option strategy

The New York Stock Exchange (NYSE) matches buyers and sellers of stocks.  An auction system, high buy and low sell being matched by Specialists.  Trades taking place when the two agree on price, one coming to the other.

Market orders mean agreeing to the best price at that moment in time.  The moment in time the Specialist gets the order, not the moment in time it was placed.  Market orders are a truly scary thought.  I’ve heard countless stories dealing with market orders, all of them horror stories!

An orderly market requires a relatively equal number of buyers and sellers in a close proximity of price.  Trading halts when an order imbalance occurs.  The Specialist’s job entails filling market orders fairly.  They need time to determine the price for matching market buys with market sells.  In an effort to be fair, trading might also halt pending news.  Most major announcements come before or after the opening bell.

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The NASDAQ market works differently.  Unlike the NYSE’s trading floor, the NASDAQ trades stocks electronically.  And unlike the NYSE Specialist system, the NASDAQ uses Market Makers.  The Market Makers create a fair and orderly market by bidding and/or offering.  They try to buy stock at their bid or sell stock at their ask.  They try to make the Bid/Ask spread like the option Market Makers.  They are not required to be on the floor of an exchange.  With limitless location possibilities and only the volume and size of trades to deal with, most NASDAQ stocks have large numbers of Market Makers.  It takes commitment to be a NASDAQ Market Maker.  It’s not a part time job.  It also takes an inventory of stock to trade from.  This calls for large sums of money.

Option Market Makers are like a blend of the NYSE Specialist and the NASDAQ Market Maker.  Options trade on an actual exchange like the NYSE, but Market Makers offer liquidity with ready Bids and Asks.  The major difference lies in the number of possibilities.  You either buy stock or you sell it.  Option trades include both buying and selling, both puts and calls, with countless strike price choices.

Option Market Makers don’t start with a large inventory, they create the option contracts as buyers and sellers appear.  They would just as soon not ever own stock.  If they do, it means the buyers and sellers of options are not in equal proportion.  Their profit comes from buying at bid and selling at ask, called the Bid/Ask spread.  Option Market Makers buy and sell numerous option contracts, not always the same ones.  Through the use of Delta, Market Makers and option traders are able to remain basically market neutral or completely hedged.

Delta is a measurement of change in an option compared to the change in the underlying.  Delta is also the measurement of relativism between option contracts.  This relativism is what Market Makers use to hedge.  They try to remain at Zero.  Neutral.

To show how Market Makers trade Delta Neutral, let’s make some assumptions.  Let’s say an in the money (ITM) call has a Delta of .75, an at the money (ATM) call has a Delta of .50, and an out of the money (OTM) call a Delta of .25.  If a retail investor buys an ATM call from the Market Maker, the Market Maker is now short a Delta of 50.  Remember 100 shares per contract, means .50 x 100, so the decimal is dropped..  If someone then sells two OTM calls to the Market Maker, the Market Maker is then buying a total Delta of 50.  So selling -50 Deltas and buying +50 Deltas, equals zero Deltas.  Therefore the Market Maker is considered Delta Neutral.  A snapshot risk free trade.  Snapshot, meaning at the instant the trade takes place.  Technically, the risk is the Gamma, the change of Delta.

Puts are measured in negative Deltas.  This can be quite confusing.  Delta measures the change in the option verses the upward movement of the underlying.  So if your stock moves higher, the put would move lower.  Disturbing as it seems, two negatives make a positive.  If the stock price drops, with a negative Delta, the put option increases.

Selling a call option with a Delta of .50 and buying a put option with a Delta of -.50, the net effect is zero.  Buy 20 options with Delta of .75 sell 60 contracts with a Delta of .25, Neutral.  Long 20 contracts with a Delta of .75 = + 15000, selling 60 times .25 = -15000.  15000 minus 15000 equals nothing.  Hedged or Delta Neutral.

Some stocks went up.  (Hopefully yours.)  Some stocks traded lower.  Some stock prices stayed the same.  (A few flat lined dead on arrival, many roller coasted up and down back to the starting point.)

I was just recently in Las Vegas, for business of course.  I enjoy going by the gaming tables.  Market research, crowd psychology.  Seeing how people bet their cash.  Well chips anyway, if bettors had to use real money, they might recognize how much money they just lost.

Ever watch people learning to play craps?  They’ll use real money.  Haven’t they heard of paper trading?  Maybe because the pit boss and the other casino employees are always willing to help.  Lots of assistance available to make a bet.  No matter what color the chips.

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Gambling and specifically craps have much in common with options: complex risk reward curves.  Since the IRS doesn’t allow deducting crap table loses from your income taxes, why would anyone want to throw dice.  They can bet options, I mean trade options.

Many amateur options traders invest as if they were at a casino.  No regards for the odds, just mesmerized by the big potential payoff.

Anyone who has been around Wall Street any length of time knows there isn’t many “sure things.”  Truly, time’s passing is the only safe bet.

In this example we will trade based on Theta alone.  We will consider the other “Greeks” asleep.  In reality, they are NOT dormant.  The fact is, you could set your trades up to minimize their effects.  Remember it’s best not to awaken a sleeping giant if at all possible.

Our hypothetical example will be four At the Money (ATM) options on a single stock:

One month option = $ 1.00
Two month option = $ 1.41
Three month option = $ 1.73
Four month option = $ 2.00

With these hypothetical examples, let’s enter a simple time or calendar spread.  We will buy the four month option for $ 2.00 while simultaneously selling the one month option for $ 1.00.  Our net cost would be $ 1.00 ($ 2.00 less $ 1.00).  Again for demonstration purposes we will not take commissions nor the bid/ask spread into consideration. And also ignore strike prices as well.

If everything remained the same except for time’s passage, after one month the option we sold (short position) would be worthless to the buyer.  An At the Money (ATM) option has no value at expiration.  A $ 1.00 profit to us, offset by the $ .27 loss on our four month turned three month option, brings our position value to $ 1.73.

Anyone who can find situations where all the variables remain constant for one month deserves to make 73% on their money.

In our perfect example situation, we could now sell another one month option for another Dollar. After the second month, the option we originally bought would have lost half its time, but only $ .59 of its value.  Now priced at $ 1.41, the income would be equal to its original cost, $ 2.00.  Our cost would be zero.  Our profits infinite.

Closer to expiration, owning options costs more.  Inversely, selling options closer to expiration can pay more.

If the one month ATM option is $ 1.00, and the four month equals $ 2.00, then the nine month option would be priced at $ 3.00.  Continuing forward, the 16 month option’s price would be $ 4.00 and $ 5.00 would buy the 25 month option.

If we could sell one month of time for $ 1.00, we could pay for the 16 month option in four months.  Giving us a year of potential for free.

Please don’t base trades on any one option pricing component, while ignoring the others.  You’ve been given enough information to be dangerous.  If you trade with blinders on, you tend to get blind sided.

Knowledgeable traders earn the right to have less money at risk and greater potential for profits.  Knowledge comes with experience, and experience comes with time, regardless of real chips or paper trades.

Time Passes

Beginning traders go broke taking big losses.  Novice traders fall victim to attrition through multiple small losses.  Advance traders falter taking small profits.  Where are you on the evolutionary chain of traders?

The ability to pick market direction reigns as the most important factor for success for all option traders.  Understanding option pricing helps traders magnify gains, and avoid losses.

Many new option traders dig themselves such a deep hole they can’t climb out.  At least, can’t climb out fast enough.  Stock prices go up, they go down, they may end up where they started, but time always passes.  Sometimes, there just isn’t enough time.

Have you heard the joke, “Convicts are the number one buyers of options, nothing makes time fly like owning an option.”  If you break a Law of option pricing, you don’t go to the jail house, you go to the poor house!

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What does all this mean?

An option’s rate of erosion shouldn’t surprise or scare anyone.  Option buyers can calculate time’s expense before buying.  This is done with the Greek called Theta.  Option sellers can predetermine maximum returns.  Traders can know the cost of carrying option positions, both long and short.  Hedged position traders can profit from the continual and constant passage of time.

Time’s Effect on Option Pricing:

Time value and time decay ranks as one of the easiest components of option pricing to understand.  The time value of an option includes everything but the intrinsic value.  Time costs money!  More time, more money.  Less time, less money.  It’s that simple.

But options can’t be simple, they have to have some complexity.  Time passes rhythmically with the tick of a clock, but time value erodes at a different tempo.  Time value decays at its square root.

The square of a number is the product of a number multiplied by itself.  1 x 1 = 1, 2 x 2 = 4, 3 x 3 = 9, etc.  The square root is the other side of the equation.  It’s the equal divisor.  The square root of 1 is 1, the square root of 4 is 2, the square root of 9 is 3, etc.

The Laws of option pricing dictate time value is highest for the At the Money (ATM) option.  Not sometime or most of the time but always.  Time value drops as the strike prices move In and/or Out of the Money (ITM, OTM).  Strike prices Deep In and/or Out of the Money (DITM, DOTM) have the lowest time value.  Not sometime or most of the time but always.

To better understand time value and its rate of decay, one should think in price units and time units.  Price units include dollars and cents; In the case of options, dollars and fractions of dollars.  Time units can be days, weeks or months.  You can even use hours, minutes or seconds.  We won’t discuss an option’s blink of an eye decay rate, but we could mathematically figure it out.

A Hypothetical Example of At the Money (ATM) Call options, (All other option pricing components being constant):

One Time Period = The Square Root of One Price Unit
Two Time Periods = The Square Root of Two Price Units
Three Time Periods = The Square Root of Three Price Units
Four Time Periods = The Square Root of Four Price Units

Insert the time period of your choice, months, weeks, days.  Insert the price unit of your choice dollars or fractions of dollars.  For our example, lets make it months and dollars.

1 Month = $ 1.00 (Square Root of 1 = 1)
2 Months = $ 1.41 (Square Root of 2 = 1.41)
3 Months = $ 1.73 (Square Root of 3 = 1.73)
4 Months = $ 2.00 (Square Root of 4 = 2)

We could extrapolate, the nine month option would cost only $ 3.00 (Square Root of 9 = 3), the 16 month option’s price would be $ 4.00 (Square Root of 16 = 4).

We could replace months with weeks and dollars with fractions, such as 1/2.  Therefore if the one week option were priced at $ .50, the four week option should be $ 1.00, the 16 week option would be $ 2.00.

If we assume four weeks per month, the consistency of the pricing of time becomes evident.  We can see the one month option and the four week option are both priced at $ 1.00.  $ 2.00 buys the four month option and/or the16 week option.  Continuing the math, the 16 month/64 week (LEAP) option would be priced at $ 4.00.

Both equations provide an equal answer:

16 Time Periods = The Square Root of 16 Price Units.
16 Months = The Square Root of 16 Dollars.
16 Months = 4 Dollars.
64 Time Periods = The Square Root of 64 Price Units.
64 Weeks = The Square Root of 64 ½ Dollars.
64 weeks = 8 x .50. = 4 Dollars.

Stock prices go up, they go down, they may end up where they started, but time always passes.  The passage of time can be a profitable journey.

Any Car Racing Fans Out There?  Stock Car Race Fans?  Drag Race Fans?

I like to think of Stock trading like Stock Car Racing.  (Convenient?)  Your car races the track at a constant 100 mph. (Delta of 1.00)  As long as you don’t spin out and hit the wall, (drop in price) or take too many pit stops (stagnant price movement), you will win your race and claim the prize of profits in your account.

I like to compare option trading to Drag Racing.  You buy at a point, desiring your option to slingshot in speed to a much higher price.  The quicker the better.

With Stock Racing you have time on your side, a 500 mile course gives you opportunities to get back on top.  Time is also on the side of stock traders.  Stock prices can rise sooner or later.  Sooner being better.  Timing is much more important to the option trader.  In Drag Racing, if you jump the gun they don’t restart the race, you’re red flagged, you lose.  With option trading you need to be not only right, but right on time.

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With Drag Racing and option trading you want to be lined up from the start because there is less room for mistakes.

To win a Stock Car Race you need sustained speed over a long distance.  Winning a Drag Race isn’t based on speed, but acceleration.  The fastest car doesn’t win, the quickest does.

Option trading, like Drag Racing is based on acceleration.

Back to Option Pricing (very necessary to understand for option strategy) :

Delta measures the change of an option relative to the change of the underlying.  Delta is quoted like a snapshot in time, however, it is dynamic.  Delta changes, it responds to the passage of time and to the movement of the underlying asset.  The change of Delta is measured by Gamma.

Beginner option traders have probably never heard of Gamma.  Novice traders might be aware of the term, but don’t understand Gamma’s significance.  Professional option traders and Market Makers understand and trade Gamma.  To a hedge trader, those with large multiple positions, Gamma is the most important component of option pricing.

Knowledge of certain concepts is necessary before attempting to understand Gamma.

Everyone should know what In the Money (ITM), At the Money (ATM), and Out of the Money (OTM) means regarding strike prices.  These terms indicate if an option has any intrinsic value.  Does the option have equity, in addition to potential.  On expiration day, the time is gone, the potential has passed, the only options with value are the In the Money (ITM) options.

Traders buy options hoping the intrinsic value increases, or the extrinsic value decreases.  Extrinsic is the opposite of intrinsic.  Intrinsic measures the amount in the money, extrinsic measures the amount out of the money.

Example:

Let’s say a stock is at $ 20.00, the $ 17.50 call is In the Money (ITM) $ 2.50.  It has $ 2.50 of equity, or intrinsic value.  The $20.00 call has no equity, no intrinsic or extrinsic value, it is At the Money (ATM).  The $ 22.50 call has no equity, no intrinsic value, but the extrinsic value is $ 2.50, it is Out of the Money (OTM).  As a general rule, extrinsic value is not used.  Most traders consider Out of the Money (OTM) options as having zero intrinsic value.  This is true, but you should be aware of the existence of extrinsic values.

If in our example, the stock were to rise to $ 22.50 the $ 17.50 call’s intrinsic value would increase $ 2.50 to $ 5.00.  It is now Deep in the Money (DITM).  The $ 20.00 call would now have intrinsic value.  It changed from At the Money (ATM) to In the Money (ITM).  The $ 22.50 call lost its extrinsic value, it went from Out of the Money (OTM) to being At the Money (ATM).

Delta varies according to the Laws of option pricing.  The more In the Money, the higher the Delta.  As an option’s intrinsic value increases, so does its Delta..  Options with extrinsic values have low Deltas, but as they move from Out of the Money (OTM) towards being In the Money (ITM), their Deltas increase.  The higher the Delta the more dollar for dollar the option moves relative to the underlying.

Gamma measures the rate of change of Delta.  Suppose in our previous example, the $ 20.00 call (ATM) had a Delta of .50 (fifty) if the stock rose $ 2.50, the Delta might rise to .65 (sixty-five) as the option went ITM, the total Gamma would be .15.  Gamma usually shows up in pricing models measuring the change of Delta for a $1.00 move in the underlying.  Simplistically said, the Gamma in our example on the $ 20.00 ATM call was .06.  Delta increased .06 (six) for each $1.00 move of the stock.  2.5 times .06 equals .15.  In reality, the Gamma might have started at a slightly different figure and changed with the stock price.  Don’t worry, there isn’t a “Greek” to measure the rate of change of the rate of change of the rate of change etc.

Delta is speed.  Gamma is acceleration.

I buy options because of Gamma.  I’m a Drag Race fan.

I hope people are getting some useful information from these “Basic” posts.  Don’t worry we will be getting more specific about option strategies especially using weekly options.

 

Introducing: Delta

Options are complex!  Their value being determined by a long mathematical equation, with many sub-equations and variables.  I can’t write the formulas out for you.  Not because they’re secret, but because my keypad doesn’t contain the crazy looking symbols used in the formulas.

Each aspect of option pricing is a separate component of the formula. To remove confusion, each component has a Greek title; Delta, Gamma, Theta, Vega, and Rho.  Do you wonder? Should that last sentence read, “To ADD confusion?”  Everyone knows Vega is not Greek.  It’s a Chevrolet.

The first and most important of the “Greeks” is Delta.  It is probably one of the most common known of the “Greeks,” but it can be looked at three ways.  Two of which are widely accepted.  The third is far less important and really only theoretical.  Most quasi-knowledgeable traders only know one or two.

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The first and most important way to look at Delta:  Delta measures the rate of change in an option’s price compared to a one point ($1) movement in the underlying security.

Since the rate of change in the price of a stock is measured dollar for dollar, their movement is 100%.  Stocks have a Delta of 1.00.  Don’t worry; stock prices do not have any other “Greeks,” only Delta.

Option prices, which don’t move the same dollar for dollar as stock prices, have lower Deltas.  Think of it as a percentage of the movement of the stock price.  If a stock goes up $1 and an option on that stock went up 1/2, it had a Delta of .50.

Many times Deltas are not mentioned with decimals but as whole numbers.  Since options trade 100 shares of stock per contract, the decimals are dropped.  Example:  .50 x 100 = 50.

Deltas can never be over 1.00 (one hundred).  If you ever see an option move greater than the underlying, it was caused by another of the “Greeks.”  In our examples, we will assume everything else remains constant.  In reality, the other “Greek” forces are at work, but for explanation sake, they will remain silent.

The at the money (ATM) Call will typically have a delta of .50.  In the money (ITM) will have a higher delta.  The Delta is still higher on deep in the money (DITM).  The opposite is true for out of the money (OTM) and deep out of the money (DOTM) options, their Deltas are lower.

An understanding of Delta helps option traders choose strike prices.  To be profitable with small price movements, you will need to buy ATM or maybe even ITM options.  The difference between the Bid/Ask spread may be too great to overcome with OTM options.

The parameters of our hypothetical example:  $30 stock, $25 Call price $6 Delta .75, $30 Call price $2 Delta .50, $35 Call price $1 Delta .25.  If the stock price increases $1 to $31, the $25 Call would increase .75 to $6.75.  The $30 Call would rise to $2.50, the $35 Call would increase to $1.25.

Let’s say the Bid/Ask spread on the $35 Call was .75/1.00 when the stock was $30.  After the $1 price rise in the stock the Bid/Ask spread might have become 1.00/1.25.  If you buy @ $1 and can only sell @ $1, you lose the cost of commissions.

Delta is dynamic.  When the stock price moves, the Delta changes.  Delta will increase as the stock price increases.  Delta will decrease if the stock price falls.  This change is known as Gamma.  Think of Delta as speed and Gamma as acceleration.  We will go into Gamma later in much greater detail.

Delta also changes as time passes.  As option expiration gets closer the Delta for the ITM option increases towards 1.00, and the Delta for the OTM option decreases towards .00, while the ATM option’s Delta will almost hold at .50, right until expiration.

OTM options are usually a bad deal.  There’s generally not enough time for the price to rise and the Delta is too low, the exception is with Leaps.  The Deltas on Leaps will be closer to .50.  ITM Leaps will have lower Deltas than short term options.  OTM Leaps will have higher Deltas than short term options.  Most people are unaware of this phenomenon.  It can be used to great advantage in calendar spreads.

Every option trader should know Delta!  Its okay not to know Rho, but knowledge of Delta is essential.  You will need to understand Delta before trying to grasp Gamma (my favorite).

In order to understand option strategies, especially using weekly options it is necessary to understand Delta – hopefully you do now.  As always if you have any comments please leave them below.

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