Option Strategy During Earnings Season

Option Strategy During Earnings Season

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

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

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

200 of Long $200 Call Options

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

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

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

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

Portfolio Recap :

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

GREEKs Profile :

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

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

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

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

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

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

Stock Dividends and Its Impact on Options

Stock Dividends and Its Impact on Options

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

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

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

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

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

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

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

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

Why Conversions and Reversals Cause Stock Volume Spikes on Expiration Days

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

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

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

and by rearranging this formula,

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

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

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

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

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

the same can be explained about Reversals, which is

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

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

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

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

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

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

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

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

What is a Conversion?

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

say AAPL is at $200 now.

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

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

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

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

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

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

Conversions and Reversals

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

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

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

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

the answer lies in Conversions and Reversals....

Explaining Risks through Greeks

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

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

we move on to more specific Greek talk..

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

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

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

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

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

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

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

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

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

Theta Risks

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

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

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

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

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

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

A very important lesson about Theta is this...

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

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

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

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

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

Bull Call Spreads with Positive Theta

Bull Call Spread

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

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

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

Some traders like to establish

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

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

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

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

QUIZ :

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

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

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

Covered Call Variety

Covered Call

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

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

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

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

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

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

now...consider the following alternative :

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

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

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

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

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


QUIZ :

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

assumption : NOT a dividend paying Stock...

Result of GS Trade

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

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

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

QUIZ :

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

Delta Neutral Discussion

Delta-Neutral Trading

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

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

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

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

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

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

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

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

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

Trading Options on Goldman Sachs?

GS - Goldman Sachs

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



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

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

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

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

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

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

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




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

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

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

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

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

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

Formulating Option Trade by applyng GREEKS

TLT - iShares Trust Barclay's 20 Plus Yr Treasury


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



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

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

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



This is one possible setup employing ONE contract size :

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

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

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

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

The maximum profit is unlimited !

GREEKS for this trade :

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

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

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

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

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

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

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

Greeks - Theta Explained

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

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

Theta Risks

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

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

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

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

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

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

A very important lesson about Theta is this...

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

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

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

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

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

Greeks - Delta and Gamma Explained

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

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

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

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

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

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

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

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

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

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

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

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

ITM vs OTM Covered Calls

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

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

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

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

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

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

A Trvia Quiz

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

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

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

Question :

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

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

Enjoy

Answers will be posted by 16Nov09

Rho Rho Rho Your Boat

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

For example, given the following scenario :

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

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

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

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

Call + StrikeValue = Put + StockPrice + Interest - Dividend

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

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

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

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

Stock = Call + StrikeValue - Put - Interest + Dividend

Using the above scenario, the formula easily translates to :

80 = 3.75 + 80 - 3 - 1 + 0.25

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

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

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

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

The Sobering Truth about Options Trading

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

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

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

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

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

but why does this happen?

there can be many reasons for this....

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

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

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

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

Low Risk - Premium Generating Option Proposition on SPX

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

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

Our Trade Position

1 x Short SPX Oct 1005/1000 Put vertical spread

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





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

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

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

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

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

Forget the fast money

By Larry Haverkamp

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

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

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

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

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

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

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

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

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

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

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

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

This above is a fair statement...

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

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

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

Flaw 1: Predicting the unpredictable

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Flaw 2: Zero-sum and worse

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

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

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

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

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

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

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

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

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

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

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

This article was first published in The New Paper.