options strategies

Percentage movement is meaningless in stocks.  Own 1000 shares of a $10 stock and you have the same $10,000 tied up as owning 500 shares of a $20 stock.  The same $10,000 buys you 100 shares of a $100 stock.  If any of these stocks move up 10%, a $10,000 position would increase to $11,000.

Percentage movement for option is essential.  Stocks need to make decent price moves in order for its options to have their prices affected.

Strike price choices on a $10 stock maybe limited to $7.50, $10, and $12.50.  Going two strikes In or Out of The Money (ITM, OTM) would add the $5 and $15.  Both of which are 50% from the current price.

The $20 stock would have $17.50, $20 and $22.50 strike prices.  If two strikes In or Out of The Money (ITM, OTM) are available, they would only be 25% from being At The Money (ATM).

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The $100 stock’s strike price availability would all be closer in terms of a percentage.  The $90 and $110 choices would be two In or Out (ITM, OTM), yet they would only be 10% In or Out (ITM, OTM).

If a $100 stock moves 10%, it will pass through two strike prices.  If it moves 10% down, it would pass through the $95 and $90 strikes.  If it moved up, it passes through the $105 and the $110 strikes.

If a $20 stock moves 10% it comes close to moving one strike.  It would still be $0.50 away from either the $17.50 or the $22.50.  Close, but not close enough.

A 10% move on a $10 stock doesn’t get the price much closer at all to the next strike price.  Less expensive priced stocks need bigger percentage movements.

The significance of strike price distance versus stock prices as terms of a percentage should be clearer.  All equal percentage price movements affect all stocks equally, they do not affect options the same.  A 10% move is a big thing to options on high priced stocks, but lower priced stocks require larger percentage moves to affect their options.

If a stock’s price is too low, you may consider buying the stock as opposed to trading options on it.  You should certainly rule out trading Out of The Money (OTM) options on them.  Match the strategy to the stock price.

Margin requirements vary on plays.  Buying options requires the money to pay for them.  Buying stock either requires full payment, or you may purchase them on margin.  (Check with your broker for specific margin requirements.)  Generally speaking stocks need to be around $5 minimum in price to be optionable.  In such case the typical margin is 50%.  That is, you need to have half the money available, your broker will loan you the other half.

When you sell options, you will need to put something up as collateral.  With Covered Calls, the most often sold option, the collateral is the stock the option is written against.  You either need to pay for the stock in full, or buy it on margin.  By putting up only 50% of the cost and selling the option and receiving 100% of the premium you may more than double your return.

Naked Puts have more aggressive margin still.    Many brokers only require 25% security for the value of the stock.  Successful Naked Put selling may have less commissions than Covered Calls.  Naked Puts done right cost one commission versus Covered Calls three.

Always run through different strategies and pick the best one depending on your risk tolerance, account size and your expected move in the asset.

Profits from stock trading come by buying low and selling high.  Profits fuel capitalism.  Profits built America.  Corporate profits come from buying low and selling high.  Every successful business is based on this simple concept.

The main difference between corporate profits and investing profits is, the adding of value.  McDonalds buys potatoes low and sells them high.  They add value by peeling, cutting and frying these potatoes; then selling them as french-fries.  The basic concept remains buy low/sell high.

Investors don’t add value.  They can’t dip their stock certificates in chocolate and have fancier more valuable shares.  A share is a share, is a share.  All shares are equal.

Buying low and selling high requires valuations.  How else would you know if something is high or low.  You can’t trade using 20/20 hindsight.  You need to know what something is worth and what it should be worth.  Not just stock or option valuations, but for anything.

There are rules of thumb for everything.  Example, something is only worth what someone is willing to sell it at or pay for it.  Price measures value.  To measure the value of a stock at any time look at the last price traded.  It is the most current match of a willing buyer and a willing seller.  Trades require buyers and sellers.  With every trade, you truly have both opinions.  Prices move based on supply and demand.  More buyers cause increasing prices, more sellers and prices decline.

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Free Appraisals

Antique dealers earn their living through their knowledge.  Buying and selling provides their income, but their knowledge allows their transactions.  They need to verify authenticity, rate condition, know market values and marketability.  They use this insight to buy low/sell high.

Many antique dealers supplement their antique trading profits by offering appraisals.  Often before insuring certain items, insurance policies will require professional written appraisals stating value.  In the worse case scenario of a claim, a written appraisal saves untold amounts of grief.

Some antiques are too large or delicate to transit, so the appraiser must travel to inspect them.  Time cost money.  The appraisers need to charge for their time.  None of this is done for free, well almost nothing.  Many people seeking appraisals are doing so to value their item for sale.  Loss leader appraisal services generate antiques coming through the doors.  Many dealers offer appraisal services as a means to buy.

An antique dealer friend of mine told me a story of a client who didn’t want to pay for his services, but wanted them just the same.  He explained how this person had a “valuable” piece of antique furniture.  When told of the cost of the appraisal, including the travel time to come look at it, the client asked for a free appraisal over the phone.  The antique dealer was used to people trying to avoid paying for his services and played a little game with any skin-flints.

Hold It Up To The Phone

He told them to bring the phone near the piece to be able to better describe it.  Then he asked to have the phone held closer so he could see the item better.  He asked to have the phone moved around the piece very systematically.  The phone was placed inside every nook and cranny.  Upon completion, the antique dealer announced the piece looked counterfeit.  The person became so concerned.  Was he sure?  Well only in person could he know.

Knowledge also provides professional stock traders with their living.  And unlike antique dealers, they give free appraisals.  Every time they buy or sell, they state their opinion on what that particular stock is worth at that very moment.

The last trade gives the universally accepted valuation of a stock.  Whether one share or one million shares exchanged hands, the last recorded trade sets the value of all existing shares.  This skew allows profit potential.  Volume is a key to stock and option traders.  Price movements on low volume don’t confirm valuation changes as well as large volume moves.

The market capitalization of a company is figured by multiplying the number of shares outstanding by the current price of the stock.  Theoretically, if a stock trades millions of shares at a level, then trades one last share at a much different level, the market cap is based on this last share.

This is the problem with after hours trading.  The spreads are wide, with volume low.  Valuations swing wildly as trades take place from low bids to outrageous offers.  The willing buyers want to steal stock.  The willing sellers want a small fortune.  Until after hours trading gets tight bid/ask spreads, think of it like unscrupulous antique dealers trying to underpay ignorant owners or overcharge non-knowledgeable collectors.

Unlike businesses that add value, traders need to mine equity.  Investors need to use knowledge, experience and research to find gold mine stocks.  Not literal gold mining companies, but value waiting to be pulled out.  Gold in the ground is worthless until someone stakes a claim, commits resources to extract the value.

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.

Episode I.

Is there a Trekkie out there who can help me out?  I understand the Black-Scholes option pricing formula, but I just can’t comprehend Star Wars.

People with tents sleeping in line waiting to buy tickets to a movie.  Not just any movie, but a movie that’s playing everywhere.  Multiple theaters, gobs of seats, and plenty of screenings.

I have a few thoughts as to why anyone would go through all the trouble to be among Star War’s first viewers.

Crowd Mentality!  The media hypes the movie, and a feeding frenzy begins.

Bad Math Skills!  Until there’s a scarcity of theaters, there’s no scarcity of seats.  Each theater has hundreds of seats, one per person.  Don’t forget they empty the theater and show the movie again.  Over and over, infinitum.

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Bragging Rights!  Every time a day one viewer watches the video, he will remember he’s able to tell his grand kids he saw the movie on May 19th not May 20th.

Bad Business Skills!  Who is smarter?  The guy in a tent for a week, or his buddy who pays him $20 to buy an $8 movie ticket?

Too Much Free Time!  Hello, don’t people have anything better to do than wait days to buy a ticket to a movie?

Am I missing something?  I just don’t get it.  While you’re at it, explain to me how Episode One can come 20 years after the first movie.

I haven’t seen the movie yet, was it worth the hype?  Was the expectation greater than the event?

What does this have to do with option pricing?

I get e-mails from many mathematically challenged, crowd following option traders who don’t know the value of time and can’t brag about good trades.  Besides, even I have to jump on a bandwagon every once in a while.

Don’t forget the suspense.  Our last column ended in a cliff hanger.  Will the sequel be worth the hype?  Does understanding Implied Volatility and Vega help traders to win more often and lose less frequently?

Enough excitement, back to option pricing.

In mathematical equations you solve for the unknown.  Two plus two equals what number?  That’s too easy.  Let’s use multiplication instead of addition.  Two times two equals?  Still too simple, how about option pricing?  Without going into tremendous detail of option pricing formulas, here’s the gist.

The price of the stock compared with the strike price has a value.  The amount of time to expiration is easily calculated.  As are interest rates and dividends.  You take all these components plus the expected volatility, plug them into the pricing formula, and solve for the unknown; the option’s price.  Actually the option’s theoretical price.

While mathematical formulas determine theoretical value of options, market forces determine the price at which options trade.  The market consists of buyers and sellers.  Supply and demand.

More buyers equals higher prices.  You can’t pitch a tent to be one of the lucky, you need to write a check.  On the flip side of the coin, excessive sellers and/or insufficient buyers drive prices lower.

Market Makers estimate with formulas.  Charging according to whatever the traffic will bear.  If the market won’t support higher prices, it drops.

The Dark Side of the Force.

Back to our make believe world, where nothing changes unless we allow it.  Without any movement to the stock price, interest rate, dividend, and time to expiration; the price of an option can still vary.

The funny thing about all our previous make believe examples, this one might not be so made up.  In reality, an option’s price may fluctuate without any other circumstantial difference.  This situation can happen.

A rumor may spread about a take over possibility.  The interest rates and dividends could certainly remain the same before and after the rumor.  The stock price might not move.  In no time at all the price of the options could sky rocket.  The hype could end just as sudden and the stock price not falter, but the option price melts.  Could it be, the expectation was greater than the event?

What about earnings reports?  After the announcement, there is no guess work, no unknown, no expectation.  Option prices tend to drop, the sizzle is gone and all that is left is steak, or gristle.  Don’t fuel the fire by over paying for options.

Comparing Implied Volatility to Expected Volatility tells if an option is fairly valued.  If the Implied Volatility is less than Expected Volatility the option is said to be undervalued.  If Implied Volatility is greater than Expected Volatility the option is overvalued.

Vega measures option price changes based on volatility.  Although Vega is considered one of the “Greeks,” it’s not actually Greek.  It’s Spanish.  Or as most would say, A foreign language.

“May the Implied Volatility be with you.”

 

The Big IF

The biggest battles of the Cold War were often fought during the Olympics.  No matter what flag you saluted, it was US verses that “Evil Empire.”  I don’t know about you, but I always felt the other country’s athletes used performance enhancing drugs.  Not to mention their judge’s scores reflected definite political bias.  Biased scoring could award a gold medal to a silver or bronze performance.

You’ve seen the kids who score and rank everything and anything. Holding up a card that is either a 6 or a 9, depending on which end is up.  “Solid nines, but a six from the Russian Judge.”  Simultaneously in Russia kids are jokingly scoring, “A six from the American Judge.”  It’s all perspective.

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Option pricing has its own “Russian Judge,” volatility.  If you don’t understand volatility’s role in option pricing, your gold medal trades might not make it to the platform.

Option prices are based on a number of components; time, interest rates, dividends, price (stock & strike) and potential.  Potential, also known as volatility, is the most subjective.  Hence the ability to be the kink in our attempt for the gold.

Time is constant with all options.  Three days from now or three weeks from now is the same, no matter if you are trading Amazon.Com or AOL.

Interest rates may change up or down, but it’s the same rate for every stock.

Dividends will vary stock by stock.  General Electric’s dividend has nothing to do with General Motors.  So dividends are figured on a stock by stock basis.  The dividends will be the same no matter what strike price, no matter if it’s Puts or Calls, no matter if you’re buying or selling.

Options are priced as a snapshot in time.  The math between price and strike prices at a given point in time is easily figured.

The simplicity of option pricing ends here.  (As if you thought it was simple so far.)

Volatility is the MOST IMPORTANT component in option pricing.  Simultaneously, it may be the MOST DIFFICULT to understand.

Mathematically speaking, volatility is the annualized standard deviation of daily returns.  Translated, it measures the stock’s price fluctuation.  The more the stock moves the higher the volatility.

Volatility scores potential movement of the underlying stock.  The “Greek” symbol Vega measures volatility.  Proving the point volatility is complex, Vega isn’t actually a Greek letter.

With me so far?  It gets worse.  Concerning option pricing, there are four types of volatility; Historical, Future, Expected, and Implied.

Historical Volatility

Simply stated, how much the price of a stock has moved in the past.

Without going deep into math, let me explain the concept.  If you have two $ 50 stocks, the price is currently the same, but historical volatility may differ.

If one stock’s 52 week high/low is $ 40/60, while the other’s is $ 45/55, it is easy to see which stock trading range is greater.  The more a stock’s price moves, the higher historical volatility.

If you have two $ 50 stocks with equal 52 week high/lows, their historical volatility may still be different.  If one had a daily trading range of $ 5, its historical volatility would be higher than a stock with a daily trading range of $ 2.  (Daily trading range equals the difference between the high and low during a one day period.)

Easily verified, historical volatility measures the actual prior price movement.

Future Volatility

An almost useless concept.  Future volatility is historical volatility before it happens.  Price movement before it moves.  After it moves, it’s not in the future, it’s not in the present, it’s in the past. Confirmed after it happens.  Future volatility is accurately measured in the future looking backwards, after it became fact.  Of the four, it is the least important Volatility.

Expected Volatility

Expected volatility deals with the future.  Generally based on prior price movements, it assumes the stock will move in a certain pattern.  Not the what it’s moved, not the what it will move, but the what it should move.

Fairly valued options are calculated according to expected volatility.  However, not all options are fairly valued.  Some options are undervalued and many more are overvalued.  As with anything, buy low sell high.

Certainly more important than future volatility, arguably more important than historic volatility, but definitely less important than implied volatility.

Volatility prices options, but as you will see option pricing determines volatility.

Implied Volatility

The Big IF, the “Russian Judge,” the other side of the coin, the pick pocket of option pricing.  Call it what you want.  Implied volatility costs option traders more money than anything else.

Understanding Implied volatility and Vega allows traders to win more often, but more important to potentially lose less often.

Next we will discuss implied volatility and its ramifications in greater detail.

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