similar strikes, when compared to Sept's? This is exactly opposite of what I described above.
There's no anomaly here. The only reason for Oct's options theta to be higher than Sept's is because of the markedly increased IV in the month of Oct. All that's been described about theta being highest at the ATM Oct option still applies.
But it should now be evidently clear to all that IV has a potent effect on other Greeks, including Theta. But had Oct's options IV be closer to ~39%, then those theta will likely be lower than their corresponding partners in Sept.

Increased IV will increase theta and a decreasing IV will decrease theta, everything else being constant.

This is the reason, that many traders will SELL options during HIGH Implied Volatility days and the reason why Asian traders shd NOT buy options (puts or calls) when HSI, SSE, STI do a stunning move...those warrants are very expensively priced. Since asian retail traders cannot SELL warrants, you are being forced to BUY them, if you wana trade warrants !!!! when the dust settles, and IV drops back to sane level, even if the index or stock price remain unchanged, your warrant values will drop very drastically....becos IV dropped.

Puts and Calls of Same Strike have Same Theta

There's is usually very difference in Theta figure for Calls and Puts of the similar strikes.

Theta can kill Long option traders, silently...

What About Gamma ?

2008-09-12T05:18:00.000-07:00

Gamma

Gamma's sole purpose is to affect the Delta. It can either be friend or a foe to Delta.

As we have discussed, Delta, is the greek that determines the amount of change to the option price, when the underlying moves by a point.

Then, you will understand when Gamma is defined as the Delta's delta; ie, Gamma determines the amount of change to Delta when the underlying moves by 1 point. If delta is a the 1st derivative then the gamma is the 2nd derivative. If delta is velocity, then gamma is acceleration.

Let's look at Visa (V), currently trading at $71. The current option chains are shown below.

A Long 70Call has a delta of 0.56 and a gamma of 0.08. If V rallies up $1, then 70Call delta will change to 0.64 (0.56 + 0.08). If V drops by $1, the same option's delta will also drop to 0.48 (0.56 - 0.08).
So, it is clear that Gamma has a direct impact in the value of the option's delta. The more +ve Gamma that option position has, the bigger the movement of value option's price will swing.
This is the reason that when Long OTM Call positions are very unreactive to underlying price movement. The V example shows this.
Look at 80Call option, this is OTM Call. It has a delta of 0.04 and a corresponding gamma of 0.02. Even if V rallies from $71 to $72 now, the 80Call delta will only be increased to 0.06 (0.04 + 0.02), which translates to a 6 cents movement in 80Call value. Obviously, this OTM Sept80Call isn't worth much now; about 7.5cents and has only a 4% chance that it will become ITM by 8 days time, when this option expires.
Do you remember how we conclude that this OTM80Call has only 4% chance of getting ITM? If not, you should re-read the post on Delta.

Now for the confusing part.

Supposing you had Long V 65Call which has now a 0.82 delta and 0.04 gamma. But imagine, for some reasons, your gamma was -ve 0.10. This can happen when you have multiple option positions of the underlying, that results in a +ve delta and a -ve gamma.
If the position has a NET +ve 100 delta, supposedly, you would want the stock to rally, since a NET +ve delta is a bullish position and will be profitable only when a rally occurs. BUT, the overall gamma of this combined positions, as stated was -ve 20. Then in a 1 point rally, your delta will be reduced to +ve80 (100 - 20). This is no good. Of cos, as the stock rallies up $1, you will still make that $100 (from the initial 100 deltas), but supposing it now rallies another point, from $72 to $73, effectively, you additional profit is only $80. You will still be making money, just not as much. What is responsible for this mess up? Gamma, of cos.

Similarly, in any bearish position, where the delta is -ve, you will want to gain delta as time passes. In this case, gaining delta for a bearish position, means making the delta more "-ve"; as in -0.9 is better than -0.2. This is the tricky part; so pay attention. You will still want a +ve gamma for a -ve delta position. It is not intuitive, but it is correct notion. A +ve gamma will make a -ve delta more -ve , when the price of the underlying drops.

Another way of looking at Gamma, is to think in terms of Volatility. If you were Long or Short a position, you certainly want price action, don't you? Afterall, a stationary market will slaughter all single directional bets, like Long Call and Long Put. Hence, when you have such positions, you want Gamma to be as gigantically +ve as possible.

But, if your option strategy is for the quiet market, then you want -ve Gammas to "tame" those deltas, and even making them as small as possible..

Hence, option writers (stationary or non-volatile option positions; such as Short Strangle or Short Straddle), will want -ve gammas in their option portfolio....

If you look carefully at the option chain above, you will see that gamma is largest for ATM options. This is always the case. The reason is very simple. At expiration, all ITM Call options will have delta +1 and all OTM Call options will have 0 delta. Similarly, ITM Puts will have -1 delta and OTM Puts will have 0 delta.
Now, we are 5 minutes away from closing bell of expiration day. V is trading at 74.90, the 75Call has a good chance of being ITM and is now 0.25 delta. One second passes and V trades 75.05, this 75Call's delta immediate jumps to 0.89. See the movement of delta from 0.25 to 0.89. That huge change is caused by Gamma. Hence, all ATM options has the largest Gamma.

so, in summary, this is how these 2 GREEKs interact with Calls and Puts

.................................................Delta....................Gamma

Long Call..................................+ve...........................+ve
Short Call.................................-ve............................-ve
Long Put..................................-ve............................+ve
Short Put.................................+ve...........................-ve

Volatility

2008-09-11T11:06:00.000-07:00

Volatility

A word on Volatility.

A stock is said to be more volatile than others or when compared to its past , it means that its stock price has a tendency to fluctuate over a large range.

Hence, a sector ETF maybe less volatile when compared to a single stock of that same sector. This is because this ETF encompasses a wide variety of stocks. If only a small number of stocks within this ETF make huge price movement, and a great deal of others stay relatively unchanged, then the price of this ETF will not gyrate as much. It's all about statistics.

Volatility is, in fact, everything about mathematical statistics.

To understand Volatility a step further, we must introduce another statistical term, called Standard Deviation. They are a pair of Siamese twins. Speaking of one without referencing to another, is of little meaning.

Let's not talk soldiers on paper, so to speak. Let's use a real life example. Lehman Brothers (LEH)

LEH is current trading at ~$5. It was traded for ~$20 some 6 weeks ago and $65 just 9 months ago. One can consider LEH as a highly volatile stock. LEH price dropped a hefty 92% over a period of just 9 months. But exactly how volatile is this LEH and how do we quantify its volatility.

To exact how volatile a stock is, we must always look into its past price action; ie its historical price movement. Therefore, when we refer to a stock's past volatility over a period, we actually mean its Historical Volatility (HV). There's little for argument on this HV figure. Afterall, its the past and how can we argue that the price actions didn't occur.

The only debatable issue is the period in which this HV is calculated. Should the period used for calculation be 1 month, 6 months, 1 year, 5 years, or more? There's no straight answer. For a pattern trader, the shorter term HV makes more sense than to a long term investor, who might be more interested in a 3 year HV. Different periods used will show different HV, the very same reason why MA50 and MA200 are different. Therefore, one must know the period used when deriving HV.

At $5, LEH now exhibits a volatility of ~300%. This 300% is an annualized figure. What this means is that, ceteris paribus, in a year's time, LEH will have a 68% chance of trading between +300% or -300%. Now, of cos, $0, is the most that LEH can go to. But +300% means that LEH could be at $20 by then, and there's a 2/3 chance of it happening. To paraphrase, and using the Gaussian distribution (aka as Normal distribution), LEH stock price has a 68% chance of making ONE standard deviation movement in price, a 95% chance of a price movement within TWO standard deviations and a 99% chance of a THREE standard deviations movement, all in a year's time.

What if a trader wants to know the volatility other than the annualized 300% volatility? The calculation is as such:

3 month vol = 300% x 1/2 = 150% (square root of 3months /12 months = 1/2)
1 month vol = 300% x 1/3.46 = 87% (square root of 1month / 12months = 1/3.46)
1 week vol = 300% x 1/7.2 = 42% ( "" )
1 day vol = 300% x 1/16 = 18.75% ( "" )

so, with 1 day volatility at 18.75%, LEH could range between $5.93 to $4.06, all this in ONE day...

a quick check on LEH's performance today....5..30 to 3.88....now, that's pretty accurate, so far.

Delta Hedging

2008-09-11T09:05:00.000-07:00

Delta - Revisit Again

Delta Hedging

In the above example of positions in IWM, there is a net +ve 9.65 deltas (let's just round this off to +ve 9).

This simply means that, at that juncture, if IWM rallies 1 point (meaning $1), this position will gain 9 cents or if IWM drops by $1, then this overall position will lose 9 cents.

Suffice to say that, a trader must watch the overall delta figure. If the delta of this IWM shoots up to 1000, then for every $1 movement of IWM, the portfolio will either win or lose $1000.

Now for the concept of delta hedging.

A trader may decide to hedge this above investment portfolio when the overall delta position becomes too large. Supposing, that the IWM options portfolio above went from +ve 9 delta to +ve 200 delta, which means this trader will win or lose $200 with every 1 point movement in IWM shares at that new delta figure.

Decidedly, this is too much of a risk for this trader to stomache. He can take either of these actions :

a) cut down the position size of his options, either by closing off bullish positions or adding on bearish positions, which will generate -ve deltas. as a result, this +ve 200 delta will be reduced.

b) Short IWM stocks. for every 100 shares of IWM that he shorts, he will accumulate -ve 100 delta. ONE Long share of IWM has corresponding ONE +ve delta, so ONE Short share is ONE -ve delta.

If he wants to reduce his delta overexposure by 100, then he could Short sell 100 shares of IWM. He will then bring his overall delta down to +200 from +100. This technique is known as Delta Hedging.

But delta changes all the time; it never stays static, not unless the underlying freeze in price movement.

Therefore, delta hedging is cumbersome, involves high overhead costs and is usually only practiced by professional traders/fund houses/floor traders, where the commission fees are markedly lower to non-existent.

So, the purpose of this writeup, is only to highlight that deltas change and for many reasons. In this case, deltas can change because the underlying IWM price changes. However, it is important to note that deltas can and will change, even when IWM price remains relatively unchanged. Deltas change with the passage of time and Implied Volatility.

How To Handle Butterflies At Expiration

2008-09-10T12:45:00.000-07:00

Bull Spread - Long OTM Call Fly (addendum)

A few key characteristics of this spread to take note of.

a) The maximum profit will occur when the underlying trades exactly at the Short strikes; ie SPY = 126. The chance, as mentioned, is low.

b) This spread consists of 4 options, since it involves 2 call spreads. Correspondingly, the commission fees is comparatively higher than most other option spreads.

c) Depending on where the underlying is trading at expiration date, one may not have to close off all the Call positions inherent in this fly.
Supposing, come very close to expiration date, perhaps even on the day this spread is to expire, SPY is trading at $120, making all the Calls Out of The Money, then simply just accept the 0.34 as your maximum losses and let this spread expire worthless. It is pointless to close off this spread, pay another 4 way commissions when there's no benefit for doing so.
Supposing, on expiration day, SPY is trading at $134, even though making all of your Call positions of this fly spread ITM, it is still pointless to expense another 4 way commissions to close off this position, when you would also be experiencing the maximum losses of 0.34. By closing off this position, won't make you a penny richer. Hence, why increase the losses further with commissions payable to exit.

The interesting part, is when SPY, on expiration date, trades between your profitable range of 124.34 and 127.66.

This is a little complex. So bear with me.

If SPY is within 124 and 126 range, you MUST at least sell off the Long124Call position, otherwise, you will be assigned, resulting in you being the proud owner of SPY ETF shares. You could sell of the entire fly spread as well. Which of the two actions to take, is more of an art than an exact science.

Let me explain...supposing you have 1 hour left on expiration date, and SPY is hovering around 125 region and SPY has been struggling to head higher. You think that SPY will not go beyond 126, nor will it drop below 124 within the next hour. Then you could just sell the Long 124Call and let the remaining Calls expire worthless. This will cut down on your trade commissions.

However, if you think there is a good chance that SPY will trade above 126 at the closing bell, then it is best that you close off the entire fly spread. The reason is this; if you had just closed off the Long 124Call position, leaving behind 2 short 126Calls, you are exposing your short calls getting ITM at closing bell. If SPY indeed closes at >126, you will be obligated to deliver SPY ETF shares and if you dont own them, then you will have Short stock positions come monday after expiration. These are not cheap stocks, to short stock, you need to have a huge amount of money in your account to margin this short stock position. If you dont have enough funds in your account, problems will balloon.
(to minimise the complexity of this explanation, the suggestion is to close off the entire fly spread, when in actual fact, you could just close off only the 124Call and 126Calls. Leave the 128Call alone, unless SPY went mad and shoots above 128 at the last minute before closing bell)

Thus, butterflies can be beautiful to look at, but potentially problematic to handle. The advice is, be very familiar with the concepts of this spread before trading the Fly.

Bull Spread - Long OTM Call Butterfly

2008-09-10T11:20:00.000-07:00

Bull Spread

Long OTM Call Butterfly

Yes, i know how intimidating this high sounding name can be. So, let me attempt to explain what this Bullish Spread is about, in a way that even I can understand.

The simplest definition of a Long Call Butterfly is this : Long Call Spread + Short further OTM Call Spread

For our example to illustrate the Long OTM Call "fly", we will use SPY (SP500 Index ETF). SPY is currently trading at 123.60

Long +1/-1 SPY Sept124/126Call and Short -1/+1 Sept126/128Call

Breaking this down granularly, it is:

Long SPY Sept124Call and Short SPY Sept126Call (which is a Long Call Spread)
Short SPY Sept126Call and Long SPY Sept128Call (which is a Short Call Spread)

As you have read, this Long Call Spread is a bullish position, which has limited profits and limited losses. Hence, limited risks in exchange for limited rewards. Similarly, this accompanying Short Call Spread, will also have limited upside and downside. Hence, in a gist, a Long OTM Call fly is a limited risks and limited reward position.

Under normal circumstances, a fly is an affordable option strategy with the aim of reaping multi-fold returns. This can occur but the probability of this event occurring, is correspondingly low. Low probability of success, translates to lower cost of this trade; fair.

When to use : Mild Bullish Outlook
How to establish : LONG OTM Call Spread and Short further OTM Call Spread
Debit or Credit : Usually a small debit
Margin Requirement : Yes
What is the Maximum Profit : Limited
What is the Maximum Loss : Limited

Profit/Loss Explanation
Debit of Long 124/126Call Spread: -0.84
Credit of Short 126/128Call Spread : +0.50
Total NET Debit = -0.34

Max Profit : 1.66 (strike 126 - strike 124 - 0.34 debit paid)
Max Losses : 0.34
Breakeven Points : 124.34 (124 +0.34) and 127.66 (128 - 0.34)
Profitable Range : SPY between 124.34 and 127.66

Take this opportunity to solidify this calculation concept. Once understood, it will help with understanding future examples.
Basically, the Long Call Spread of this fly has a maximum profit of 2 (126 - 124). But you have already paid 0.34 for this position, and so, in reality, the Max Profit can only be 1.66 (2 - 0.34). Only if SPY trades above 124.34 at expiration, will this position be profitable. Hence the breakeven point is 124 +0.34.

Similarly, the max that you can lose on the Short Call Spread is also 2 (128 - 126). But in order that you do not lose more than 2, you must account for the initial 0.34 debit paid. Hence, the second breakeven point is 127.66 (128 - 0.34).[/i]

Risk/Reward Returns : 0.34 /1.66 = 20.5% in 9 calendar days or 830% annualized returns.

With such a high risk/reward returns, one can expect that the probability of success for this trade, is low. This is the trade off. Think of it as paying 50cents for a TOTO ticket. It pays very handsomely if your TOTO numbers are picked; but that's a slim chance. Consequently, you only need to pay a small price for this chance, a mere 50 cents.

Therefore, just remember that a Long Butterfly is like buying TOTO... small saw to chop a big tree.

P/L Chart - Long +1/-2/+1 SPY Sept 124/126/128 Call Butterfly

Bull Spread - Long Call Ratio Spread

2008-09-09T11:09:00.000-07:00

Bull Spread

Long Call Ratio Spread

While this is a Bull Spread option strategy, it can be a market neutral to bullish bias and non directional option strategy.

When to use : Neutral to Bullish Trend
How to establish : LONG 1x Call and Short 2x Call
Debit or Credit : Credit (preferably)
Margin Requirement : Yes
What is the Maximum Profit : Limited to between the Long and Short strikes
What is the Maximum Loss : Unlimited

Example :

Starbucks (SBUX) is trading at $15. You believe that their recent cost cutting measures will optimise their operations by lowering costs and perhaps even increasing their margins. However, you think that SBUX could stay range bound with a possible rally when it reports earnings in Sept. But the upside to SBUX price should have a ceiling in the near term with such uncertainty in consumer spendings.

Again, because we are now in Sept and the Oct Call options will be expiring in a month's time, you do not wish to be disadvantaged by Theta (the greek for time decay). Theta is most aggressive for options with ~30 days remaining to expiration. You want a strategy that will mitigate losses resulting from theta and also since you opine a upward limit to where SBUX price will go to, you then establish this option strategy :

Long 1x SBUX Sept15 Call and Short 2x Sept 16 Call - this is known as a Long Call Ratio Spread

This position is similar to a Long Call Spread, with an added Short OTM Call; meaning, in our example,

Long SBUX Oct15Call and Short Oct16Call (which is a Long Call Spread) and added Short Sept16Call

The Short Calls position is established mainly for 2 reasons :
a) To compensate you for the loss due to time decay, as Short options earns you time value whereas Long options penalizes you Theta.
b) You believe that SBUX will NOT head much higher

Note here, that the contract size of the Short position is 2 times of the Long position. This is known as a 1 x 2 ratio spread. You could, if you choose to, establish a 1 x 3, 1 x 4, 2 x 5, or any other contract size combinations but the size of the Long position is always smaller than the Short position. More importantly, the bigger the multiplier of the Short option, the bigger the assumed risks. Hence, a 1x4 Ratio Spread has a bigger risk component than a 1 x2 or 1 x3 Ratio Spread.

Special Note : Ratio Spreads can start by having a -ve Delta, or a small +ve Delta, even though this is considered a Bullish Spread. Recall that you always want large +ve Deltas for bullish position

A simple way to look at a Long Call Ratio Spread, is this. It is a Long Call position, where the premium paid to establish this bullish position, is entirely funded by the multiple Short OTM Call positions. This ratio spread, should be established for a NET credit, or it will not be justifiable for assuming the associated risks of unlimited losses.

In our example, Oct15 Call is priced at 1.15 and the Oct16Call is trading at 0.63. By buying ONE Oct15Call and selling TWO Oct16 Calls, you will receive a NET credit of 0.11 ( 2 x 0.63 - 1.15). This means, you are actually paid to trade this position.

In this SBUX example, these are the following 2 Greeks:
Delta = -ve 0.24
Theta = 1.07

A -ve delta for a bullish position is no good. The reason is that even for a 1 point increase in SBUX price, this ratio spread is effectively losing money because the -ve delta will reduce the spread's value. The good news is, this -ve delta will have a chance of turning into a +ve delta. This effect can be caused by the passage of time and SBUX price. The inter-relationship between Greeks is a rather complex topic, which I will hope to cover in a separate post.

A +ve theta is always a good cheer. As time passes, even if SBUX price remains stationary, you add 1.07 to your ratio spread value everyday. This +ve theta value increases over time.

Profit/Loss Explanation :

(you will have to assume these option prices are correct)
Debit for (ONE contract) Long Oct 15 Call = -1.15
Credit for (TWO contracts) Short Oct 16 Call = 1.26 (2 x 0.63)
Total Credit = 0.11

Maximum loss : unlimited
Maximum profit : 1.11 ( 16strike - 15strike + 0.11 credit)
Breakeven point : 17.11
Profitable range : SBUX trades below $17.11 at expiration
Risk/Reward Ratio = if SBUX rallies to the stars, then this ratio is unquantifiably high.

The breakeven point is 17.11. The maximum profitable spread is $1 (16strike - 15strike) because you have a right to buy SBUX at $15 and you are obligated to sell it at $16, should SBUX trade above $16 anytime before and up to Oct expiration date. If this happens, you now have $1 profit as your cushion if this spread moves against you subsequently. The value of this spread peaks when SBUX is trading at $16 at expiration.
In this case, should SBUX continue to rally from $16 to $17, you are now losing $1 because of the additional Short Oct16 Call. You then use the $1 you made to pay for this $1 of losses. You can afford to let SBUX rally until $17 without incurring a loss yet. Remember, when you put in this trade, you received $0.11 credit. Therefore, your actual breakeven point is when SBUX is trading at $17.11 at expiration (not before and not after but exactly at expiration).

If SBUX trades below $15 at Oct expiration date, all the 3 Call options of this ratio spread will expire worthless and you keep all the credit received; ie 0.11 The reason that this spread will expire worthless is this. No one will exercise the Short Oct16Calls, because no one will want to buy SBUX for $16 when it is now trading below $15. Likewise, you will not exercise your Long Oct15 Call and buy SBUX at $15.

Hence, a Call Ratio Spread, allows a trader to profit, in these scenarios :

a) when the underlying rallies up to just before breakeven point
b) when the underlying stays unchanged by expiration
c) when the underlying drops in price, modestly or even to $0 value

This Call Ratio Spread is profitable in just about all possible price movements, except for a sudden and major gap up beyond the breakeven point. Then, in this case, the losses can be theoretically unlimited.

Hence, for most seasoned traders, Ratio Spreads is always among the arsenal of option strategies they employ.

+1/-2 SBUX 15/16 Call Ratio Spread P/L Chart

Bull Spread - Cylinder

2008-09-09T08:46:00.000-07:00

Long Call and Short OTM Put - aka Cylinder

A Bull Spread, as the name implies, is bullish bias and a directional option strategy.

When to use : Bullish Trend
How to establish : LONG a Call and SHORT OTM Put
Debit or Credit : Debit
Margin Requirement : Yes
What is the Maximum Profit : Unlimited
What is the Maximum Loss : Unlimited (theoretically)

Example :

SMN Ultrashort Basic Materials Proshares is currently trading at $46 You believe that there is a bullish trend to this ETF. You wish to ride the trend to the maximum.

You could just simply buy a Call option on SMN, which will give you unlimited profit potential if SMN price rallies extraordinarily. However, you are concerned about time decay on this Long Call position. The current implied volatility is at about mid point of it's historical low and high. Hence, this Long Call may not be overpriced.

However, you are so bullish on this ETF, you truly have reasons to believe that this ETF will very likely continue on its upward movement. Hence, you do not expect this ETF to drop substantially in the short term.

So, you decide that Long SMN Octt45 Call and Short Octt40 Put, this is known as a Long Call, Short Put combo (aka as a Cylinder)

This position is similar to a Long Oct 45Call, in terms of unlimited profits potential. For this privilege, you pay a premium of 4.30. This is costly considering that 3.30 * out of this 4.30 is extrinsic (or time value), which will decay in some 38 days. To mitigate this time decay, you decide to Short a Oct 40Put and receive 1.10 credit. But nevertheless, this trade is a Net Debit position, meaning you pay a fee for this Cylinder. In this case, you will pay 3.20 (4.30 - 1.10)

*Side Note : Extrinsic Value of Call option= Option Price (4.30) - {SMN price (46) - Strike Price (45)} = 3.30

Position yields a breakeven when SMN trades above 48.20 (45 + 3.20) at expiration. As mentioned, since this is a really just a Long Call (but funded by a Short OTM Put), the profit potential is unlimited.

However, nothing in trading is a free lunch. Due to the 1.10 premium collected from the Short Oct40Put, the potential loss of this position is unlimited, well at least theoretically. If SMN for any reasons, drop to $1 at expiration, the losses will be $39/share + the Net Debit amount paid.

Remember, a Short Oct40Put obligates you to BUY SMN ETF shares at $40/share, if this stock drops below $40. This is american style option, and so, assignment can happen and WILL happen as soon as SMN trades below $40. Don't ever doubt that someone will insist on selling you SMN at $40/share. A Short ITM Put, will always be assigned.

Therefore, you MUST be prepared to add SMN into your stock portfolio, when you choose this Cylinder strategy. Afterall, this should not be a conflict with your bullish view of this ETF.

Finally, note that Oct40Put has a Delta of ~0.21. Recall that Delta is a rough gauge of the probability of that option getting ITM by expiration. Thus, you must understand that the probability of this Short Oct40 Put has a 21% chance of being ITM by Oct expiration. This also means that you have roughly a 79% chance in your favour.

Profit/Loss Explanation :

(you will have to assume these option prices are correct)
Debit (means you pay) for Long Oct 45 Call = -4.30
Credit (means you receive) for Short Oct 40 Put = 1.10
Total Debit = - 3.20

Maximum loss scenarios :
if SMN trades between 40 - 45 at expiration = 3.20
if SMN trades below 40 at expiration = loss is potentially unlimited

Maximum profit = SMN trades above48.20 (above 45 Call + 3.20 debit paid)

Risk/Reward Ratio = this is a high risk and correspondingly high returns trade

Long Oct45Call and Short Oct40Put P/L Chart

Option Delta - Revisit

2008-09-08T05:29:00.000-07:00

Option Delta - The Probability of an Option Expiring ITM

The simplest way to use Delta, is to view it as :

The probability of that option expiring In-The-Money

Example of SPX OTM, ATM and OTM Puts and Calls

SPX is traded at 1242 as of 5th Sept 08.

Note that Sept 1240 Put and Call, which represents Near-The-Money, but for ease of explanation, let's just say they are both ATM Put and ATM Call.

These ATM options have close to 0.50 delta (ignore the +ve and -ve signs). This means that these ATM options have ~50% chance of being ITM by the expiration date. It makes sense, since SPX last traded at 1242, can only move up or down and all things being equal, SPX has a 50-50 chance of going either way. The ATM options reflect this probability.

Now look at the deep ITM 1180 Call, it's delta is 0.92 or a simply a 92% chance, given all things being equal, that by expiration, this 1180 Call will remain In-The-Money. Remember that this Sept Options have only 10 more days to expiration. This is a meaningful interpretation because, ITM 1180 Call strike being 62 points deep ITM currently, does obviously have a much better chance of remaining ITM by expiration as compared to OTM 1300 Call strike, which has a mere 12% (delta of 0.12) of being ITM in 10 days' time.

For this OTM 1300 Call strike to be ITM, SPX must rally past 1300 in the next 10 days. Whereas, SPX just needs to stay rather unchanged or can even dive in the next 10 days, and yet the 1180 Call strike will still be ITM, as long as SPX stays above 1180. Between the 2 options, the ITM 1180 Call, has 2 out of 3 scenarios covered and hence a higher probability of staying ITM by expiration and thus a much higher Delta of 0.92

Hence, as a back-of-the-envelope review, an option's probability of becoming ITM by expiration, can be obtained by simply looking at the option Delta.

Option Delta - Absolute Put and Call Deltas Add Up to ~1

The 1240Call has 0.53 and the 1240Put has 0.47. Note, that +ve or -ve Delta is NOT a function of whether it is a Put or Call.

The example shows -0.47 for 1240Put, only because it is saying that a LONG Put, a bearish position, will generate a -ve 0.47 Delta.

Note that the absolute values of ATM 1240 Call and ATM 1240 Put, add up to 1; ie

|0.53| + |-0.47| = 1

In fact, if SPX was traded at 1240 exactly, these ATM 1240Call and ATM 1240Put would each have a delta of 0.5, and will practically add up to a full integer 1.

This is also the reason that a Straddle, which is a Long ATM Call and Long ATM Put position, will not be profitable, when only a small movement occurs. A perfect straddle, has exactly ZERO delta; the Long ATM Call option has +ve0.5 and the Long ATM Put option has -ve 0.5, and the combined position, results in an absolute 0 delta value. Thus, for Straddles to be profitable, a huge move must occur in either direction.

However, notice that both the deep OTM Call (1180) and deep ITM Put (1300) options, and conversely ITM Call and OTM Put options, their corresponding Deltas do not absolutely add up to 1.
The reason is that these OTM/ITM option Deltas are artificially affected by Implied Volatility, Gamma and +ve/-ve PutCall Volatility skew. This is a topic for another day.

But suffice to say that the Straddle's delta changes because the Gamma of the Call and Put options change when the underlying starts making large price movements. This Gamma then causes the Straddle to either net gain or lose Delta, which translates to profits.

Bull Spread - Short Put Spread

2008-09-03T23:33:00.001-07:00

Bull Spread

Short Put Spread

When to use : Neutral to Bullish Trend (this captures 2 out of 3 possible scenarios)
How to establish : Short a Put and Long a lower strike Put
Debit or Credit : Credit
Margin Requirement : Yes
What is the Maximum Profit : Amount of credit received (limited)
What is the Maximum Loss : Amount between the 2 strike prices less credit received (limited)

Example :

GOOG is currently at $466.10 in early Sept
You expect GOOG to rally and have reasons to believe that it is well supported at $450, in the near term.
You choose options as it is too capital intensive to pay $46,610 for 100 shares of GOOG.

You could just simply sell a Sept 450Put option on GOOG and receive a premium(credit) for this sale. If GOOG's share price stays rather stable until option expiration, you benefit from time decay; ie you gain theta as time passes. If it rallies, then you profit from the decline in the Put's value.

But, you are worried that GOOG's shares price may suddenly drop drastically below $450, you will suffer (theoretically)unlimited losses. In fact, should GOOG's shares price ever drop catastrophically to $0, your losses will be equivalent to losing $450 per share. So, if you had sold just ONE contract of 450Put, your losses will be $45,000. This is no joking matter. But it would be a joke if GOOG shares become worthless.
Remember that one should not consider Short Put positions, if one is not prepared to purchase the stock at that Short strike price

Therefore, all naked short positions, whether Put or Call, and especially Short Call, can be HIGH risk trades. Traders must very closely monitor all naked (aka uncovered) Calls and Puts.

Hence, to mitigate the risk of a naked Put, you purchase a Sept 440 Put (just in case shit does hit the fan). The risk is mitigated because you will be insulated from further downside beyond $440. Your Long 440Put effectively serves as a "protective Put". This combination of Long and Short Puts, is known as a Short Put Spread.

This Short 450 Put position, obligates you buy GOOG at $450 and the Long 440 Put conveys you the right to sell it at $440. In return for this seemingly unfavourable trade, you receive a premium (equal to the amount of credit paid to you). In this example, the credit is 2.70. This credit compensates you for the risk involved in potentially buying high and selling low. Hence, a reward this risk assumed when you establish this Short Put Spread.

Position yields maximum profits when GOOG shares are at or above 450 at expiration, because this will render the all the Puts worthless. The maximum profit potential is the credit received; ie 2.70. The breakeven point for this trade, at expiration, is 447.30 (450 - 2.70). Hence, at expiration, if GOOG settles anything below 447.30, a loss will incur. The maximum losses is limited to 7.30 (450-440-2.70) because when GOOG trades below $450, you would be obligated to buy GOOG at $450 and have the right sell it at $440, a potential loss of $10. But, since you have already been credited $2.70 for this Short Put Spread, the maximum damage is reduced by this amount.

((an important note about Short Put Spreads : Consider that GOOG shares subsequently trades below $450 but higher than $440 any time before and up to expiration date. You will very likely be assigned 100 shares for every ONE contract of 450Put option sold. This means, you will need to have $45,000 in your account or if your broker grants you some leverage, a smaller amount is still nevertheless required to buy this 100 shares of GOOG at $450/share.
If this happens, you will end up with LONG 100 GOOG shares and a Long 440Put option position. If GOOG rebounds without going below $440, then your Long 440Put will expire worthless. This makes sense because you will most certainly not want to exercise your right to sell GOOG at $440 when you can sell them in the open market for a higher value.

In other words, for all Short Put Spreads, there is always the chance that you will be assigned with shares you are obligated to buy at a higher strike price, yet you may not necessarily want to exercise your right to sell those shares at a lower strike price. Please understand this assignment risk very well))

Profit/Loss Explanation :

((you will just have to assume that these option premiums are accurate))
Credit (means you receive) for Short Sept 450 Put = 8.60
Debit (means you pay) for Long Sept 440 Put = -5.90

Total Credit = 2.70

Maximum loss = 7.30 (440 - 450 + 2.70)
Maximum Profit = 2.70
Breakeven point = 447.30 (450 - 2.70)
Profit Range = anything at and above 447.30

Risk/Reward Ratio = 6.30 / 2.70 = 2.7; ie you risk 2.7 for a profit potential of 1.00 (but remember, you win in 2 of 3 scenarios. in fact, you can still profit if shares drop slowly but stays above 447.30. hence making the probability of a successful trade in 3 out of 4 cases)

The profit and loss is illustrated using the chart below

Bull Spread - Long Call Spread

2008-09-03T23:32:00.001-07:00

Bull Spread

Long Call Spread

When to use : Bullish Trend
How to establish : LONG a Call and SHORT a higher strike Call
Debit or Credit : Debit
Margin Requirement : No
What is the Maximum Profit : The distance between the LONG and SHORT Strikes (limitted)
What is the Maximum Loss : Amount paid (the debit) for the spread (limited)

Example :

RIMM is currently at $121.10 in early Sept
You expect RIMM to rally and have reasons to believe that it will have the potential to increase its share price to a maximum of $130, in the near term.
You then contemplate a bullish option position, since it is too capital intensive to pay $12,110 for 100 shares of RIMM.

You could just simply buy a Call option on RIMM, which will give you unlimited profit potential if RIMM price rallies extraordinarily. However, you are concerned about time decay on this position that is soon expiring. The current implied volatility is also high given a volatile market in the recent days. These 2 GREEKS will work against a simple Long Call position. Besides, it is also expensive to just buy a Call option.
Fyi, 1 contract of option is equal to right to trade 100 shares of the stock.

So, you decide to purchase a Sept 125 Call and sell a Sept 130 Call option spread. This is effectively, a Long Call Spread.

This Long Call Spread, gives you the right to buy RIMM at $125 and the potential to sell RIMM shares at $130, for which you pay a premium (equals to the amount of debit paid for this spread)

This position is similar to a Long Sep125 Call, but limits its upside profit potential when RIMM reaches $130. Consequently, for this reduced profit potential, you pay a smaller debit for this spread, and hence reduce your risk for this trade. Makes sense, since lower reward must be matched by a lower risk.
In this example, the premium(debit) of this spread is 1.50 (i shall only use unit rather than actual $ amount in all my examples)

Position yields maximum profits when RIMM shares are at or above 130 at expiration. The maximum profit potential is 130 - 125 net off debit paid. The breakeven point for this trade, at expiration, is 126.50 (125 + 1.50). Hence, at expiration, if RIMM settles anything below 126.50, a loss is experienced. The maximum losses will be limited to the premium of 1.50 paid and happens RIMM shares falls below 125 at expiration.

Profit/Loss Explanation :

(you will have to assume that these premiums are accurate)
Debit (means you pay) for Long Sept 120 Call = -3.30
Credit (means you receive) for Short Sept 130 Call = 1.80
Total Debit = 1.50

Maximum loss = 1.50
Maximum Profit = 3.50 ( 130 - 125 - 1.50)
Breakeven point = 126.50
Profit Range = anything at and above 126.50

Risk/Reward Ratio = 1.50 / 3.50 = 0.43; ie you risk 0.43 for a profit potential of 1.00

The profit and loss is illustrated using the chart below

What is an Option Delta ?

2008-09-03T11:30:00.000-07:00

Before proceeding to advocate the other strategies, let's pause to review the significance of a Greek, namely Delta...

What really is Delta?
This is what determines the amount of change to the option price with 1 point movement of the underlying.

When is Delta Positive and Negative?
Every option, both Calls and Puts, is assigned a delta figure. It ranges from -1 to +1.

For bullish positions, delta will range from 0 for deep Out of The Money (OTM) options to +1 for deep In The Money (ITM) options, while those At The Money options (ATM) will have a 0.5 delta.

Conversely, bearish positions, will yield -1 for deep ITM options, while ATM options will give assigned a -0.5 delta and those OTM options will have 0 delta.gains $0.04; pretty insignificant. But, it makes sense because it is so far OTM.

To illustrate this concept, let's assume IWM is now trading at $74.

A Bullish position, such as a LONG deep ITM Sep61Call, will have +1 (or very very near this integer)
Another bullish position, such as a SHORT deep ITM Sep90Put, shows a +0.925 (pretty close to +1 as well)

From the above, you will appreciate that whether the delta is positive or negative, has nothing to do with whether the option is SHORT or LONG. This is a common misunderstood fact, that can cost many bullish traders to lose money even when market rallies. It may sound impossible, but it can happen.

Hence, in a gist, whether the delta of your position is positive or negative, is dependent on whether it is Bullish (positive delta) or Bearish (negative) position.

How Does Delta Affect Option Price?

Long IWM Sep61Call (bullish position), now has +1 delta and is priced at $13.15. When IWM moves up by $1, this Call option will correspondingly move up to $14.15, exactly increasing by $1 as well. If IWM drops by $1, so will this option fall by exactly $1. The reason, it has a Delta of +1. It is hence, a 1 to 1 option to stock price movement relationship. Therefore, this call option behaves like IWM shares.

Long IWM Sep74Call, which is about ATM strike, now has a delta of 0.53 and is priced at $1.67. When IWM moves up by $1, this long call option will only increase by $0.53 and correspondingly, falls by also $0.53 if IWM drops by $1.

Short IWM Sep66Put (a OTM bullish position), trades for $0.08 and has a delta of 0.04. Note that, even while this is a SHORT position, it still has positive delta. This means, IWM increases by $1, this position will increase by only $0.04. But it makes sense, because this option is so far OTM.

The table below summarizes the polarity of Delta for Bullish and Bearish positions.

Overview of Option Strategies

2008-09-03T05:40:00.000-07:00

Option Spreads

often, we can make sound assessment on where an underlying maybe heading towards but quite lacking the correct skillsets to capitalize on that judgement.

for most investors/traders, buying or shorting stocks, indexes, ETFs, even commodities are just about the only ways to engage the market.

fortunately, Options as the derivative, can be deployed in more ways than one, either to manage portoflio risks, obtaining acceptable risk/reward returns, or simply to profit, and thus may be used as an alternative investment vehicle to trading the actual underlying.

over time, i hope to dwell into each of these Option Spreads and strategies, postulate when each can be deployed under different market conditions, their associated risks, rewards and profit potential. meanwhile, below lists the various Option Spreads and suggests which ones can be deployed under 4 different market conditions.