The seller of a time spread buys the nearer month option and sells the outer-month option in a one to one ratio.
In order to profit from the sale of the time spread, the seller is looking basically for two things.
First is a decrease in implied volatility.
As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.
Second, the stock can move.
As stated before, a time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread.
So, as long as the stock moves in either direction away from the strike, the seller's position could be profitable provided that time decay does not outperform the stock movement.
Time, unfortunately, never works in favor of the time-spread seller.
The passage of time hurts the seller because the nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value. That obviously produces a loss for the time spread seller. Time can neither be stopped nor turned back. It only moves forward which always hurts the time spread seller.
Increases in implied volatility are also detrimental to the potential profits of the time-spread seller.
When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long) due to the out month option's higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.
The seller, in theory, has an unlimited loss potential.
For the seller, the maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility.
As the seller, you will be long the front month call and short the out- month call. As we know, the out month call will be more sensitive to movements in implied volatility due to a higher vega or volatility sensitivity component. If implied volatility increases then the seller's short, out month option will increase more in value than will the seller's long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.
The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short.
If volatility does not decrease or the stock does not move away from the strike significantly before the seller's long option expires, he/she will be left short a naked or un-hedged option and a loss on the position. If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured. As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration.
The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.
Once the long option expires and the seller is left short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem. While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they probably will not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227
Sunday, October 18, 2009
Friday, October 16, 2009
Time Spread: Options Buyer Risk & Reward
Like most trades, time spreads have a maximum loss for the buyer.
As a buyer, you can only lose what you have spent.
If you paid $1.00 for the spread then your maximum potential loss is that $1.00.
If you bought the spread for $2.00, then $2.00 is the maximum potential loss.
The buyer of a time spread will be purchasing the out-month option while selling the nearer month option of the same strike in a one-to-one ratio.
Since the out-month option will have more time until expiration than the nearer month option, the out-month option will cost more. This means the buyer will be putting out money (debit spread) which makes sense. The buyer can only lose the amount of money they spent to purchase the spread. Thus the buyer's maximum risk is the cost of the spread.
The buyer can profit in several ways.
First and foremost, being a time spread, the buyer can profit by the passage of time. Options are wasting assets. So as the nearer month option decays away more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.
Second, implied volatility can increase.
As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher vega) than the nearer month option which the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.
Third, the buyer can make money due to stock price movement.
As stated before, a time spread's value is at its maximum when the stock price and the spreads strike price are identical (at-the-money).
You could have an increase in value if you owned an out-of-the-money or in-the-money time spread, and the stock moved either up or down toward your strike.
As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.
The buyer's risks are obviously the opposite of the rewards.
You can not stop or reverse time so the buyer of the spread can never be hurt by time.
Implied volatility, however, can decrease as easily as it can increase.
A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.
In the same way that stock movement in the right direction can be profitable for the buyer of a time spread, stock movement in the wrong direction can be costly.
As the stock moves away from the spread's strike, the spread decreases in value. That will create a loss for the buyer of the spread.
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com/ or 866-561-8227
As a buyer, you can only lose what you have spent.
If you paid $1.00 for the spread then your maximum potential loss is that $1.00.
If you bought the spread for $2.00, then $2.00 is the maximum potential loss.
The buyer of a time spread will be purchasing the out-month option while selling the nearer month option of the same strike in a one-to-one ratio.
Since the out-month option will have more time until expiration than the nearer month option, the out-month option will cost more. This means the buyer will be putting out money (debit spread) which makes sense. The buyer can only lose the amount of money they spent to purchase the spread. Thus the buyer's maximum risk is the cost of the spread.
The buyer can profit in several ways.
First and foremost, being a time spread, the buyer can profit by the passage of time. Options are wasting assets. So as the nearer month option decays away more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.
Second, implied volatility can increase.
As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher vega) than the nearer month option which the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.
Third, the buyer can make money due to stock price movement.
As stated before, a time spread's value is at its maximum when the stock price and the spreads strike price are identical (at-the-money).
You could have an increase in value if you owned an out-of-the-money or in-the-money time spread, and the stock moved either up or down toward your strike.
As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.
The buyer's risks are obviously the opposite of the rewards.
You can not stop or reverse time so the buyer of the spread can never be hurt by time.
Implied volatility, however, can decrease as easily as it can increase.
A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.
In the same way that stock movement in the right direction can be profitable for the buyer of a time spread, stock movement in the wrong direction can be costly.
As the stock moves away from the spread's strike, the spread decreases in value. That will create a loss for the buyer of the spread.
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com/ or 866-561-8227
Options: How a Million Dollar Options Trader Sets His Stops: Underhanded Tips and Tricks
By: Jimmy Cox
When an options trader understand that it is important to set stops on all their positions, they often don`t know where to set them. As a options trader, how close should a stop be to price of the position they are entering? Should they be tight, set quite close to the price, or a little looser? What about trailing stops?
Here are some factors to consider that will help the options trader decide where to place your stops. Not every one of these applies to every trade, but the ones that do will give you some useful guidelines.
Perhaps the most important factor that affects stops is the question of how much you`re willing to lose on a single trade.
My rule of thumb is that the options trader should never lose more than 2 percent of your trading capital on any one trade.
Yet this can be tempered by other considerations, such as how much money you have in the position.
If you have a large amount of money in a position, 2 percent may be much more than you`re willing to lose. If so, the options trader should set stops accordingly.
However, if your account is small and you`re not well diversified, a 2 percent stop may be so tight that you stop out of the position almost immediately. If this is the case, the options trader should think seriously about whether you have enough money to trade.
Another matter to take into account is how risky you believe the trade to be.
If you think the trade is a sure winner and market conditions are favourable, the options trader may give the position more room to move.
But if you think it`s got only a fair chance of working out, or if the position has serious potential to drop, set a tight stop.
Also consider how volatile the position is.
If the position routinely moves up and down in a range of 15 percent or more over the course of the day, you can`t set tight stops. If you do, you`ll be taken out by the position`s normal volatility.
If the position is choppy and too risky to trade without tight stops, maybe you`d better look for a better position to trade.
If you have reason to be confident that the position will move upward even if it swings around a bit first, it doesn`t make sense to set a tight stop because you`ll just stop out as it swings. However, if you think it might possibly move up but will definitely drop if it slips below a certain price, then tight stops are a must.
There are also a couple of basic questions to ask yourself about the position to help the options trader decide where to place the stops.
First, is the position cheap?
When a position is inexpensive, even the smallest decimal price movement will be fairly large in percentage terms. This means tight stops may be knocked out more easily. It also means that if your broker has a rule that the options trader can`t set a stop closer than .25 below the current bid, you may not be able to set a tight stop until the price moves up.
And second, what is the time frame for the trade?
On a quick day trade, tight stops are a good idea.
On a position you expect to hold for a week or two for a trend play, tight stops may or may not be a good idea depending on other factors that you`re aware of. Market conditions should always be an important part of your decision.
If the market is trending sharply upwards, tight stops may not be necessary.
If you`re trying to go long in a bearish market, tight stops are absolutely necessary.
If the market is choppy, if it has no clear direction or if it`s full of nervousness and fear, use tight stops, and ask yourself whether you should be trading at all that day.
Which of these considerations is the most important?
Since no two trades are the same, different factors will dominate on different trades. Think about all of them on every trade. If you don`t, you`ll miss something important.
Setting stops is an art. You`ll have to experiment a bit and learn what works for you.
Occasionally the options trader may stop out of a trade too soon and feel frustrated, but remember this is just like paying for insurance. Sometimes you`ll be stopped out, but other times, you will save your capital. Over time, you`ll get better at setting stops. Eventually, you will be able to have a sense of each trade, and set the stops that work best for you. Then you will be a nimble and successful options trader who can trade with any market.
Article Source :http://www.bestmanagementarticles.com/
http://stock-trading-investment.bestmanagementarticles.com/
About the Author : Who Else Wants To Learn A Simple, Step-By-Step System For Generating Quick & Easy Profits, Trading Options? - FREE FOR A LIMITED TIME - http://www.optionstradingsystems.com/index.php
When an options trader understand that it is important to set stops on all their positions, they often don`t know where to set them. As a options trader, how close should a stop be to price of the position they are entering? Should they be tight, set quite close to the price, or a little looser? What about trailing stops?
Here are some factors to consider that will help the options trader decide where to place your stops. Not every one of these applies to every trade, but the ones that do will give you some useful guidelines.
Perhaps the most important factor that affects stops is the question of how much you`re willing to lose on a single trade.
My rule of thumb is that the options trader should never lose more than 2 percent of your trading capital on any one trade.
Yet this can be tempered by other considerations, such as how much money you have in the position.
If you have a large amount of money in a position, 2 percent may be much more than you`re willing to lose. If so, the options trader should set stops accordingly.
However, if your account is small and you`re not well diversified, a 2 percent stop may be so tight that you stop out of the position almost immediately. If this is the case, the options trader should think seriously about whether you have enough money to trade.
Another matter to take into account is how risky you believe the trade to be.
If you think the trade is a sure winner and market conditions are favourable, the options trader may give the position more room to move.
But if you think it`s got only a fair chance of working out, or if the position has serious potential to drop, set a tight stop.
Also consider how volatile the position is.
If the position routinely moves up and down in a range of 15 percent or more over the course of the day, you can`t set tight stops. If you do, you`ll be taken out by the position`s normal volatility.
If the position is choppy and too risky to trade without tight stops, maybe you`d better look for a better position to trade.
If you have reason to be confident that the position will move upward even if it swings around a bit first, it doesn`t make sense to set a tight stop because you`ll just stop out as it swings. However, if you think it might possibly move up but will definitely drop if it slips below a certain price, then tight stops are a must.
There are also a couple of basic questions to ask yourself about the position to help the options trader decide where to place the stops.
First, is the position cheap?
When a position is inexpensive, even the smallest decimal price movement will be fairly large in percentage terms. This means tight stops may be knocked out more easily. It also means that if your broker has a rule that the options trader can`t set a stop closer than .25 below the current bid, you may not be able to set a tight stop until the price moves up.
And second, what is the time frame for the trade?
On a quick day trade, tight stops are a good idea.
On a position you expect to hold for a week or two for a trend play, tight stops may or may not be a good idea depending on other factors that you`re aware of. Market conditions should always be an important part of your decision.
If the market is trending sharply upwards, tight stops may not be necessary.
If you`re trying to go long in a bearish market, tight stops are absolutely necessary.
If the market is choppy, if it has no clear direction or if it`s full of nervousness and fear, use tight stops, and ask yourself whether you should be trading at all that day.
Which of these considerations is the most important?
Since no two trades are the same, different factors will dominate on different trades. Think about all of them on every trade. If you don`t, you`ll miss something important.
Setting stops is an art. You`ll have to experiment a bit and learn what works for you.
Occasionally the options trader may stop out of a trade too soon and feel frustrated, but remember this is just like paying for insurance. Sometimes you`ll be stopped out, but other times, you will save your capital. Over time, you`ll get better at setting stops. Eventually, you will be able to have a sense of each trade, and set the stops that work best for you. Then you will be a nimble and successful options trader who can trade with any market.
Article Source :http://www.bestmanagementarticles.com/
http://stock-trading-investment.bestmanagementarticles.com/
About the Author : Who Else Wants To Learn A Simple, Step-By-Step System For Generating Quick & Easy Profits, Trading Options? - FREE FOR A LIMITED TIME - http://www.optionstradingsystems.com/index.php
Friday, October 9, 2009
The Stock Replacement Covered Call Strategy
Back in 2003, (October and November '03), the giant biotech Amgen (AMGN) came under some intense pressure, trading down about $12.00 before it found what appeared to be a decent level of support, and began to consolidate. At this level, anyone interested in going long Amgen at a discounted price would be advised to do so. Implied volatility was high coming off this precipitous drop, which caused premiums in the options to increase considerably.
This scenario can be a very attractive for covered call sellers or buy-writers. On Tuesday, December 2, 2003, Amgen was trading at $58.90, the December 60 call was trading at $1.30, and there were only two weeks left until expiration.
Let's assume that you wanted to take advantage of this opportunity but you would be unable to participate in it due to capital requirements.
The stock was trading at $58.90 and you did not have sufficient funds to support buying the stock at that price. After all, the purchase of just 1000 shares would cost $58,900.00.
This is the time to consider using a strategy called stock replacement. In many instances, an insufficient amount of funds in the investors account can mean the loss of a golden opportunity when dealing with high dollar priced stocks.
So, an alternative to purchasing the stock outright is to find a way to replace the actual stock with something else which is not as expensive. In this case, a deep in-the-money call would do just that.
When a call is deep in-the-money, meaning that the strike price of the call is much lower than the stock price, the delta of the call approaches 100.
This means that there is close to a 100% chance that this option will finish in-the-money.
Because of this, the option will trade just like the stock; penny for penny, dollar for dollar (in a theoretical 100 delta scenario.)
If you recall, the term delta was mentioned when describing the option in question.
Delta is the first derivative of the stock and it has a three pronged definition.
The first is percentage change.
The delta is given as a percentage change, meaning how much in percentage terms the option price will change with a movement in the stock.
A 50 delta option will move 50% the amount the stock does. If the stock moves $1.00, than the option moves $.50.
A 30 delta option moves $.30 on a $1.00 movement in the stock, and so on.
Delta can also be defined as percent chance.
This is used to describe the percentage chance that the option will end up in-the-money.
A 90 delta option has a 90% chance of finishing in-the-money.
Finally, delta can also be defined as hedge ratio which is the amount of deltas needed to properly hedge a position.
These concepts will be discussed in more detail in future Options University courses, but for now it is sufficient to just understand these basic concepts.
It was important to explain the meaning of delta to understand that the deep in-the-money call would perform and act just like the stock.
One way to determine if the call you will select is in-the-money enough for your purpose is the delta.
A delta in the mid or high 90's is an ideal candidate.
The selection of the proper in-the-money call to use is a critical element in the success of this strategy.
In order to obtain an accurate delta of all options under consideration for stock replacement use, you can go to any number of web sites or consult your broker.
If all else fails, there is a little trick of the trade that can be used to aid in selecting a call that is deep enough in-the-money to suit the stock replacement criteria.
To do this, check the quote of the corresponding put (i.e. the December 47.5 put if you are looking at the December 47.5 call for stock replacement).
If there is no bid quoted for the put, then the call is deep enough in the money to consider it for a stock surrogate.
There are several reasons for this being an effective strategy, which we wont cover here, but for the purposes of this discussion, it is enough to know that this method does work.
So, with the stock at $58.90, the December 47.5 calls met the criteria for stock replacement.
This call had a mid to high 90's delta and its corresponding put had no bid.
The December 47.5 call was trading at $11.45 or $.05 over parity.
By purchasing this option, you would be equivalently buying the stock at $58.95 (the strike price plus the option price).Let's say that you bought the December 47.5 call for $11.45.
If a total of 10 calls were purchased (an equivalent of 1000 shares), you would lay out a total of $11,450 to fulfill your stock requirement on this buy-write.
If you had purchased the stock outright, you would have spent $58,900.
The difference between the capital needed to purchase the stock outright ($58,900) and the capital needed to buy the in-the-money call ($11,450) is the key to this trade.
Now that you have your stock (via the calls you bought above), it is time to sell covered calls against this position, which would be the December 60 calls for $1.30.
If the stock stays at its present level, you would then capture the $1.30 premium that you sold the December 60 calls for because they finished out-of-the-money at expiration.
The $1,300 profit in this scenario represents an 11.35% return in only two weeks. This well out-performs the return garnished on a $58,900 investment which would only be a 2.21% return in the two weeks, if you purchased the actual stock.
As we know, the maximum profit of $2.35 will be attained if the stock reaches $60.00 or above.
This return comes from the $1.30 you received in the premium for the sale of the now worthless December 60 call plus a $1.05 profit from the December 47.5 call you purchased.
With the stock now at $60.00, the December 47.5 call is worth parity, which is $12.50.You purchased the call for $11.45 thus you received a $1.05 capital gain in the option.
This profit of $2350.00 represents a 20.5% return in two weeks verses a 3.98% return in two weeks, if you had purchased the actual stock.
As you can see, you are getting the same overall dollar return on much less money - which creates a much higher percentage rate of return.
This is one of the positive leverage effects that the proper usage of options can provide.
When you initiate this trade, you are buying and selling two different options simultaneously which is known as a spread.
A spread is a trade which involves the buying of one option against the sale of a different option simultaneously and will be covered briefly in the next section.By buying the December 47.5 calls for $11.45 and then selling the December 60 calls at $1.30, you are buying the December 47.5 December 60 call spread for $10.15. This type of spread is known as a vertical spread.
Article Source:
http://www.articlesbase.com/investing-articles/the-stock-replacement-covered-call-strategy-270123.html
About the Author:
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com/ or 866-561-8227
This scenario can be a very attractive for covered call sellers or buy-writers. On Tuesday, December 2, 2003, Amgen was trading at $58.90, the December 60 call was trading at $1.30, and there were only two weeks left until expiration.
Let's assume that you wanted to take advantage of this opportunity but you would be unable to participate in it due to capital requirements.
The stock was trading at $58.90 and you did not have sufficient funds to support buying the stock at that price. After all, the purchase of just 1000 shares would cost $58,900.00.
This is the time to consider using a strategy called stock replacement. In many instances, an insufficient amount of funds in the investors account can mean the loss of a golden opportunity when dealing with high dollar priced stocks.
So, an alternative to purchasing the stock outright is to find a way to replace the actual stock with something else which is not as expensive. In this case, a deep in-the-money call would do just that.
When a call is deep in-the-money, meaning that the strike price of the call is much lower than the stock price, the delta of the call approaches 100.
This means that there is close to a 100% chance that this option will finish in-the-money.
Because of this, the option will trade just like the stock; penny for penny, dollar for dollar (in a theoretical 100 delta scenario.)
If you recall, the term delta was mentioned when describing the option in question.
Delta is the first derivative of the stock and it has a three pronged definition.
The first is percentage change.
The delta is given as a percentage change, meaning how much in percentage terms the option price will change with a movement in the stock.
A 50 delta option will move 50% the amount the stock does. If the stock moves $1.00, than the option moves $.50.
A 30 delta option moves $.30 on a $1.00 movement in the stock, and so on.
Delta can also be defined as percent chance.
This is used to describe the percentage chance that the option will end up in-the-money.
A 90 delta option has a 90% chance of finishing in-the-money.
Finally, delta can also be defined as hedge ratio which is the amount of deltas needed to properly hedge a position.
These concepts will be discussed in more detail in future Options University courses, but for now it is sufficient to just understand these basic concepts.
It was important to explain the meaning of delta to understand that the deep in-the-money call would perform and act just like the stock.
One way to determine if the call you will select is in-the-money enough for your purpose is the delta.
A delta in the mid or high 90's is an ideal candidate.
The selection of the proper in-the-money call to use is a critical element in the success of this strategy.
In order to obtain an accurate delta of all options under consideration for stock replacement use, you can go to any number of web sites or consult your broker.
If all else fails, there is a little trick of the trade that can be used to aid in selecting a call that is deep enough in-the-money to suit the stock replacement criteria.
To do this, check the quote of the corresponding put (i.e. the December 47.5 put if you are looking at the December 47.5 call for stock replacement).
If there is no bid quoted for the put, then the call is deep enough in the money to consider it for a stock surrogate.
There are several reasons for this being an effective strategy, which we wont cover here, but for the purposes of this discussion, it is enough to know that this method does work.
So, with the stock at $58.90, the December 47.5 calls met the criteria for stock replacement.
This call had a mid to high 90's delta and its corresponding put had no bid.
The December 47.5 call was trading at $11.45 or $.05 over parity.
By purchasing this option, you would be equivalently buying the stock at $58.95 (the strike price plus the option price).Let's say that you bought the December 47.5 call for $11.45.
If a total of 10 calls were purchased (an equivalent of 1000 shares), you would lay out a total of $11,450 to fulfill your stock requirement on this buy-write.
If you had purchased the stock outright, you would have spent $58,900.
The difference between the capital needed to purchase the stock outright ($58,900) and the capital needed to buy the in-the-money call ($11,450) is the key to this trade.
Now that you have your stock (via the calls you bought above), it is time to sell covered calls against this position, which would be the December 60 calls for $1.30.
If the stock stays at its present level, you would then capture the $1.30 premium that you sold the December 60 calls for because they finished out-of-the-money at expiration.
The $1,300 profit in this scenario represents an 11.35% return in only two weeks. This well out-performs the return garnished on a $58,900 investment which would only be a 2.21% return in the two weeks, if you purchased the actual stock.
As we know, the maximum profit of $2.35 will be attained if the stock reaches $60.00 or above.
This return comes from the $1.30 you received in the premium for the sale of the now worthless December 60 call plus a $1.05 profit from the December 47.5 call you purchased.
With the stock now at $60.00, the December 47.5 call is worth parity, which is $12.50.You purchased the call for $11.45 thus you received a $1.05 capital gain in the option.
This profit of $2350.00 represents a 20.5% return in two weeks verses a 3.98% return in two weeks, if you had purchased the actual stock.
As you can see, you are getting the same overall dollar return on much less money - which creates a much higher percentage rate of return.
This is one of the positive leverage effects that the proper usage of options can provide.
When you initiate this trade, you are buying and selling two different options simultaneously which is known as a spread.
A spread is a trade which involves the buying of one option against the sale of a different option simultaneously and will be covered briefly in the next section.By buying the December 47.5 calls for $11.45 and then selling the December 60 calls at $1.30, you are buying the December 47.5 December 60 call spread for $10.15. This type of spread is known as a vertical spread.
Article Source:
http://www.articlesbase.com/investing-articles/the-stock-replacement-covered-call-strategy-270123.html
About the Author:
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com/ or 866-561-8227
Thursday, October 8, 2009
Trading Naked Calls & Puts
Author: Ron Lanieri
An option is a derivative trading product that is best used by investors as a hedging tool providing profit protection and profit enhancement. Although it is a powerful risk management tool, it can also be used effectively as a stand-alone trading vehicle.
Under the proper conditions, options do not have to be paired with stock or another option to be an effective trading tool.
To successfully trade naked options, an investor must realize that certain options will fit certain scenarios and certain options will not.
One of the major misconceptions that investors have about options stems from the fact that most do not know how to trade them properly.
When they lose money trading them, they feel that there is something wrong with the option.
They do not understand that options are on a higher, more sophisticated level when compared to stocks.
Stock trading has fewer variables involved and is therefore easier. No one is saying that the individual investor isn't smart enough to trade options. The problem is not intelligence; it's just education and experience. Most investors have not been properly educated in the proper use of options, and even fewer have had any real experience trading them.
One of the biggest problems investors have is this:
Even if you buy a call and the stock goes up, you can still lose money.
Most investors tend to buy out of the money options at a cheap price.
The stock trades up a little, which is the right direction, but the option still loses money and the investor wonders why.
What the investor fails to realize is that in order for the option to be profitable the options delta must out-pace its rate of decay.
Implied volatility also plays a key role if the stock does trade up while implied volatility decreases, the options delta must then outperform the decrease in volatility.
Remember, when volatility increases, the price of all options goes up. When volatility decreases, the price of all options goes down.
We have categorized options in several ways.
One way is by the option's strike price, and its distance from the stock price.
We identified these options as either in-the-money, at-the-money, or out-of-the-money.
In our discussion about trading naked calls and puts, we will identify trading opportunities or situations that fit each of these types of options, for both calls and puts. But it is important to first review the definition of Delta before continuing.
Remember, delta tells you how much the option will move with a similar move in the stock and is given as a percentage.
For example, a 33 delta option means that the option will move 33% of the movement of the stock and 70 delta option will move 70%.
In-the-money options act like stock. The deeper in the money the calls are, the more they act like the stock.
As the call moves deeper and deeper in the money, the calls delta approaches 100 which means it's price movement will reflect 100% of the stock's movement.
(This is discussed in more detail later in “The Stock Replacement Covered Call Strategy”).
In fact, deep-in-the-money options are sometimes even used to replace stock positions.
If you look at the charts below, you can see how closely the in-the-money call mimics the upward movement of the stock (2nd quadrant).
In the money options are best used for smaller stock movements.
The reason is that in-the-money options contain less extrinsic value. The extrinsic value can work against you when purchasing an option because extrinsic value is affected by time decay.
As you wait for your stock movement, the in-the-money option will decay less than either the at-the-money or out-of-the-money options because it has less extrinsic value.
The amount of money you lose in time decay must then be made back by additional stock movement.
Obviously, the less you lose in decay, the less the stock has to move for you to be profitable because it has less decay loss to make up for.
This is because an in-the-money call has a high delta and a much higher percentage chance of finishing in-the-money by expiration so they follow the stock more closely.
With less extrinsic value loss to make up for, a smaller movement in the stock will produce a greater profit.
For a call example, as you can see in the chart below, the in-the-money produces a profit with the least amount of stock movement.
With less extrinsic value, the ITM option has a lower break-even point.
For chart below, stock price = $35.00
Strike Price Option Price Delta Breakeven Extrinsic Value
$30 5.20 85 35.20 $.20
$35 1.00 52 36.00 $1.00
$40 .30 20 40.30 $.30
About author:
Ron Ianieri is a professional options trader, former floor trader, and market maker on the PHLx options exchange. As co-founder of the Options University, Ron teaches hundreds of aspiring options traders from all over the world how to trade options 'the right way'. Click here to learn more: optionsuniversity.com
Article Source:
http://EzineArticles.com/?expert=Ron_Lanieri
An option is a derivative trading product that is best used by investors as a hedging tool providing profit protection and profit enhancement. Although it is a powerful risk management tool, it can also be used effectively as a stand-alone trading vehicle.
Under the proper conditions, options do not have to be paired with stock or another option to be an effective trading tool.
To successfully trade naked options, an investor must realize that certain options will fit certain scenarios and certain options will not.
One of the major misconceptions that investors have about options stems from the fact that most do not know how to trade them properly.
When they lose money trading them, they feel that there is something wrong with the option.
They do not understand that options are on a higher, more sophisticated level when compared to stocks.
Stock trading has fewer variables involved and is therefore easier. No one is saying that the individual investor isn't smart enough to trade options. The problem is not intelligence; it's just education and experience. Most investors have not been properly educated in the proper use of options, and even fewer have had any real experience trading them.
One of the biggest problems investors have is this:
Even if you buy a call and the stock goes up, you can still lose money.
Most investors tend to buy out of the money options at a cheap price.
The stock trades up a little, which is the right direction, but the option still loses money and the investor wonders why.
What the investor fails to realize is that in order for the option to be profitable the options delta must out-pace its rate of decay.
Implied volatility also plays a key role if the stock does trade up while implied volatility decreases, the options delta must then outperform the decrease in volatility.
Remember, when volatility increases, the price of all options goes up. When volatility decreases, the price of all options goes down.
We have categorized options in several ways.
One way is by the option's strike price, and its distance from the stock price.
We identified these options as either in-the-money, at-the-money, or out-of-the-money.
In our discussion about trading naked calls and puts, we will identify trading opportunities or situations that fit each of these types of options, for both calls and puts. But it is important to first review the definition of Delta before continuing.
Remember, delta tells you how much the option will move with a similar move in the stock and is given as a percentage.
For example, a 33 delta option means that the option will move 33% of the movement of the stock and 70 delta option will move 70%.
In-the-money options act like stock. The deeper in the money the calls are, the more they act like the stock.
As the call moves deeper and deeper in the money, the calls delta approaches 100 which means it's price movement will reflect 100% of the stock's movement.
(This is discussed in more detail later in “The Stock Replacement Covered Call Strategy”).
In fact, deep-in-the-money options are sometimes even used to replace stock positions.
If you look at the charts below, you can see how closely the in-the-money call mimics the upward movement of the stock (2nd quadrant).
In the money options are best used for smaller stock movements.
The reason is that in-the-money options contain less extrinsic value. The extrinsic value can work against you when purchasing an option because extrinsic value is affected by time decay.
As you wait for your stock movement, the in-the-money option will decay less than either the at-the-money or out-of-the-money options because it has less extrinsic value.
The amount of money you lose in time decay must then be made back by additional stock movement.
Obviously, the less you lose in decay, the less the stock has to move for you to be profitable because it has less decay loss to make up for.
This is because an in-the-money call has a high delta and a much higher percentage chance of finishing in-the-money by expiration so they follow the stock more closely.
With less extrinsic value loss to make up for, a smaller movement in the stock will produce a greater profit.
For a call example, as you can see in the chart below, the in-the-money produces a profit with the least amount of stock movement.
With less extrinsic value, the ITM option has a lower break-even point.
For chart below, stock price = $35.00
Strike Price Option Price Delta Breakeven Extrinsic Value
$30 5.20 85 35.20 $.20
$35 1.00 52 36.00 $1.00
$40 .30 20 40.30 $.30
About author:
Ron Ianieri is a professional options trader, former floor trader, and market maker on the PHLx options exchange. As co-founder of the Options University, Ron teaches hundreds of aspiring options traders from all over the world how to trade options 'the right way'. Click here to learn more: optionsuniversity.com
Article Source:
http://EzineArticles.com/?expert=Ron_Lanieri