Option Strangle Magic » Options Trading Strategies

Online Options Trading â Portfolio Measures and Trade Performance Metrics

admin — Wed, 06 Jan 2010 21:52:50 +0000

The Reward of Profit and the Risk of Losses for retail option trading needs to be managed at 2 related levels of performance: Portfolio and Trade Specific.At the Portfolio level for online options trading, there are 3 types of Targets that must be set, even before you trade.Maximum Return Target: complete achievement of the âidealâ measure. Dream of the âidealâ that stretches you beyond what is practical. For example, earn 2-3 times your monthly living expenses with the monthly trading profit. This is to stretch your imagination well beyond mediocrity. Even if you fail, you just might end up with more than your original target.Minimum Return Target: the lowest acceptable measure, achievable under most conditions, excluding a catastrophic market event. Use the historical annualized return of the S&P 500 between 10%-12% (prior to the 2008 financial pandemic), as the lowest acceptable boundary.Â The S&P 500 being a widely accepted benchmark for trading equities is adequate to base the minimum target off, though your portfolio needs to be profitable â being ahead of the $SPX in negative territory does not count.Â Below the historical annualized return range of 10%â12%, is the 3 Month T-Bill, presently near zero.Â While the T-bill theoretically represents an âabsolutelyâ zero risk investment, even the safest investments will still carry a residual amount of risk no matter how small that risk is.Â The point is this.Â You got into options and all that Greek terminology, not to make salads; but to beat the performance of equities as an asset class.Â If your portfolio’s return is between what is near zero-risk and 10%â12% per annum, you are just delaying reaching a point of pain that marks failure in grasping the base-line ability to control risks.Â If the returns of your portfolio are between 0%â12% and you plan to continue trading options, processes within your trading process will need to be reâengineered.”Halt Trade” Target: cumulative losses reach an absolute amount below the Minimum Return, making it necessary to stop trading altogether for a stated period.Â 10% of [(60% x Cash Balance at the start of the year); or Net Liquidating Value].Â Example, for a $50,000 trading account, 10% x (60% x $50,000) = $3,000 of losses in total, is the absolute amount to halt trading.Â Why 10%? Blowing up your self-funded capital is final.Â There is no bail out package, as a home options trading business does not have access to bank loans; or, shareholdersâ equity to finance your personal trades.Now, drilling down to Trade Specific performance measures.Even before you calculate the metrics, characteristically, what makes for a consistently managed portfolio are these traits:

Where can I see this step up function in a consistently profitable portfolio, with these portfolio measures and trade performance metrics? Follow the link below, entitled âConsistent Resultsâ to see a model retail option traderâs portfolio that shows these traits.Moving onto the hard metrics.Â Thereâs 2 ways to count the Return on your trading capital.

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

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

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

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

Advantages and Disadvantages of At-the-money Option, In-the-money Option and Out-of-the-money Option

admin — Tue, 15 Dec 2009 21:52:58 +0000

An at-the-money option has both advantages and disadvantages over stock and in-the-money options. First, the at-the-money option will be cheaper then both the stock and the in-the-money option. So there is less capital requirement and less total risk.

Remember, when buying an option, you can only lose what you spend. The problem is the amount of extrinsic in the at-the-money option.

In order for you to profit from buying an at-the-money option, you need the stock to make a move very quickly. Because you have so much extrinsic value, you will be battling against the option?s daily rate of decay.

So, the movement of the stock must happen quickly enough and large enough to offset the amount of money you will be losing daily as expiration draws near.

With this said, the best chance you have to make money when buying a naked at-the-money option is to use it as a short term trade. The longer you hold onto this option, the harder it is for you to be profitable due to the options decaying extrinsic value.

At The Money Call vs. In The Money Call

An out-of-the-money option presents many of the same advantage & disadvantage parameters to the investor. The out-of-the-money option is even cheaper then the at-the-money option which means more leverage and less risk.

However, with a smaller delta, the stock must move much more than either the in or at-the-money options in order for the options to become profitable. Again, we need the option?s delta to outpace the option?s rate of decay.

Now, with the out-of-the-money option, there is less extrinsic value than the at-the-money option so the amount of total possible decay (cost of the option) and the rate of this decay is less than the at-the-money option.

By being further out-of-the-money, this option needs more movement from the stock. As a naked option, this out-or-the-money example is extremely speculative and should only be used naked when the investor feels there is a very good chance of a stock having a large percentage move.

An investor must understand that the odds of them profiting from the purchase of a naked out-of-the-money option is very slim. When purchasing a naked out-of-the-money option, be prepared to lose your entire investment.

Out of The Money Call vs. At The Money Call

Although options can be traded by themselves for directional plays, and can perform well under the right conditions, they are much better used in coordination with stock or other options in formatted strategies which will be discussed in the next section.

While buying naked calls and puts can provide some of the biggest leverage and highest returns, they can also involve the most risk. This strategy should only be used by experienced options traders or traders using risk capital.

Options Trading Mastery: Time Decay and Volatility Trading Opportunities

admin — Tue, 15 Dec 2009 10:05:41 +0000

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

Factors that Affect Strangle Prices

admin — Fri, 04 Dec 2009 09:24:37 +0000

Since the Strangles’ profit potential is dependent on its price from purchase time to expiration, the investor should be aware of the several factors that affect the Strangles’ price.
Stock Price
The first is, of course, stock price. The stock’s price will dictate the value of both components of the Strangle – the call and put thus affecting the Strangle price as a whole. As the stock price moves, the prices of the call and the put will fluctuate via the current Deltas of the options and thereby affect the price of the Strangle.
As the stock moves higher, the price of the call will increase while the price of the put will decrease. However, they do not move linearly meaning that as the stock continues higher, the call’s value increases progressively more while the put’s value decreases progressively less. The option’s changing Delta causes this non-linear effect.
The call Delta increases as the stock goes up while the put Delta decreases as the stock goes up. This opposing effect continues until finally the call gains value dollar for dollar with the stock (once its Delta reaches 100) indefinitely. At the same time, the put value-loss stops because the put now has no value (as put Delta approaches 0). Of course, the opposite is true if the stock trades down.
The call will lose value progressively slower until it reaches $0 while the put will gain value at an increasing rate until the Delta becomes 100 and then the put will gain dollar for dollar with the stock indefinitely. The effect of stock movement on the dollar value and Delta value of the Strangle is in the chart below.
Again, we will use the July 60/65 Strangle as an example. The Strangle will be worth $3.31 ($2.11 for the call, $1.20 for the put). For clarification, these prices are not expiration prices. This Strangle has three weeks to go before expiration.
Stock $ Call $ Call Delta Put $ Put Delta Strangle $
55.50 .23 7 5.23 -76 5.46
57.50 .42 15 3.86 -62 4.28
59.50 .78 24 2.74 -50 3.52
61.50 1.35 34 1.85 -38 3.20
63.50 2.11 45 1.20 -28 3.31
65.50 3.13 56 .74 -19 3.87
67.50 4.35 66 .44 -13 4.79
69.50 5.77 75 .25 -08 6.2
Implied Volatility
A second factor that affects the pricing of a Strangle is implied volatility. As implied volatility increases, the value of the Strangle increases. As stated, the price of both calls and puts increase as implied volatility increases.
A Strangle will feel an increased effect when volatility increases because the strategy employs two options working together and not against each other. When a strategy uses two options working against each other, the effect of implied volatility on the strategy is the difference of its effect on each option. This is different from a Strangle. With a Strangle, the two options are working together combining the effect of implied volatility on each option.
Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option’s volatility sensitivity component or Vega. An option with a $.05 Vega will increase five cents in value for every tick that implied volatility increases and likewise will decrease in value five cents for every tick that implied volatility decreases.
Because the Strangle combines a call and a put, the Vega value of the call adds to the Vega value of the put. This means that the Vega of a Straddle is the sum of the Vega of the call plus the Vega of the put.
Look back at our example. If the July 65 call has a .10 Vega and the July 60 put has a .07 Vega then the July 60/65 Strangle will have a .17 Vega. This means that for every tick that implied volatility increases, the July 60/65 Strangle will increase $.15 in value.
Conversely, for every tick that volatility decreases, the July 60/65 Strangle will decrease in value. The chart below shows how the Strangles’ value changes at different implied volatility levels.
Stock Price Vol. Level Call $ Put $ Strangle $ Strangle Vega
63.50 30 2.11 1.20 3.31 .168
63.50 40 3.02 1.97 4.99 .173
63.50 50 2.92 2.80 6.72 .174
63.50 60 4.83 3.63 8.46 .174
63.50 70 5.73 4.46 10.19 .174
When you study the chart, you can see that as implied volatility increases or decreases the value of the Strangle increases or decreases by the amount of the Strangles’ Vega multiplied by the amount of tick change in implied volatility.
Time
Finally, time is another major factor affecting the price of a Strangle. As you have learned from our previous strategies, time takes a toll on all options. Its effect is even more pronounced on this strategy that combines two options for the same time period.
A Strangle will see a much higher rate of decay than a single option. From previous discussions, we should be familiar with the option decay chart and its non-linear curve. As time goes by, the Strangle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m. The implication to the buyer and seller should be obvious.
The passage of time decreases the value of the Strangle and thus always favors the seller. Time works against the buyer. The buyer has only until expiration to get either a large stock or implied volatility movement to offset the price paid for the Strangle.

How to Trade Options – Book Review – Lawrence G. McMillan, McMillan on Options

admin — Wed, 02 Dec 2009 23:09:02 +0000

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

Options Trading Mastery: An Imaginary Spread Scenario

admin — Wed, 02 Dec 2009 09:10:10 +0000

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

Options Trading Strategies â Intermarket Analysis in Brief for Retail Asset Allocation

admin — Tue, 01 Dec 2009 14:17:31 +0000

If you are trading a mix of Verticals, Calendars and Iron Condors across highly liquid indexes like the DJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP, is your trading risk adequately diversified? No.In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes.Â Bear in mind the MNX and the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index.Â Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP – both the SPY and the XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled.Â Duplication is not diversification.Â Even if you allocated capital to the smaller versions of the Dow: DJX, the European style cash settled version of the DIA which is the American style stock settled version.Â Moreover, if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and away from large-caps, you just sunk more of your trading capital into equities.Â Again, you cannot achieve diversification by adding more capital in the same asset class.Â You need to learn how to trade options without concentration risk in stocks.Â Do not confuse asset category (market capitalization) with asset class.This is where there is a need to understand Intermarket relationships.Â Intermarket analysis requires the simultaneous analysis of 4 main Asset Classes: Currencies (U.S. Dollar remains most liquid of all major traded currencies), Commodities, Bonds and Stocks.Â Synchronizing the rotation of asset allocation within your own portfolio lies in getting a grip on how these four markets interrelate with each other.Hereâs the synopsis of the relationships.Â Commodities lead bonds, bonds lead stocks and stocks lead commodities.Â The cycle holds true at least in a normal inflationary/disinflationary environment.Â Other than itself, Commodities affects 2 markets (Bonds and Stocks); effectively, impacting 3 out of the 4 Intermarket relationships.Â Even if you do not trade Commodity ETFs as part of your portfolio, you need to track Commodities as a leading economic cycle indicator.Â The futures/Mini Futures that you see on news headlines/trading screens are relevant only as daily gauges for stock market behaviour.Â They are not a cycle indicator across Asset Classes.So, you may already understand the criteria to define a “normal” economic cycle for the Directional Relationships to behave “ideally” (see below); BUT, how do you determine which Asset Class is driving the cycle? In other words, at a given point in the Intermarket cycle, how do you determine which Asset Class has the DOMINANT Relative Strength to trade? Follow the link below for a video-based course, to learn how Relative Strength – a rotational algorithmic measure is used to replace conventional Fundamental Analysis, as an asset allocation technique.Moving on, hereâs the Business Cycle in brief.Â Bonds lead stocks, to trend in the same direction â except during deflation when bonds rise and stocks fall.Â On average bonds are 18 months ahead of stocks in rising to their peak or falling to their bottoms; thereafter, stocks follow in the same direction.Â If bonds have not broken down yet, this extends the gains in the stock market, acting as support for prevailing stock market levels.Â The real risk begins to build 5-7 months after the bond market peaks or bottoms, thereafter the next 6 months stocks accelerate in the direction bonds have set.Typically, commodities and bonds have an inverse relationship: as commodities rise, bonds falls but as commodities fall, bonds rise. Inflationary expectations affect bond prices. US Dollar movements which is tied into Monetary Policy changes affects commodity prices.Â Commodities lead bonds 12â18 months in advance (it takes this long for Monetary Policy to come into effect) and 24â27 months before the economy fully absorbs the policy changes.Now, the relationship between commodities and stocks. Stocks tend to lead commodities. Commodities are a hedge against inflation, with price inflation and higher inflation expectations occurring towards the end of the business cycle.Money and company growth using credit (loans) takes time to make its way through the economic system, from making prices rise to raising expectations on inflation. Thus, commodities usually outperform at the end of the business cycle.Rising bond prices generally raise stock prices in recovery, with falling commodity prices confirming an economic expansion phase is in play. As the expansion matures and begins to decelerate, watch for bonds to turn down first (as interest rates rise), followed by stocks.Finally, it is after commodities outperform stocks and start turning down, this signals the end of an economic expansion with the probable start of activity decelerating, then slipping into an impending recession.Retail traders can keep reading about the economics of interâmarket analysis and asset diversification. Though, they will not solve these key issues, every option trader trading with USD $25-$50K or less, must deal with for retail asset allocation purposes:

… if you can afford to diversify …

Where can I learn how to trade options profitably using Intermarket analysis with retail asset allocation methods? Follow the link below, entitled âConsistent Resultsâ to see a profitable retail option traderâs portfolio that is set up to cycle in and cycle out of Intermarket relationships, between asset classes.Why is it possible? Iâm using optionable ETFs (Commodity, Currency, Emerging Market and REIT), as well as optionable broad based/sector Equity Indexes, to trade the volatilities of each respective asset class. I do not need to trade Commodities and Currencies directly.Â Remember, volatility can be added to/reduced from the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or, ALL at the same rate.

Options Trading Strategies – Book Review – Sheldon Natenberg, Option Volatility and Pricing

admin — Mon, 30 Nov 2009 13:43:04 +0000

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

Options Trading Strategies – Book Review – Guy Cohen, The Bible of Options Strategies

admin — Sun, 29 Nov 2009 21:16:59 +0000

Most trading literature on option strategies tend to lean towards mathematical formulas to define the construction of a spread. Guy Cohen has chosen to use pictorial logic, even with the Greeks unique to a particular strategy, to piece together the legs of a spread with diagrams.Diagrams that connect with each other are a much more intuitive way to learn for those less inclined to numerical formulas. Still, the logic of the math remains robust and intact. The layout of the book makes it easy to navigate around the text. In addition to strategies being listed by the chapter and page there is a reference to the strategy’s main category with sub-categories, which are:

Guy Cohen has extensive experience of both the US and UK derivatives and stock markets. He specializes in trading and analytics applications ranging from real estate to derivatives and has developed comprehensive business, trading and training models, all expressly designed for maximum user-friendliness. There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number. The percentages represent how much each chapter makes up of the 302 pages in total, excluding appendices.1 The Four Basic Options Strategies. 20, 6.62%.2 Income strategies. 68, 22.52%.3 Vertical Spreads. 30, 9.93%.4 Volatility Strategies. 56, 18.54%.5 Sideways Strategies. 44, 14.57%.6 Leveraged Strategies. 20, 6.62%.7 Synthetic Strategies. 54, 17.88%.8 Taxation for Stock and Options Traders. 10, 3.31%.Focus on chapters 2, 4, 5 and 7, which makes up about 74% of the book. These chapters are relevant for practical trading purposes. Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective. Chapter 2: Income Strategies. These strategies construct spreads where part of the spread sells Theta as premium within a shorter term (typically 30-45 days), to collect income. In its entirety the strategy may result in a Net Debit or Net Credit spread. There are 13 types of spreads in this category: Covered Call, Short (Naked) Put, Bull Put Spread, Bear Call Spread, Long Iron Butterfly, Long Iron Condor, Covered Short Straddle, Covered Short Strangle, Calendar Call, Diagonal Call, Calendar Put, Diagonal Put and a Covered Put (a.k.a. Married Put).Chapter 4: Volatility Strategies. These strategies use spreads that are indifferent to price direction, so long as price explodes out of range. For a given explosion in price, the volatility of the spread needs to rise for a Net Debit spread and fall for a Net Credit spread,. There are 11 spread types are defined in this category: Straddle, Strangle, Strip, Strap, Guts, Short Call Butterfly, Short Put Butterfly, Short Call Condor, Short Put Condor, Short Iron Butterfly and Short Iron Condor.Chapter 5: Sideways Strategies. These strategies involve non-directional spreads, requiring price to drift within a confined range. As price remains range bound, the volatility of the spread needs to rise for a Net Debit spread and fall for a Net Credit spread. There are 11 types of spreads in this category: Short Straddle, Short Strangle, Short Guts, Long Call Butterfly, Long Put Butterfly, Long Call Condor, Long Put Condor, Modified Call Butterfly, Modified Put Butterfly, Long Iron Butterfly and Long Iron Condor. Chapter 7: Synthetic Strategies. Synthetic strategies mimic the risk profile of a stock, futures or other option position by combining calls, puts with or without stock. Though typically, most synthetic positions are either long or short stock. If you have a 401K plan or employee stock purchase plan that is long stock, then it may make sense to consider synthetic strategies, as you are already long Delta. There is unlimited risk for some synthetic spreads, regardless if the strategy involves stock or not. There are disadvantages to using synthetics. 12 spread types are defined in this category: Collar, Synthetic Call, Synthetic Put, Long Call Synthetic Straddle, Long Put Synthetic Straddle, Short Call Synthetic Straddle, Short Put Synthetic Straddle, Long Synthetic Future, Short Synthetic Future, Long Combo, Short Combo and Long Box.From a retail option trader’s viewpoint, I prefer to establish positions without the use of stock. Using stock synthetically in a position makes each trade more capital intensive than it needs to be. Especially, if your trading account is below USD $50,000. The use of stock in configuring these positions does not add material merit in controlling risk and there is no added monetary benefit in tying up available trading capital in a stock-dependent synthetic position that could otherwise be achieved without the use of stock. As an options trader in the first place, you want as little to do with the stock itself as possible, other than to configure the required option position around the underlying product, which can be substituted with a cash-settled Index instead of a stock-settled Index.Out of a total of 56 strategies covered in the book, I have reduced the list down to 35 Limited Risk Spread types that do not need to include stock as part of its original construction. Limited Risk means there is a cap to the maximum loss – “Capped Risk” is the term used in the book. This should always be the starting point of any strategy you choose to construct. Do not just look at the unlimited profit (Uncapped Reward) side of the strategy without realizing that there is an unlimited loss (Uncapped Risk) side to same strategy.Limited Risk Spreads with “Unlimited” Reward and their Directional outlook.1. Long Call. Bullish.2. Long Put. Bearish. 3. Put Ratio Backspread. Bearish; reverse Bullish.4. Call Ratio Backspread. Bullish; reverse Bearish. 5. Straddle. Indifferent/~Neutral.6. Strangle. Indifferent/~Neutral.7. Strip. Bearish.8. Strap. Bullish. 9. Guts. Indifferent/~Neutral. 1-9 are Debit spreads: IV needs to rise.10. Bull Put Ladder. Bearish. 10-11 are Credit spreads: IV needs to fall.11. Bear Call Ladder. Bullish. Limited Risk Spreads with Limited Reward and their Directional outlook.12. Bear Put Spread. Bearish.13. Bull Call Spread. Bullish.14. Long Call Calendar. Bullish; Indifferent/~Neutral.15. Long Put Calendar. Bullish; Indifferent/~Neutral.16. Long Call Butterfly. Indifferent/~Neutral.17. Long Put Butterfly. Indifferent/~Neutral.18. Long Box. Indifferent/~Neutral.19. Long Call Condor. Indifferent/~Neutral.20. Long Put Condor. Indifferent/~Neutral.21. Long Iron Butterfly. Indifferent/~Neutral.22. Long Iron Condor. Indifferent/~Neutral. 12-22 are Debit spreads: IV needs to rise.23. Bear Call Spread. Bearish. 23-35 are Credit spreads: IV needs to fall.24. Bull Put Spread. Bullish.25. Short Iron Butterfly. Indifferent/~Neutral.26. Short Iron Condor. Indifferent/~Neutral.27. Diagonal Call. Bearish.28. Diagonal Put. Bullish.29. Modified Call Butterfly. Bearish to ~Neutral.30. Modified Put Butterfly. Bullish to ~Neutral.31. Short (Naked) Put. Bullish.32. Short Call Butterfly. Indifferent/~Neutral.33. Short Call Condor. Indifferent/~Neutral.34. Short Put Butterfly. Indifferent/~Neutral.35. Short Put Condor. Indifferent/~Neutral.Other than the 35 Defined Risk Spreads that do not require stock as part of their original construction for entry, there are 6 Defined Risk spreads that need stock to configure their positions. The 6 positions that I have deliberately excluded from the list above are the Long Call Synthetic Straddle, Long Put Synthetic Straddle, Synthetic Call, Synthetic Put, Collar and Covered Call.In conclusion, for new to intermediate traders do not be overwhelmed by the 56 strategies in the book. It’s entitled the “Bible of Options Strategies” for a reason. What is critical is to get a deep understanding of the Long Call, Long Put, Short Call, Short Put, Long Vertical Call/Put, Short Vertical Call/Put and the Long Calendar Call/Put. That is the 4 Basic Options Strategies, plus the Vertical and the Calendar – the only 2 strategies that floor traders define as true spreads. The other combinations are a mixture of the basics with or without stock.

Options Trading Mastery: Vertical Spread Test Scenario

admin — Sun, 29 Nov 2009 21:16:59 +0000

Let’s put together what we’ve been talking about, develop an imaginary spread scenario and set it in real life events.
In October, let’s say that you begin to hear about IJK stock. It looks interesting, so you then use a variety of sources to learn about IJK: news, charts, outside analysts, internet research etc. From your investigations you decide that this stock is poised for a strong upward move and you’d like to take advantage of it.
However, each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.
Now is the time to investigate IJK spreads. Since you are bullish on the stock, you investigate the bullish plays of the call spreads and the put spreads. You check the pricing of both since you are aware that implied volatility and time decay will affect both your purchase price and your selling price if you decide to sell out the spread before expiration.
Let’s say that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. The spread is called Nov. 50-60. The spread’s cost is $3.50, which means you pay $3500 for the trade, inexpensive when you consider that to purchase 1000 shares of IJK stock would have cost you $50,000! Now, you wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.
First, if the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you lose the $3500 that you paid for the spread. Second, if the stock begins to move up, you first recoup your investment and then move into profits. After the stock has moved up $3.50 you are at the breakeven point. Every money advance after that represents profit.
The chart below represents the spread’s losses and gains and your total profit
This chart is based on stock prices at expiration Friday in November. Until then the spread’s value fluctuates between $0 and its maximum (the difference between strike prices) of $10.00
At any time until expiration, you can sell out of the spread but what you receive for the price may be influenced by implied volatility and time decay and that will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3500 investment is $6500.
You paid $3500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6500 profit which is a 186% return.
If you had invested $50,000 for 1000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.
For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

Option Strangle Magic » Options Trading Strategies

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Options Trading Strategies – Book Review – Guy Cohen, The Bible of Options Strategies

Options Trading Mastery: Vertical Spread Test Scenario

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