Option Quiz

April 6, 2012

This article originally appeared at Option Elements.

eagle claw

Let's Stay Sharp!


There was a quiz on another option blog last week and I thought it was a good idea to constantly brush up on our skills. Tests and quizzes always are good to help you know if you really understand a subject or not.

I’m thinking this might be a good weekly article to keep us sharp. Let’s try a short quiz:

1. With a stock price of $58, a 50-strike call will have a minimum value of:
A. $0
B. $10
C. $8
D. $5
E. Not enough information to answer the question.

2. If you sell an option, the most you can lose is the amount you sold the option for.
A. True
B. False

3. Options are similar to what other financial product?
A. IPO’s
B. Bonds
C. Insurance
D. Mutual Funds

4. “Buy stock and sell call options” is commonly known as what strategy?
A. Synthetic Long Put
B. Covered Stock
C. Covered Call
D. Naked Call

5. Which options have the highest time premium component?
A. Out-of-the-money
B. At-the-money
C. Over-the-money
D. In-the-money

6. Which option has the highest VEGA with the stock at $100 on March 1st?
A. MAR 115 CALLS
B. APR 115 CALLS
C. APR 120 CALLS
D. MAY 120 CALLS

Submit your answers to quiz@optionelements.com and we’ll send you the answers back right away!


Euro Futures Options Trade Closed: +12.12% in 20 Days

November 23, 2011

This article originally appeared at Option Elements.

We’ve had our Euro Futures Options trade on for 20 days and it is up +12.1% on the Reg T Margin. I think it’s time to close this one. Here’s a chart of the Euro with our trade profit and loss shown.

Euro Futures Options Price Chart

Euro Futures Price Chart

View the full size image here

Looking at the EURUSD chart, it looks like it’s in a trading range now and testing support around 1.35. Considering we have 75% of our maximum profit at 1.35, this seems like a good time to take the trade off. Here’s what the option chain and risk chart are as I close this trade:

Euro Futures Option Chain

Euro Futures Option Chain

Euro Futures Options Risk Chart

Euro Futures Options Risk Chart

View the full size image here

We netted +$338 on maximum risk of $2788 or +12.12% return on this trade in 20 days.

No Adjustments

You probably noticed I had no adjustments for this trade. I just let it go. Why could I do that? The risk on the upside (ie.. the wrong direction) was defined and small. The market moved in the correct direction I thought it would and it wasn’t a super fast move so I didn’t have to defend it.

This is a good example of setting up a defined risk trade and not over trading it. You can sleep pretty well with trades like this.

SPAN Margin

I want to talk about the SPAN margin a bit. The maintenance margin is only $288, which means that’s all your broker should require in your account for maintenance.

Why do I use $2788 to calculate the yield?

$2788 is the maximum risk you have if the EURUSD goes to zero (actually expires below 1.28). I’ve been burned in the past thinking the Margin I was using was really only $288 but this is the wrong way to use portfolio margin in my opinion. It is VERY EASY to over leverage yourself with portfolio margin. If you treat all of your trades as Reg T, you’ll keep yourself out of major trouble if you have reasonable risk management.

I’ll start looking for another trade for you.

Graphics from OptionVue 6 Software


Butterfly Spread versus Short Straddle

November 9, 2011

This article originally appeared at Option Elements

I read a forum question asking about the difference between a Butterfly Spread and a Short Straddle. The answer was a bit short and incomplete.  I’ve done both of these trades and there are pros and cons for both, as with any trade.  Let’s roll up our sleeves and dig a little deeper.

What is a Butterfly Spread?

A Butterfly Spread is a limited risk trade, selling at-the-money options and buying long options to define the risk and create the “wings.”  You can create a butterfly with all calls, all puts or a combination of calls and puts.  For example:

Calls Only Puts Only Calls and Puts
(Iron Butterfly)
BUY 1 XYZ 110 Calls
SELL 2 XYZ 100 Calls
BUY 1 XYZ 90 Calls
BUY 1 XYZ 110 Puts
SELL 2 XYZ 100 Puts
BUY 1 XYZ 90 Puts
BUY 1 XYZ 110 Calls
SELL 1 XYZ 100 Calls
SELL 1 XYZ 100 Puts
BUY 1 XYZ 90 Puts

Notice how you are always selling two options at the 100 strike and buying one long option above and one option below.  This is a traditional Butterfly Spread and Iron Butterfly (combination of Puts and Calls).  Here’s what the risk chart looks like:

Butterfly

Butterfly Example

You can create many variations of the butterfly buy selling unbalanced combinations.  We’ll leave that to another day.

What is a Short Straddle?

A Short Straddle is the middle of the Butterfly Spread without the extra long options (“wings”).  For example:

Calls and Puts
SELL 1 XYZ 100 Calls
SELL 1 XYZ 100 Puts

You still sell same options as the iron butterfly, but you don’t buy the long options.  This has unlimited risk on the upside and downside.  This is what makes this trade scary in fast moving markets.  You can lose money quickly in either direction.   Here’s what it looks like:

Straddle

What’s the difference between a Butterfly Spread and a Short Straddle?

Let’s compare the Greeks for each trade:

Delta: Similar delta for both trades

Gamma:  The Short Straddle has a higher Gamma, which means as the market moves away from the short strike, your delta will change faster and you’ll money quicker with the Short Straddle.

Theta: Because the Short Straddle has no long options, it will have higher theta.  This means you can get to your profit target faster with a short straddle.

Vega: The Short Straddle has much more negative Vega because it has no long options.  If you are in a high volatility environment and anticipate volatility lowering, a Short Straddle will make money faster due to the larger negative Vega

If you can keep up with the gamma and delta changes, a Short Straddle is very attractive.  You are very vulnerable to big market moves however, which is why this is NOT for inexperienced option traders!   You need to hedge quickly if the market moves.  Market Makers buy stock.  Retail traders can do the same thing but it is expensive to do so.  Futures Options have been my favorite for this strategy because you can hedge with the underlying futures contract very quickly.

Which is better?

In my opinion, defined risk trades, like the Butterfly Spread, are superior.  I can sleep at night. I can’t lose more than my initial debit. It might take me longer to get my profit target, but I don’t worry about blowing up my trading account with defined risk trades.  This doesn’t make a Butterfly Spread butter or worse than a Short Straddle.  I prefer the advantage of defined risk.  Another trader might prefer the higher short Vega and theta and be willing to closely monitor the position.  That’s a personal decision.

Above all, no matter which strategy you prefer, have a trading plan and stick to it!  Know what you are going to do in advance. Don’t make up the rules as you go.  That turns trading into gambling.


Credit Spreads: The Mirage Refuted

October 29, 2011

Mirage in the desert

This article, “Credit Spreads: The Mirage Refuted,” originally appeared at Option Elements

I have a beef with option educators who mislead people with false and inaccurate information to help sell their products and services.  Everyone has a right to sell his or her wares but only in an ethical manner.  You might not have control over an affiliate’s words, but the copy on your own website should be accurate and truthful.

So what got me all riled up today?

I came across an article at SJ Options about Credit Spreads that really rubbed me the wrong way.  Morris Puma made a few statements in his article on credit spreads.  I’m quoting Morris, who said:

1. The truth is that Credit Spreads have a high probability of making a profit

2. Sooner or later, virtually all option traders who use only Credit Spreads wipe out their trading accounts

3. This is one of the riskiest trades that you can do with options

Let’s examine these statements to see why I disagree with each one.

1. The truth is that Credit Spreads have a high probability of making a profit

This is only true for far out-of-the-money credit spreads with a low delta of the short strike option.  This is something you would typically see as part of an iron condor.  You can estimate the probability of the short strike being it-the-money at expiration by the absolute value of the Option Delta.  For example:

XYZ Stock is at $100

120 Call is @0.30 with a 6 delta

115 Call is @0.65 with a 12 delta

Sell the 115 calls and buy the 120 call is a $0.30 credit.  The short 115 call has a delta of 12, so there is approximately a 12% chance the option will expire in the money, or an 88% chance this spread will expire worthless.  This is the example Morris is thinking of, but it is not the only way to trade a credit spread.  Here’s another example:

XYZ Stock is at $100

100 Call is @5.00 with a 50 delta

95 Call is @8.00 with a 71 delta

Buy the 100 calls and sell the 95 calls for a $3.00 credit.  In this case, the short delta is 71 so there is roughly a 71% chance it will expire in the money.  Because the short strike is your maximum profit, your breakeven occurs above this price slightly.  The probability of profit will normally be around 40-45%.   This leads us to several observations:

– The higher the delta of your short call, the lower the probability of profit will be.

– The higher the delta of your short call, the better reward to risk ratio you have

If you want a high probability of profit, sell low deltas.  If you want a lower probability of profit with a better return (but more risk), sell a larger delta.

2. Sooner or later, virtually all option traders who use only Credit Spreads wipe out their trading accounts

I know several option traders who use credit spreads to trade directional opinions and do fine with them.  The key is having a trading plan and following it.  One example is to take a spread off if it makes 50% to 70% of the maximum possible profit and exit if you are down 25% to 50% of the maximum profit.  You have to do your own research for the trades you put on to get the numbers appropriate for you.  The key takeaway is having a plan.

Your plan might be to set and forget it but this will typically not work due to slippage and commissions over time.  If you assume options are fairly priced, then slippage and commissions will result in a negative outcome mathematically.  This is true for ANY option trading, not just credit spreads.

You need a trading edge

To get a trading edge, you have to be better than the market at something… prices (market makers have this advantage), directional forecasting (are you really better than average at picking direction?), adjusting or something else.   You need to do something better than average.  You don’t need to be the best at it, just better than some of the other market participants. What’s your edge?

3. This is one of the riskiest trades that you can do with options

Really Morris?  Really?  This is the craziest statement he made in his short article.  He’s contradicting himself.  Earlier in the same article, he says Credit Spreads have a high probability of making a profit.  Then he says it’s the riskiest trades you can do with options.  Which is it Morris?  You can’t have it both ways!

I can think of a LOT of riskier option trades.  How about buying far out-of-the money put or call near expiration with a delta under 5?  That’s a 5% chance of making money.  I’d say that’s a LOT riskier than the vast majority of credit spreads.  As long as your short option delta is > 5%, you’ll have a higher probability of profit than that long put or call.

Credit spreads don’t have as much volatility risk as a long call or put too.  Some of the risk might be hidden with the long call or put but the credit (or debit) spread minimize the effects of Vega because you are buying and selling similar amounts of Vega.

In conclusion

Morris is not alone in making outlandish statements to scare option traders.  Don’t be fooled with this drivel.  Credit spreads are no more or less risky than any other type of option trade.  You can have aggressive or conservative credit spreads.  It’s all up to you how you want to trade it.


Long Call versus Married Put

October 20, 2011

Two Rhinos

I’ve noticed a pundit or two saying that a Married Put is not the equivalent position as a Long Call. This drives me up the wall.  The two positions are synthetically identical.  I finally couldn’t take it.  I was reading this article by Kurt Frankenburg on Long Calls vs. Married Puts and decided I had to say something.   Investors and traders should know these two positions are identical.

Let’s begin with the trade Kurt Frankenburg put on.  He quotes these prices on April 27, 2011  (633 days to expiration):

Stock: CTSH at $81.40

Jan 2013 85 Calls at $12.60

Jan 2013 85 Puts at $15.00

I used OptionVue’s back trader at the closest I could get was at 13:00 Central with the following stock and option prices:

Stock: CTSH at $81.42

Jan 2013 85 Calls at $11.80 (bid 11.00 ask 12.60)

Jan 2013 85 Puts at $14.65  (bid 14.30 ask 15.00)

From the start, Frankenburg is stacking the deck in his favor since he’s buying the call at the ask (correct) and selling the put at the ask(incorrect).  He should be selling the put at the bid of 14.30.

You should NEVER pay the ask or sell at the bid unless you have to close a position NOW.  This is rare.  Since we are entering the trade, we can be picky.  I would offer the mid-price of the option.  In Frankenburg’s example, he gives up 0.80 for the call but only 0.35 for the put.

The other factor is the interest in the option pricing model.  This is a 633 day trade.  If you tied up over $8,000 for 633 days, what would the cost of carry be?  This is interest minus dividends.  I don’t think CTSH pays a dividend, so let’s consider dividends to be zero.

The option mid-prices were

Call 11.80

Put 14.65

We can use the Put/Call Parity equation to calculate the interest.

Call – Put = Underlying – Strike + (Interest – Dividend)

Let’s plug in the numbers…

Call – Put = 81.40 − 85.00 + Interest

Call – Put = −3.60 + Interest

11.80 − 14.65 = −3.60 + interest

-2.85 = −3.60 + Interest

Interest = 0.75 per contract or $75

$75 of interest on $8,425 of cash for 633 days is a 0.51% annual rate of return. So the math seems to be correct if you use the option mid-prices. Let’s re-examine the trades with option mid-prices and use the same capital for both trades:

Stock: CTSH at $81.40

Jan 2013 85 Calls at $11.80

Jan 2013 85 Puts at $14.65

Married Put = $8140 stock + $1465 put = $9605 capital

Long Call  = $1180 call + $8425 cash = $9605 capital

What’s the maximum risk for each trade if the stock drops to $50 per share?

Married Put

$81.40 stock purchase price – $85 strike price – $14.65 paid for the put = $1105 Maximum risk

Long Call

$1180 call – $75 of interest received on the initial $8425 cash = $1105 maximum risk

 

What is the profit for each trade if CTSH closes at $100 on Jan 2013 option expiration day?

Married Put

$100.00 stock price – $81.40 stock purchase price – $14.65 paid for the put = $395 Profit

Long Call

$100.00 stock price – $85 strike price  – $1180 call + $75 of interest received on the initial $8425 cash = $395 Profit

 

The risks and profits are identical using the same capital!  The two positions are equivalent.

Which trade is easier to execute? 

The Long Call is one trade with lower option prices because it it out-of-the-money.  This will have less slippage than the Married put.  The Married Put has slippage with the stock and the put.  Clearly it’s easier to keep track of a single Long Call and slippage is less.

Why would you want to do a Married Put?

There are two reasons I can think of:

– You don’t want to be tempted to over-leverage yourself.  Buying a call for $1180 requires you to put the remaining $8425 in a cash for the duration of the trade.  Many people can’t do that.  This is the big point Frankenburg makes, and it is a valid concern.

– You already own the stock AND YOU DON’T WANT TO SELL THE STOCK YET.  Buying the Married Put could be to protect gains in the stock and collect any dividends while protecting you from a decline in the stock price.  This is a different situation than putting the Married Put on together with a stock purchase at the start of the trade that we’ve been discussing above.

What is the danger of a Long Call?

Over leveraging yourself.  It’s easy to do.  You have $8425 of cash for 633 days in this example.  Can you trust yourself to leave it alone and not use it for margin with another trade?  If you have the discipline to not use your cash for margin for other trades, then a Long Call is good substitute for a Married Put

In Summary

The Married Put and the Long Call have IDENTICAL risk charts if you don’t forget to consider interest and dividends.  If you decide to trade with Long Calls, DO NOT over leverage yourself.  All trades have good and bad.  There’s no trade that is better than another trade.  If you think that, you’re missing something.  Look for the risk you aren’t seeing and make sure you really compare apples to apples and not apples to applesauce.


Do Risk Free Trades Exist?

October 10, 2011

Shark

This article, “Do Risk Free Trades Exist?,” originally appeared at Option Elements

A risk free trade.  It sounds great doesn’t it?  Just put on as many of these trades as you can because it’s a sure thing.  You can’t lose money.  I remember attending an option trading seminar years ago with a trade they created with a risk chart completely above the zero profit line.  You couldn’t lose.  That’s what it looked like.  After I came home from the seminar, I tried to find this type of risk free trade but never could duplicate it.  Is there really such a trade?

No. Every trade has risk

There are two types of risk in “risk free” trades:

– Risk you don’t see

– Risking unrealized profits

Let’s take a look at each of these types of risk.

Risk you don’t see

In the case of the option trade I was trying to duplicate, the risk I wasn’t seeing involved volatility.  Option prices have many components, but volatility, price and time to expiration are big factors.  If you have options with different expiration months, you DO have volatility risk.  Just look at your Vega.

Any calendar spread trader will tell you about volatility crush.  This is when your long Vega time spread gets hammered when volatility collapses.  The whole risk chart shifts down and can turn a beautiful risk chart into an ugly nightmare.  When evaluating any option position, especially if it involves multiple expiration months, you have to consider what you volatility risk is, or Vega.  It’s not shouting at you like a chart, but it’s a hidden shark waiting to get you if you aren’t careful.

Risking unrealized profits

This one really bothers me. If you buy an at-the-money call and your underlying stock goes up, your call should profitable.  What happens if you sell two calls against it and buy an additional call to create a butterfly spread.  This butterfly spread has a risk chart completely above the zero profit line.  You can’t lose right?

Wrong

The way I think about it is what would it cost to put on that butterfly spread if I didn’t have any open positions already?  The risk involved in the new position, is the risk you are taking.  You are paying for it with unrealized profits, but your alternative is to close your position and walk away.

In our example, if our call had a $300 profit and the butterfly had a maximum risk of $250, you are risking $250, even though your trading software says the worst you can do is make $50.  You can pocket the $300 and not open the butterfly spread. You avoid the hidden risk of $250 by closing the trade entirely.

Can you find the risk?

The next time you see a risk free trade, look for the risk.  It’s there like a shark, waiting for you.  The two most common places you’ll find the risk are volatility or using unrealized profits.  The two quick tests are checking the Vega and asking yourself what the risk would be if I didn’t have any open positions.

If it looks too good to be true, it probably is.


Here I am

October 9, 2011

I didn’t want to do a Hello World like everyone else.  This is a quick “here I am” to start this blog off.