Category Archives: Options

Options Trading Strategies: Risk Reversal

June 17, 2010   admin   No comments

Yesterday we saw options traders position for decent upside in wireless semiconductor company Qualcomm (QCOM) by purchasing 14k October 40 calls combined with the sale of 14k October 30 puts, otherwise known as a risk reversal. The options trader paid $0.66 (total proceeds of $924,000) for the 14k October 40 calls and collected $1.01 (total proceeds of $1,414,000), thus in aggregate collecting $0.35 ($490,000) for the trade. Within this risk reversal strategy, options traders benefit greatly if shares of QCOM trade above the $40 level upon October expiration.  Options traders begin to lose with shares of QCOM trading below $29.65 upon October expiration. The graph below highlights the P/L of the October 30-40 risk reversal options trade in QCOM:

As can be seen in the graph, not only does this options trader profit with shares of QCOM trading above the $40 level at October expiration, but the options trader also profits from the strategy as long as shares trade above the $30 level at October expiration (keeping the $0.35 collected at trade inception). That being said shares of QCOM would need to decline over 15% from current levels in the next 4 months for the risk reversal P/L to dip into negative territory. Seems like a pretty good risk/reward setup for options traders carrying a positive bias on QCOM over the next few months. For more information on the risk reversal and other options trading strategies visit OptionsUniversity.com.

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Options Trading Strategies: The Bull Call Spread

June 15, 2010   admin   No comments

Shares of my favorite DVR service provider, TIVO, surged 5% yesterday on takeover speculation. The suitor for TIVO is rumored to be Direct TV. There are many ways options traders can position for upside in TIVO, the options trade that stood out yesterday involved a purchase of a bull call spread. In the bull call spread options trading strategy an options trader placed an order to buy 1k Jan 11 strike calls for $1.16 and simultaneously sold 1k Jan 17.5 strike calls at $0.34, yielding a net debit of $0.82. The $0.82 paid (total proceeds of $0.82*100*1000 = $82,000) represents the most the options trader can lose in the bull call spread. Maximum profit of $5.68 (or $568,000) is generated with shares of TIVO trading at $17.50 upon January expiration. A P/L payout graph of the TIVO bull call spread options trading strategy is highlighted in the chart below:

The options trader likely purchased a bull call spread instead of outright calls to 1) minimize the impact of implied volatility changes, and 2) to monetize his view that shares of TIVO are unlikely to fetch a price tag much higher than $17.50 in an acquisition. If shares of TIVO blow past that $17.50 strike at option expiration, the option traders’ profit would be limited to the $5.68 mentioned above. A large move higher in TIVO shares between now and expiration would be cause for the options trader to explore closing out the bull call spread at a handsome profit. For more information on the bull call spread and other options trading strategies visit OptionsUniversity.com.

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Selling Puts: The Disciplined Way To Invest

June 10, 2010   admin   No comments

TradeMonster options commentary is highlighting a bullish trade in Sirius XM (SIRI) this afternoon. An options trader established a bullish position in SIRI by selling puts, more specifically selling 5k July 1 puts at $0.08. We consider this a bullish trade merely due to the fact that the options trade yields a profit with shares of SIRI trading above $0.92 upon expiration. The maximum profit on the options trade is only $0.08 which equates to $40,000, while the maximum potential loss of the options trade is $0.92 * 100 * 5000 = $460,000! See diagram below for P/L levels at expiration.

So why would an options trader risk $460,000 (if shares of SIRI went to 0) in order to make at most $40,000? The answer is likely that the options trader really doesn’t want to be a trader of SIRI options; he would really like to be a shareholder of SIRI stock. Selling puts is a great way to enter into a stock position in a company. By selling puts the options trader is agreeing to buy shares of the underlying stock at the strike price (in this case $1) should shares trade below $1 at expiration. Should shares of SIRI increase the options trader would not participate in the upside, pocketing only the $0.08 ($40,000) collected at the sale. Selling puts provides a disciplined method to entering a stock position, forcing the options trader to commit to purchasing shares at a specific level instead of compromising and buying shares on the open market for slightly above your target price. And for shares trading at very low dollar amounts, every penny means that much more.  For more information on selling puts and other options trading strategies visit OptionsUniversity.com.

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Options Trading Strategies Exposed: Ratio Call Spreads

June 09, 2010   admin   No comments

As mentioned in a recent post on TradeMonster, one of the key advantages of the Trademonster options trading platform is the access to OptionMonster trade commentary. Earlier this morning OptionMonster’s Heat Seeker tracking system detected bullish activity in American Tower (AMT) options. An options trader purchased October 45-47.5 1×2 ratio call spreads in AMT, 3000×6000 times. With shares of AMT trading around $42, this specific options trader is utilizing a ratio call spreads structure to express a moderately bullish view on AMT for very little cost (in this example no cost). A breakdown of the AMT 1×2 ratio call spreads trade is highlighted in the graph below:

As part of the trade the options trader purchased 3000 Oct 45 calls for $2.10 and sold twice as many Oct 47.5 calls at $1.05, net-net no premium outlay to put on this specific options trade. As highlighted in the graph above, the options trader loses nothing on the trade as long as shares of AMT trade at $50 or lower upon expiration. The options trader achieves maximum profitability (+$2.50) if shares of AMT trade at $47.50 upon expiration. The options trade begins to lose money with shares of AMT trading at or above $50 (+19% from current levels), so essentially the options trader is betting shares of AMT increase but not by more than 19% over the next few months. Maximum loss on this ratio call spreads options trade is unlimited as shares of AMT theoretically could increase to infinity.

With AMT recently providing a first quarter update, upside could very well be limited through the October time-frame.  So it doesn’t seem like a bad bet given there really is no downside to the options trade with shares of AMT trading below $50 at expiration. I keep stressing “at expiration” mainly because the paper P/L of the trade can vary wildly through the life of the trade depending on price action. For greater detail on how to manage ratio call spreads options trades as well as other options trading strategies visit OptionsUniversity.com.

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Variance Swap: The Purest Way To Trade Volatility

June 09, 2010   admin   No comments

Market volatility is back in case you haven’t noticed and institutional options traders are ecstatic. Volatility is the lifeblood of options trading as the heightened price activity typically leads to more trading and as a result greater commissions (if you’re on the sell side!). From an investor’s standpoint, volatility is not necessarily a good thing or bad thing but finding ways to monetize a view on volatility to either hedge a portfolio or for pure speculation hasn’t been the easiest thing to do. People often look to the VIX as the ultimate gauge of market volatility. The VIX, commonly referred to as the ‘fear gauge’, is calculated by taking an average of implied volatilities of front and next month S&P 500 options. Being that the VIX is an average of implied volatilities it cannot be traded as is. There are however, many instruments available to trade the VIX including: VIX futures, VIX options, VIX ETNs, options on VIX ETNS, etc… For institutions looking to express a view on volatility the purest way to implement such a view in the markets is by trading a variance swap.

What Exactly is a Variance Swap?

When an options trader buys or sells an option he/she is effectively expressing a view on the implied volatility of said option. If the trader believes the implied volatility of the option is less than the theoretical volatility the option should carry when pricing options using the Black Scholes formula (or binomial model) the trader is likely to take a long position in the option. If the trader believes the current implied volatility of the option is higher than the theoretical implied volatility obtained through Black Scholes or the binomial model (or other option pricing models) then he is likely to short said option. That’s why we say an options trader is long volatility when he buys options and short volatility when he sells options. However when you buy or sell a put or call you are also taking a directional position: buy a call, sell a put = Bullish; sell a call, buy a put = Bearish. For traders looking to express a volatility bias without taking a directional position they can buy/sell: 1) straddles/strangles, 2) options delta neutral, or 3) variance swap.

Straddle and Strangle Options Revisited

We covered straddles and the strangle option in the previous post, I Confess…I Enjoy Being Strangled, so I won’t go into great detail here. But basically the strategies involve buying a call and put with the same strike (straddles) or different strikes (strangle option) with the same expiration. These structures are delta neutral (meaning void of a direction bias) at inception and thus primarily are traded based on the volatility bias of the trader. However, straddles and strangle options quickly lose their delta neutral characteristic as soon as the stock moves away from the spot price. Thus the position needs to be altered over time to maintain a delta neutral stance.

Buying or Selling Options Delta Neutral

Another alternative in singling out and trading the volatility in an option is through delta neutral trading. In simple terms under a delta neutral strategy a trader would purchase a put or call and take a position in the underlying stock according to the delta of the put (call) to offset the direction bias of the option position. For example say a call option has a delta of 0.60, if a trader buys 100 contracts the position would be synthetically equivalent to being long (100 contracts x 100 shares per contract x 0.60 (delta) = 6000 shares of stock. In order for the trader to get rid of the direction bias of the long call position he must short 6000 shares of stock. This action would bring the portfolio to a delta neutral point for the moment. But as the stock moves around the delta hedge needs to constantly be adjusted requiring the trader to purchase or sell shares on a daily basis to maintain a delta neutral stance. The position profits in the end if the volatility of the option the trader bought ends up being less than the resultant realized volatility and the stock moves higher and lower and not just in a straight line (path dependency).

The Variance Swap

As you can see in the previously discussed options making a volatility bet using options requires constant monitoring and adjustment of the stock hedge.  However there is a strategy that allows for traders to express a pure volatility bias without the need to constantly manage an offsetting stock position: the variance swap. A variance swap is an over-the counter (OTC) product between 2 counterparties that agree upon the duration, dollars per volatility point, strike, and underlying security. In very simple terms, a variance swap is equivalent to betting the over/under in a football, basketball or other sporting game. If the trader wants to bet that the volatility of a stock is going to be higher than a specified volatility strike then he would purchase/ go long a variance swap and if the trader believed that the forthcoming realized volatility would be less than the specified volatility strike he would sell / go short a variance swap. The payout would differ from a standard over/under bet in that the amount of payout would be dependent on just how much over or under the resulting volatility ends up being over the volatility strike ($ per vol point). A payoff of a long variance swap is illustrated below. While there are some characteristics of the structure that may be of concern to some investors (counter-party risk, collateral requirements, bid/ask spread, etc..) the variance swap remains the purest way to trade volatility. For further information on the Variance Swap and other Options Trading Strategies visit OptionsUniversity.com.

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The Goliath of All Discount Option Brokers: 5 Reasons Why TradeMonster Destroys The Competition

May 28, 2010   admin   No comments

Whether you are a newcomer to options trading or fairly experienced options trader, it is important to find a quality options trading platform to place your trades. While there are many discount option brokers out there, only a few provide the advanced tools, market commentary, and ease of trading one would expect from a high quality options trading platform. And for my money the best discount option broker out right now is TradeMonster. Below are 5 reasons I believe why Trademonster beats all other discount option brokers.

Discount Option Brokers — Reason #1: Options Trading Strategies Easily Accessed

When trading on the TradeMonster platform, it becomes immediately clear that this platform was created by options traders for options traders. All the options trading strategies from simple call spreads to more advanced options trading strategies such as an iron butterfly option is easily accessible with the click of a button. The option greeks associated for each strategy are highlighted next to the specific strikes, giving options traders a quick glimpse of the risks associated with all chosen options trading strategies to help determine the best alternative. Switching back and for the between strategies is extremely simple.

Discount Option Brokers — Reason #2: Advanced P/L Charting

The TradeMonster platform allows options traders to instantaneously view the expected P/L from all options trading strategies during the decision making process. P/L charts are highlighted in color and through the use of spectral maps, options traders will be able to see graphically exactly where the risks lie in their options trading strategies.

Discount Option Brokers — Reason #3: Paper Trade Options

This is crucial. Great options traders often need to test various options trading strategies and seek continuing education in order to refine their trading skills. One easy way to do this is to paper trade options. TradeMonster allows its options traders to paper trade options with a simple click on a drop down menu. Traders can create a paper trading options account alongside a “real money” account and can toggle between the two accounts easily (Clearly you must be careful when utilizing this function to make sure you are trading in the correct account when placing trades!) I use the “paper trade options” functionality all the time. It’s great when you have an idea that you aren’t too sure about and you want to see how the trade would’ve turned out if you had put money towards it. The best part – TradeMonster provides full functionality under its paper trade options tab so it really feels like you are trading real money.

Discount Option Brokers — Reason #4: Real-Time Options Commentary

OptionMonster, TradeMonster’s affiliate site, provides updated, real-time commentary on the options market. Information is everything in options trading and OptionMonster provides a wealth of information from general market commentary, significant option trades, to live from the option pits video.

Discount Option Brokers — Reason #5: Attractive Rates

TradeMonster’s rates are some of the most attractive in the business. The chart below highlights TradeMonster’s pricing compared to other discount option brokers:

Visit TradeMonster today, open an account with as little as $2,000 and start trading with the big boys!

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The Essential Guide To Options Trading

May 26, 2010   admin   No comments

Having been in the options business for over 10 years, I’ve had the opportunity to read some of the absolute best books on options trading in the marketplace. As a grizzled vet I tend to read a lot and have recently been focusing a lot of my reading time on more specific areas of the options business such as expiration trading and dispersion / correlation trades. So when asked recently for book recommendations for someone looking to break into the options trading business I had to dig deep in the crates to come up with a solid book that would prepare a burgeoning options trader for upcoming interviews…

For a comprehensive background into options trading, the history, dynamics, general applications and the like you can’t go wrong with Hull’s Options, Futures & Other Derivatives or Natenberg’s Option Volatility & Pricing. These are absolute must-haves for anyone interested in a career as an options trader. Chock full of information, these options books come off as rather dry and may not help you as much if you’re looking to cram for a pending interview. Cramming aside I would definitely make sure you pick up a copy of both (and it wouldn’t hurt to drop the names Hull and Natenberg at some point throughout your interview).

For someone with limited time but mathematically inclined, I would absolutely recommend Jeff Augen’s The Options Trader’s Workbook for an overview of options trading. Instead of banging you over the head with historical facts or boring you with 10 pages on the derivation of Black Scholes, The Option Trader’s Workbook takes a problem solving approach to learning options. From option pricing basics to more complex multi-legged trades, Augen delivers the material in an easy format with accompanying problems to make sure you comprehend the material as you progress. Working through the problems is the best kind of training you can get outside of actually trading options with your own money on the line, which I highly suggest for anyone serious about learning the options business!

The Option Trader’s Workbook includes close to 150 problems with accompanying detailed answers.The questions become harder and more complex throughout but working them out in the end should prepare you to dominate most options trading interviews. So definitely pick up Jeff Augen’s The Options Trader’s Workbook and happy trading!

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The Butterfly Effect: Exploring the Inherent Risk in the Butterfly Option

May 26, 2010   admin   No comments

The butterfly option is a three-legged (with a total of four options) option trade used primarily when an options trader has a distinct opinion of where he believes a stock will trade at a specific point in time.  The options trader can monetize his strong view by risking a relatively small amount of money to yield gains in excess of 100% should his view prove correct over the term of the trade.

How To Structure a Butterfly Option

A long butterfly option can be thought of as the combination of a short straddle and a long strangle option. The options trader, in accordance with his stock thesis, would short 2 calls (or puts) at the strike he believes the stock will trade around at the options’ expiration. Obviously selling a naked straddle would expose the options trader to substantial risk, actually unlimited risk due to the naked call portion of the straddle which is unbounded. To alleviate upside and downside risk, the options trader buys a strangle option with strikes wider than the strike of the straddle. The strikes of the butterfly option are typically evenly spaced as illustrated in the payout diagram below. The long strangle option caps the potential loss of the long butterfly option trade, and thus the max loss and gain of this particular option trade is known at the outset of the trade, making a lot of risk managers very happy.

Sample Risk Profile of A Butterfly Option

In the example above the options trader purchased the February 550-570-590 butterfly option in Google (GOOG) consisting of a long 550-590 strangle option and a short Feb 570 straddle. You can also view this option trade as a long Feb 590-570 put spread and short 570-550 put spread, either way is fine, whichever way is easiest for comprehension.  With shares of GOOG trading around $585 at the inception of this option trade, the options trader was clearly bearish on shares of GOOG through February expiration. The options trader ends up paying $250 for the chance to make $1750 (a 700% return!) should shares of GOOG trade at $570 upon expiration. That’s a remarkable return but one has to consider just how likely it is for shares of a highly liquid technology stock to trade at a set specific price weeks in the future (has to be severely low). The max loss on the trade is $250 should shares of GOOG trade above $590 or below $550 upon expiration. The butterfly option trade in this example yields a profit with shares of GOOG trading between $552.50 and $587.50.

Other Ways to Profit From a Butterfly Option

In the example above we assumed the options trader would hold the GOOG butterfly option until expiration to achieve maximum profitability. However the options trader doesn’t necessarily have to hold the position until expiration to yield a profit. Since the butterfly option is inherently short volatility, should the implied volatility of the short options decline the options trader could close out of the trade at a profit prior to expiry. If implied volatility increases the option trade could show a paper loss in excess of the maximum loss indicated above. Just remember this is a paper loss and the butterfly option still would only result in a $250 loss at worse if held until expiration.

For further information on the Butterfly Option and other Options Trading Strategies visit OptionsUniversity.com.

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The Naked Truth: Selling Puts — Not As Risky As You May Think

May 25, 2010   admin   No comments

Quick question, what is more risky selling puts or buying stock and selling calls against the stock position (covered call writing strategy or buy-write strategy)? If you said selling puts you would be wrong. If you answered the buy-write strategy, you’d be wrong as well. Actually these positions are equivalent according to put-call parity. Put-Call parity is the formula that defines the relationship between the price of a call option and a put option.

Selling Puts: The Payout

Think about it, when selling puts the options trader would receive premium for the sale and the amount of the premium collected would be the maximum amount of profit he could expect from the trade under all scenarios. If the stock jumped 100 points by expiration, the options trader would still only profit by the amount of the premium collected. However, on the downside, the options trader loses point by point after shares fall below the strike of the put that was sold. The trade turns negative once shares fall below the strike minus the put premium collected. So basically you have significant downside loss potential (bounded by zero) and limited upside potential (bounded by the put premium collected) when selling puts. What would this look like in diagram form? See for yourself below:

The Buy-Write (Covered Call Writing Strategy)

Let’s take a look at the dynamics of the buy-write strategy. Under this strategy the options trader goes long stock and shorts an upside call, collecting premium in exchange for potential profits from a significant increase in stock price. Thus, the investor bears full downside exposure to potential movement lower in stock price, and is capped in upside exposure by the difference between the stock price and strike price + premium collected. Sound familiar? What would the payout of the buy-write strategy look like, see below:

As you can see, the payout for the buy-write and selling puts strategies maintains an identical profile. So are there any advantages to selling puts over a buy-write / covered call writing strategy? In a word, YES. 3 of the main advantages of selling puts over a covered call writing strategy are highlighted below:

  1. Less capital commitment: Selling puts requires the options trader to only post margin for a % of the max potential loss of the trade. Whereas the buy-write / covered call writing strategy requires the investor to purchase shares at the current market price minus the premium collected for the call sale. The lower capital commitment of the selling puts strategy allows the investor to utilize the capital, that otherwise would have been used to purchase shares, on other investing opportunities.
  2. Lower transaction costs: This is as simple as 1 transaction (selling puts) vs. 2 transactions (buying stock, selling calls).
  3. Hard-to-Borrow securities adds some juice to put implied volatility: The implied volatility of put options often maintain a higher implied volatility than would be dictated by put-call parity in circumstances where shares become hard to borrow. This scenario presents an attractive opportunity for options traders with bullish opinions on the stock to structure positive bias trades using options. Traders end up collecting more premium for the sale of put options on the stock presenting an even greater advantage to the selling puts strategy in comparison with the covered call writing strategy as the call implied volatility remains unaffected (or even lower than normal).

For further information on Selling Puts / Covered Call Writing Strategy and other Options Trading Strategies visit OptionsUniversity.com.
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Pop Your Collar Option & Protect Your Money

May 25, 2010   admin   No comments

Investing in the stock market is inherently risky. Your fortunes can go up or down on events that may not have anything to do directly with the securities you own which can be extremely frustrating. Well fear not there are several ways to protect your stock positions from dramatic declines. One option is buying puts on the stock; another is through the use of a collar option.

Buying Puts on Long Stock Positions

Investors who own shares of stock are naturally exposed to downside moves in the stock. This is the risk investors bear for the possibility of unlimited profit should said shares rise to the moon. However there are times when investors become wary of an upcoming time frame, whether it is ahead of an event, general macro trends, or even a product announcement that could alter the face of the company. These investors should consider buying puts to protect themselves from sharp stock declines.

The advantage of buying puts for protection is the downside of that position becomes fixed for the duration of the option’s life. An illustration of long stock + long puts (synthetically equivalent to long calls) is included below. One disadvantage to the long put is cost. Investors have to pay up for that protection and if the put is purchased ahead of a known company event that the market perceives will push the stock significantly one way or another, the cost of the put will likely be higher (due to increased implied volatility) than the cost under normal conditions.

The Collar Option as an Alternative

Investors looking for a cheaper way to hedge their stock position and lessen some of the implied volatility concerns should consider the collar option. The collar option combines the purchase of a downside put with the sale of an upside call option. In this scenario the investor would pay less for the hedge (fixed floor) due to call sale proceeds that end up paying for some portion of the collar option cost. The collar option trade can be structured to where the cost of the put is paid entirely through the sale of the call option and the investor pays nothing out of pocket, this is referred to as a zero cost collar. But like we said before, nothing in life is free. The lower price of the collar option comes at a cost, primarily giving up some of the upside in shares. Under the collar option strategy, the investor ultimately locks in a trading range for shares, an effective risk management technique in volatile markets. A payoff diagram of a long stock + collar option is highlighted below:

Effective Use of the Collar Option

The collar option is an effective hedging tool. Officers of corporations sometimes have a sizeable portion of their compensation packages tied up in restricted stock that they are unable to sell for a given length of time. Instead of just sitting on gains in the stock and hoping shares don’t fall by the time the restricted period ends, some officers decide to structure a collar option which would lock in gains (at the expense of further upside). I’m sure a lot of the internet entrepreneurs pre-bubble wish they would have utilized these collar option strategies when their cash bleeding companies where trading at ridiculous 200x+ multiples during the boom.

For further information on the Collar Option and other Options Trading Strategies visit OptionsUniversity.com.

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