Published on Sep 24, 2020 at 3:18 PM
  • Strategies and Concepts

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running posts diving into the finer details of options education. This week, we are looking at hedging -- a simple idea that often takes on a more advanced meaning when put into practice in the market.

If a trader is to make any sort of bet about the future of an investment, they may not necessarily want to put "all their eggs in one basket." A hedge, most simply, is an opposing position to a related asset. Hedging reduces the potential risk of adverse price movement, so if the security doesn't go the way you were hoping, you still have this opposing position to fall back on. At the end of the day, it limits the affects of both risk and reward.

A common example in daily life is insurance. For example, buying travel insurance costs some money, but it limits the risk of having to spend a great deal more money if something unexpected comes up. On Wall Street, it can be prudent to expect volatility, or, as we noted for insurance, the "unexpected." Hedging has investors transferring some of that potential risk in various ways, such as eyeing two sector competitors, both bullish and bearish options for the same stock, etc. 

For options traders, there are quite a few different strategies that can be used to hedge. Protective puts, for example, are used to hedge against losses on an existing stock position, while protective calls are often used by short sellers to limit the risk of potential upside.  

Published on Sep 10, 2020 at 3:55 PM
  • Strategies and Concepts

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running posts diving into the finer details of options education. This week, we are exploring how weekly and monthly options trading differ. 

Stock options are contracts that represent the right to buy (or sell) shares of the underlying equity at a predetermined price, and by a predetermined date. These options are a flexible way to trade, with long or short predictions in the way of calls (bullish) or puts (bearish). As indicated by their names, weekly stock options expire on the Friday's of their respective week, while monthly stock options expire on the third Friday of each month. Weekly options are listed the Thursday eight days prior, and it's worth noting that weekly stock options aren't offered on the monthly options expiration date. 

Weekly options trading allows traders to make more short-term bets on a stock, relative to the standard monthly trading. This lets traders take more recent news into account, and speculate on close upcoming events, for example, increased upside or downside for a stock after it reports quarterly earnings. However, due to their short life-span, it's difficult to revise your trade before the contract expires if the stock makes an unfavorable move. 

Lastly, when it comes to trading these options, here are the top 10 mistakes to avoid according to Schaeffer's Senior V.P. of Research Todd Salamone. These trading errors will help give more clarity to what can happen in a hectic market. 

Published on Aug 28, 2020 at 1:20 PM
  • Editor's Pick
  • Strategies and Concepts

While we love to focus on expanding our knowledge and terminology around trading stocks, it's also important to dive into potential mistakes an investor could make while working within the market. Below, we have a list of 10 trading mistakes that we asked Schaeffer's Senior V.P. of Research Todd Salamone to dive into, to develop more clarity on what it could mean for an options trader if they fall victim to a hectic market.

1. Misallocation of capital

When buying options, there are many opportunities to make gains of 100%, 200% and even more in short time periods, and such gains can be achieved on relatively small moves in the underlying. But depending on the types of options that you are buying, there are also chances that you can lose 100% of the dollars invested in a particular trade. So, given the risk of a total loss on a trade, but also the strong potential to double, triple, or even quadruple your money, the dollars you commit to trading options should be a significantly less dollar commitment than what you trade with stocks. By doing this, you have the potential to achieve the same profits as a stock trader, but with significantly less money at risk. 

2. Thinking a high win-rate means profit

Win rate, average win, and average loss are the key factors in determining bottom-line profitability when buying options. Because you pay a time premium that decays at a non-linear rate AND you have a defined period for your expected move to happen -- defined by the expiration date – option buyers should expect a below 50% win rate. Therefore, in order to achieve profits, the average win must be higher than the average loss. In other words, it is important to focus on letting profits run and cutting losses short when possible. Those with high win rates trading options tend to take profits quickly, resulting in puny winners; and they tend to hold on to losing trades, hoping they will turn into winners - a recipe for disaster. A 60% win rate with a 20% average win and 60% average loss results in a 12% loss, assuming equal dollars in each trade. Flip those numbers (40% win rate, 60% average win, 20% average loss) and a 12% profit occurs.

3. Not diversifying your portfolio

In options trading, this can mean many things, including diversifying strategies to ensure you have exposure to the unknowns and different market environments. For example, strategies such as straddles allow one to profit from explosive moves in either direction; while credit spreads and other premium selling strategies allow on to profit in calm, directionless environments. But even if option-buying is your only strategy, diversity within an options portfolio implies exposure to both calls and puts, different time frames with respect to time played until expiration and more than one set up for both call and put trades. For example, calls set ups might include a momentum-based, breakout strategy and also a strategy that looks for oversold situation in which the underlying is pulling back to support.

4. Lack of discipline

Lack of discipline can mean a number of things. Broadly speaking, whether you are an inexperienced trader that has learned from a successful trader, or an experienced trader who knows what it takes to make money, a lack of discipline means taking short cuts and consistently ignoring know rules and guidelines to achieve bottom-line success. For example, even though a key metric to successful option buying is achieving an average win that is much higher than your average loss, a trader with a lack of discipline will be quick to take profits and be negligible about cutting losses. Or, one will ignore money management principles, such as plowing significantly more money into a trade right after experiencing a losing trade because he wants to make his money back quicker or think he is “due” for a win, even though the results of previous trades are totally independent of the results of the next trade. 

5. Trading without an edge

What is it that you know that few, if any, know? With options, this can pertain to a signal that gives you a clue on direction for a particular underlying that the masses are unaware, or something about its options – its open interest configuration or the pricing of the options - that make the risk-reward attractive now versus other times. When trading, you are embarking on a journey with many others that are trying to accomplish the same thing, and some are taking a view that directly opposes you. Like anything in which competition is involved, those with an edge have a leg up. 

6. Front-running drivers

It is natural for anyone speculating in the market to want action all the time. But beware, especially when buying options, you have a defined time in which the stock has to move and in most cases, there is a time premium embedded in the option’s price that decays at a non-linear rate over time. As such, it is not a good idea to front-run drivers, as these factors work against you, and thus more precision is needed than a stock buying strategy. Remember, there is a big difference between buying a stock and buying an option. While options give you the advantage of reduced dollars at risk and leverage relative to buying an equity, there are risks you take on in exchange for these benefits.  The smart option buyer recognizes these risks and works to reduce them through patience and an understanding of the “Greeks,” or the various factors that determine an options price.

7. Buying what’s cheapest without understanding the Greeks

Some are drawn to options because they are cheap. You can buy a 10 cent option, which typically controls 100 shares of the underlying equity or exchange-traded fund, for $10 (0.10 x 100 shares). And this might look “cheap” relative to a $4.00 option, which costs you $400 ($4.00 x 100). The 10 cents option could be on the ones that deliver 1,000 percent returns, but the chances are slim. You have to look at the delta, which is an approximation of the option being worth anything at expiration, since the delta is a measure of the sensitivity to the underlying’s price. It is the nickel and dime options that usually have a 90% or more probability of being worthless at expiration. If such options make up the core of your option-buying strategy, you run a high risk of losing your entire trading capital devoted to options. In other words, cheaper is not necessarily better. 

8. Poor option selection

There are a myriad of routes available when trading options, including the many strike prices available and the expiration played. The upside of this is the flexibility and ability to fit the time frame with the indicator(s) you are using, the downside is that this can be intimidating and overwhelming to the inexperienced options trader. One focus when buying options should be tied to your risk tolerance, as some options can produce higher returns than others, but with that comes the higher probability of losing your entire investment. This is often when strike selection becomes important when you lock into a specific time frame. Speaking of time frame, the expiration you select is also important, and as such, aligning your time frame with your indicators is critical when trading options. 

9. Trading illiquid options

If you are an individual trader, beware of the difference between the bid price (the price at which you can sell an option) and the ask price (the price at which you can buy the option). This is known as the spread. The more liquid options will have narrower bid and ask price, such as a nickel or dime difference. The most liquid options will have a penny difference on some contracts. The average daily volume of a contract and its open interest can also be indicators of liquidity, although sometimes the open interest may be attributable to only one day or two days of trading during the contract’s life, depending on the situation.

If you are consistently trading illiquid contracts with wider spreads -- selling the bid and buying the offer -- you are incurring significant slippage. In such situations, work the order by placing limit orders between the bid and ask to see at what point they’ll fill the order. If they don’t fill it, cancel the order and try again. Keep in mind that in the more liquid situations where there is decent volume and a narrow spread, there is a chance that you can buy an option at the bid, or sell at its ask. Over time, this can give you an advantage.

10. Focusing on singular time frames (only intraday, only monthly, etc)

This applies to reaching charts. Sometimes traders get fixated on intraday or daily charts, and have zero perspective on resistance or support levels or longer-term moving averages that may lie just overhead or below that could impact the price action. So, even if you are playing a shorter-dated option, such longer-term levels could impact the short-term price action. As an option trader, such awareness is critical in appropriately defining the risk-reward in a trade. If such a situation arises, it may cause you to pass on the trade, or decide to play an option with a longer time til expiration to give it time to break through the support or resistance that was not visible on a shorter-term chart.

Published on Aug 20, 2020 at 2:09 PM
  • Strategies and Concepts

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running a weekly post about options education. Last week, we covered the basics of pairs trading. This week, we will be diving into the definition of short interest.

Short interest measures the level of investor pessimism toward a certain stock. More specifically, it is created when investors sell shares that they do not own outright, but can borrow from a broker. In doing so, they are hopeful that the security's price will drop, so that they can buy the shares back at a discount later on. In other words, if a stock's price declines, investors can buy the cheaper shares and return them to the broker. Since the shares they returned cost less than what they made selling the borrowed stock, they are able to turn a profit.

There are risks associated with this type of trading. For instance, if investors are wrong about a stock and the price rises, they could lose money when they buy shares back at a higher rate. A broker could also demand a position to be closed out at any given time, forcing investors to buy shares back and return them regardless of the stock's current price.

Things can snowball quickly when these bearish bets are proved wrong. If a stock increases dramatically, investors who were selling shares short rush to buy the stock back as soon as possible, in an effort to curb further losses before prices become even higher. This rush to buy back the stock is called a short squeeze, and it only serves as additional tailwinds to the security in question. Finding stocks that are heavily shorted and could be ripe for a short squeeze is a key component of contrarian trading.

When it comes to short interest, there are key indicators investors should be mindful of. Nonetheless, these definitions are valuable when trying to decide on how to invest in an equity.

Published on May 19, 2017 at 3:25 PM
Updated on Aug 18, 2020 at 1:45 PM
  • Strategies and Concepts

Recently, we discussed buying call options or initiating bull call spreads if it appears an underlying stock will move up. This week, we will discuss the opposite; how buying put options can help you get the most out of a stock’s downturn.

What is a Long Put?

For "vanilla" bears, buying a put option on an equity is an attempt to profit from its predicted decline. A put option affords the trader the right to sell 100 shares of the underlying stock at the strike price of the contract, should the shares fall below the strike prior to the option's expiration date.

In the same way that call options provide leverage over buying a stock outright, long puts offer leverage compared to shorting a stock. The initial premium paid for the put represents the maximum loss on the trade, where unhedged short selling poses the risk of theoretically unlimited losses. In addition, a put buyer can achieve a greater return on investment compared to a short seller.

Here’s an Example:

Let’s revisit our favorite trader, Trader A. Trader A is bearish on stock XYZ, which is showing fundamental and technical weakness amid high expectations. XYZ is trading at $45 per share, but trader A thinks it is due to fall in the coming months. Instead of selling the shares short, trader A buys to open one June 50 put option on XYZ, which is asked at $5.55. The cost of this option contract is $555, as one contract represents 100 shares of the underlying. That's opposed to the short seller -- or Trader B -- who would be on the hook for $4,500 to short 100 shares of the stock outright.

Possible Outcomes

Trader A will profit if XYZ finishes below its breakeven point by the time June expiration rolls around. The breakeven point of the purchased put option is the strike price minus the net debit; $44.45 in this scenario. The extent of the profit is determined by how much the shares fall by the expiration date. If XYZ fell to $40 by the expiration date of June 16, the 50-strike puts would have an intrinsic value of 10 points, or $1,000. Minus the $555 paid for the put, that's a $445 profit (not including brokerage fees) -- an 80% return on Trader A's initial investment.

Trader B, our short seller in this scenario, could buy back his borrowed shares at $4,000, making $500. While short-selling in this case netted a slightly larger profit, on an absolute basis, it returned only 11% of Trader B's initial risk.

Meanwhile, let's say XYZ stock rallies to $55 within the option's lifetime. In this situation, Trader A would be out the $555 he paid for the 50-strike put option. On the other hand, the shares Trader B borrowed at $4,500 would now cost $5,500 to buy back -- a $1,000 loss.

Tips When Looking to Buy Puts

When selecting the right option to buy, traders need to consider their specific expectations for the underlying stock. Where do you think the stock is going, and how long will it take to get there? Answering these questions can help you determine the right strike price and expiration date. 

Option buyers should also seek equities with low or undervalued volatility. The Schaeffer's Volatility Index, or SVI, essentially tells us if traders are overpaying or underpaying for a stock's front-month options, from a historical perspective. The SVI averages the implied volatility of front-month options that are at the money. Then, by using a percentile rank, we can determine if those options are seemingly cheap or expensive, from a volatility perspective. Stocks with an SVI near the bottom of their annual range offer attractively priced short-term options.

Published on Aug 13, 2020 at 1:25 PM
Updated on Aug 13, 2020 at 1:40 PM
  • Strategies and Concepts

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running a weekly post about options education. This week, we are exploring the ins and outs of pairs trading.

Pairs trading, as indicated by the name, is the combination of two separate, yet related options plays, on two different securities in the same sector. One play is bullish (established by buying calls) and the other is bearish (established by buying long puts), providing investors a way to play a directional trading idea while also protecting against unexpected headwinds from a particular sector, or the market as a whole. 

When it comes to practicing pairs trading, there are several ways to profit. For one, both the bullish and bearish positions could become profitable, allowing winning on every side of the trade. In the second scenario, the bullish stock outperforms the bearish stock, and the relative outperformance leads to overall profitability. And third, even if these investors are wrong about the losing side of the trade, the most they would lose is 100% of the original premium paid. Still, they have unlimited potential for gains on the winning side. In other words, if the whole segment moves in a direction, they could lose the premium and still profit well beyond it on the other side.

There are also disadvantages to this type of trading. For instance, investors are opening two trades at the same time, meaning premiums are higher than just buying a directional call or put. Pairs trading also relies on volatility and a directional move by one or both of the underlying stocks. If volatility suppresses, or both stocks trade sideways, you could lose on both legs as the time premium decays, and both the call and put are sitting at losses. 

When it comes to pairs trading, there are best practices you can implement to be successful. Nonetheless, these distinctions are valuable when trying to decide on how to invest in an equity.

Published on Aug 6, 2020 at 3:08 PM
Updated on Aug 13, 2020 at 8:56 AM
  • Strategies and Concepts

As retail traders flood the market a return to the basics may help novice traders understand the fundamentals of options trading, we're going to run a weekly post about options education. First up is the difference between call and long call options.

Though their names may sound similar, call and long call options are inherently different. A call option is a contract that gives investors the right -- but not the obligation -- to buy a stock at a certain strike price, allowing them to profit from an asset that rises in value by buying it a lower strike price. Meanwhile, long call options traders are actually buying shares of a certain stock, with the belief that they will rise beyond a certain strike price before a pre-determined expiration date. One of the main differences, therefore, is that long calls can instantly give you equity, while calls give you the ability to buy shares at a discount.

There are advantages and disadvantages to each one of these. For one, the potential for profit on long calls is astronomical, as there are technically no limits to how high a stock could go. In addition, long call investors get paid dividends, since they are also shareholders. As for call traders, they could get a bargain on a booming stock, and their risk is limited since the cost of contract is the most they could ever lose, should it not live up to expectations.

That being said, call buyers may not necessarily see as much of a profit, and will not get paid dividends as they do not have equity in a company until they choose to buy shares. Conversely, long call traders could lose money they invested into a certain stock, if shares do not move higher than the strike price before the pre-determined expiration date. In other words, call holders won't benefit from dividend payments the same way a shareholder would.

These distinctions are important when deciding how to invest in an equity. Next week, we'll dive into how investors can use pairs trades to take advantage of a given sector.

Editor's Note: In an earlier version we referred to the two types of call options as "strategies." This has been revised and we apologize for the confusion.

Published on Sep 9, 2016 at 1:25 PM
Updated on Jul 20, 2020 at 5:10 PM
  • Strategies and Concepts
  • Expectational Analysis
  • Trader Content

Implied volatility (IV) measures the market's expectation for the volatility of an underlying stock during an option's lifetime. Knowledge of IV is especially important for option investors, as it is factored into an option's price. Or, in simpler terms, IV can provide clues to as to whether an option is "a bargain," and dramatic fluctuations in IV can affect an option player's bottom line in more ways than one. 

A high IV is typically associated a higher level of uncertainty of which direction the underlying equity will move, and is also associated with a higher cost of entry for option buyers, and a higher premium collected for sellers. Conversely, low IV indicates relatively muted expectations for the stock's future price action, and is generally associated with lower premiums. To shed some more light on the concept and uses of implied volatility, I sat down for a Q&A with Schaeffer's Senior Quantitative Analyst Rocky White and Schaeffer's Quantitative Analyst Chris Prybal.

How do you know when implied volatility is running high or dwindling?  

Here at Schaeffer's Investment Research, we have the privilege of having IV annual range calculations, which allow the user to compare current IVs to that of the past year. We can also tailor this calculation to go back further in time for emphasis or statistical usage. IV most always picks up around known events, conferences, announcements, earnings, news, and so on. 

How does Schaeffer's Volatility Index (SVI) differ from a stock's 30-day at-the-money implied volatility (30-day ATM IV)?

SVI and 30-day ATM IV are pretty close to the same thing, and they are meant to provide the same information (the short-term IVs on a stock). I’m guessing that the 30-day ATM IV uses a weighted average of two expiration dates to find an implied volatility that is exactly 30 days away. 

For example, say you have a stock that has an expiration date 25 days away, with an IV of 20%, and another expiration date 35 days away with an IV of 30%. In that case, you’d calculate the 30-day IV of 25%, right in between them, since they are both the same number of days away from 30 days. 

Our SVI, on the other hand, uses just one expiration date. It always uses the front regular monthly expiration, and finds the ATM IV of that option (once the front-month regular monthly expiration gets within a week it proceeds to the next month, because IVs can get pretty unstable the closer you get to the expiration date).  

Which options strategies would you consider employing when IV is high? 

Premium-selling strategies -- covered calls, put writes, certain spread strategies -- allow you to use the elevated IV to your advantage, knowing that ultimately it is mean-reverting (given enough time).

Which options strategies would you avoid when IV is high? 

Premium buying is much more difficult with elevated levels of IV. As noted earlier, elevated IVs are usually the result of a newsworthy event or highly volatile situation. An investor can be right on picking the direction of a move in these situations, and still lose on the said option contract because IVs collapse after the event passes, which reduces the price of the option (net-net of any directional movement). In this situation, you would need the price movement to outweigh the IV plunge. Due to this challenge, it is often difficult to make money by buying options which exhibit elevated IVs.

Are there any recent examples where you have used implied volatility to make a successful trade?

We recently made a 100% profit on Lockheed Martin Corporation (NYSE:LMT) calls in one of our Weekend Trader services. We specifically stated that "Now appears to be a good time to buy premium on short-term LMT options, with its 30-day at-the-money implied volatility of 13.2% sitting in the low 2nd annual percentile, and its Schaeffer's Volatility Index (SVI) of 12% at a 12-month low."

Is there a rule of thumb for when IV is either a useful or not-useful metric?

Monitoring IVs and successfully trading the movement of IVs is second only to monitoring price action. It is always a useful metric, and never to be avoided unless one wants to trade against known odds and probabilities.

Sign up now for a trial subscription of Schaeffer's Expiration Week Countdown! We'll send you 5 trades for expiration week, each targeting double- or triple-your-money gains in less than 5 days.
Published on Dec 23, 2016 at 1:01 PM
Updated on Jul 20, 2020 at 5:09 PM
  • Strategies and Concepts

Long-term Equity AnticiPation Securities, also known as LEAPS, are options with longer lifespans than typical options, with expiration dates between one and three years in the future. While traders can buy and sell LEAPS in the same way as standard monthly options, LEAPS also come with their own set of advantages and drawbacks.

LEAPS are generally considered a less-risky alternative to weekly and standard monthly options, mostly because there is more time for the desired price action to take place. The time decay of the option occurs at a slower rate, so the delta of LEAPS tends to be higher than standard options. This allows LEAPS to behave similarly to the underlying stock, but purchasing LEAPS requires a smaller initial investment than purchasing shares of a particular equity -- in other words, they provide leveraged profit potential compared to stock ownership.

Of course, LEAPS do have some distinct drawbacks as well. For one, LEAPS aren't available on every optionable stock. For those stocks that do have LEAPS available, traders may often find that the reward for playing LEAPS is less than the reward for paying near-term options, due to the decreased rate of time decay. Of course, the benefits of owning shares of an equity -- such as dividends and voting rights -- are also forfeited when an investor chooses to go the LEAPS path.

Let's look at an example of how LEAPS can be a good alternative to stock ownership for long-term bulls. If a trader is optimistic about Stock XYZ, which is currently trading at $105, but she doesn't want to pay the initial cash outlay of $10,500 necessary to own 100 shares of XYZ, she can instead purchase a January 2019 100-strike call option for $15, or just $1,500 (since it controls 100 shares). Since the options are already in the money by 5 points, the option likely sports a favorable delta -- in this example, assume the delta is 0.75, or 75%. This means for every single point move higher by XYZ, the LEAPS call should increase in value by $0.75. So, for just 15% of the initial cost of outright ownership of the shares, the LEAPS player is realizing 75% of the rewards. On the flip side, if the shares tank, the LEAPS player's losses are limited to the initial premium paid -- or just $1,500 -- even if XYZ falls to $0.

LEAPS can also be used as portfolio protection, especially if a trader wants to hedge against sector-specific or broad-market headwinds with index LEAPS. Index LEAPS allow traders to invest in an entire sector, or market index, and purchasing a LEAPS index put can work the same way as purchasing a protective put, but on a bigger scale.

Let us help you profit from market volatility. Target big gains in short order with a 30-day trial of Schaeffer's Weekly Volatility Trader!

Published on Nov 23, 2015 at 1:51 PM
Updated on Jul 20, 2020 at 5:07 PM
  • Strategies and Concepts

As you may well be aware, it's very common for option players to close out their trades without ever touching the underlying equity. In other words, they're not looking to acquire or sell the underlying stock; these speculators simply want to capitalize on changes in the option's price (known as "trading for premium"). Obviously, then, every derivatives trader worth his or her salt must be well-versed in the factors that influence an option's price.

Equally as obvious: one of the main factors that affects an option's price is the price of the equity on which it is based. (Assuming all other things are equal, a call option's value will increase in direct relation with the underlying, while a put option's value will increase in inverse relation with the underlying.) But how much do you know about the other catalysts that can prompt major changes in the price of a call or put contract? And do you know which Greek measures your option's probability of finishing in the money? Read on to learn more.

Implied volatility can make or break your trade.

The first and most nebulous factor is known as implied volatility. In the simplest terms, implied volatility is a measure of the market's expectations for the underlying equity's performance during the life span of the option. When implied volatility is high, options will be more expensive to purchase. Conversely, low implied volatility will translate to more affordable option prices.

Generally speaking, heightened implied volatility correlates with bearish sentiment, while low implied volatility suggests a bullish mood. Additionally, an option's implied volatility will rise ahead of scheduled events, such as earnings reports and new product launches. These occurrences can often spark major movements in the price of the underlying, and the expectation of such a move results in higher implieds. Once the anticipated event occurs, implied volatility will immediately drop.

What does this mean for option players? Well, that depends on whether you're buying or selling. If you purchase an option with high implied volatility, you need a much bigger move out of the underlying stock to profit from the trade. That's because you're paying a higher premium to buy the option in the first place.

For this reason, be wary of buying calls or puts directly prior to an earnings report or other scheduled event. When implied volatility is over-inflated, your option could potentially drop in value, even if the stock moves in the direction you anticipated.

On the other hand, hefty implied volatility readings can be a boon for the option writer. If you sell a call option with very high implieds, that translates to a higher premium payment in your pocket. Then, when implied volatility drops back to its usual levels, you can buy to close your option at a discount.

So, how do you judge whether implieds are high or low? By comparing the option's current implied volatility against the stock's historical volatility, you can determine whether the contracts are relatively cheap or comparatively pricey. Just make sure that you match up the option's life span with the proper time frame -- for example, if you're trying to gauge implied volatility on an option with two months of shelf life, compare that number against the equity's 40-day historical volatility. If the implieds are higher than historical volatility, the options are more expensive than usual. If the historical figure is higher, the options are trading at a bargain.

Time decay speeds up as expiration approaches.

Another factor that affects the price of your option is time decay, which refers to the loss of time value. While "time value" is commonly understood to refer to the amount of time priced into your option contract -- and longer-dated options do, indeed, carry higher premiums than their shorter-term counterparts -- it's important to note that implied volatility is also bundled under the umbrella of time value.

In-the-money options carry both intrinsic value and time value, while out-of-the-money options consist solely of time value. As a result, the effects of time decay are felt most acutely on out-of-the-money options.

What makes time decay so tricky is that it occurs in a non-linear fashion, and actually accelerates as the option draws closer to its expiration date. The rate at which your option will lose time value can be measured by theta, which is one of the infamous "Greeks."

Since it erodes the value of an option, time decay works against the option buyer. For every day that passes, your out-of-the-money option will lose a steadily increasing amount of time value, thereby decreasing the contract's worth.

On the other side of this equation, time decay works in favor of the option seller. Should you need to buy to close your sold option, the erosion of time value should translate to a lower buy-to-close price (all other things being equal).

Delta offers up some key information.

To clear up a common misconception, delta does not affect an option's price. Instead, delta is yet another one of those metrics known collectively as the Greeks. Its function is to measure how much your option's price will change for every one-point gain in the underlying stock. Call option deltas will always be a positive number between 0 and 1, while put option deltas will always be a negative number between 0 and -1, since a put option will lose value as the underlying stock rises.

For example, if your option has a delta of 0.70, it means that your call option will gain 70 cents for each dollar the stock rises. As in-the-money calls get close to expiration, they will approach a delta of 1. As an in-the-money put approaches expiration, its delta will move closer to -1. This indicates that the options are now moving point-for-point with the underlying security.

For this reason, an option's delta is thought to roughly correspond with the contract's chances of finishing in the money -- so, that call option with a delta of 0.70 would be said to have a 70% chance of expiring in the money. (Keep in mind that this is an estimation, not a guarantee.)

You'll also sometimes hear delta referred to as the "hedge ratio," because some traders utilize an option's delta to determine how they should hedge their investments. For example, let's say that you purchase one call option controlling 100 shares of XYZ with a delta of 0.50. Assuming that this option has a 50% chance of finishing in the money, you decide to hedge your long position by shorting the underlying stock. Using the delta as a hedge ratio, you would want to sell short 50 shares of XYZ, or 50% of your total exposure.

Published on Dec 27, 2016 at 3:57 PM
Updated on Jul 20, 2020 at 5:07 PM
  • Strategies and Concepts

A bull call spread -- also known as a long call spread -- is a strategy designed for traders who are cautiously optimistic about the upward momentum of an equity. It is most useful for short- or intermediate-term traders who think that a stock will move moderately higher, but could stall out at a certain level. For traders who see a short-term rally that may be hindered by an overhead trendline or similar point of resistance, or for bullish speculators looking to place a "discounted" options bet, the bull call spread can be an excellent way to profit.

To begin, after identifying the targeted equity and any potential levels of resistance, an option player would purchase an in-the-money call, while simultaneously selling an out-of-the-money call with the same expiration date. By writing the out-of-the-money call -- the strike of which should align with potential levels of resistance -- she will be able to offset some of the cost of the bought in-the-money call, though sacrificing some of her profit potential.

For example, imagine a trader is feeling bullish on stock XYZ, currently trading at $102. Ahead of its upcoming earnings report next month, she believes the stock could rally, though she is very wary of the overhead $110 mark, which poses both round-number resistance and is home to XYZ's 80-day moving average, a trendline that has blocked multiple rallies over the previous 18 months. She's also concerned about the cost of XYZ's short-term options, which are relatively inflated at the moment.

The trader decides to initiate a bull call spread by purchasing an XYZ February 100 call for $3.15, and simultaneously selling an XYZ February 110 call for 50 cents, for an initial debit of $2.65 per spread, or $265 total ($2.65 x 100 shares per option). This represents the maximum risk on the trade, even if XYZ falls to zero. Had the speculator simply bought the February 100 call, her maximum risk would be $3.15 per contract, or $315 total.

Once the shares rise above breakeven of $102.65 -- the 100 strike plus the net debit of $2.65 -- the spread trader will begin to see profit. However, this profit potential will be capped at the difference between the two strikes, minus the initial debit, or $7.35 per spread ([$110 - $100] - $2.65), no matter how high XYZ should soar north of $110. Had the trader bought just the February 100 call, her gains would be theoretically unlimited north of $103.15 (strike plus premium paid).

In summary, a bull call spread allows traders to enter into a bullish option play at a "discounted" rate, by selling out-of-the-money calls to offset the cost of purchasing an in-the-money calls. While the trader can lose out on potential profits in the event of a larger-than-expected rally, this option play also allows the trader to lower the entry price and limit potential losses.

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Published on Oct 18, 2015 at 11:00 AM
Updated on Jul 20, 2020 at 5:05 PM
  • Strategies and Concepts

Call buying and put selling are both considered "bullish" strategies, since they're based on the belief that the underlying stock will remain strong through expiration. However, these approaches are far from interchangeable. Here's a quick primer on when you should use each options strategy.

Let's start with buying a call. This is a pretty straightforward bullish strategy, because you're expecting the stock's price to rise. Specifically, when you buy a call, you need the stock to make a fast, aggressive move higher. This big jump on the charts will offset the ill effects of time decay (more on that later), and ensure you can collect your gains before the option expires.

Your profit opportunity in a call-buying strategy is theoretically unlimited. If the trade moves against you, your maximum potential loss is capped at the premium you paid to enter the position (no matter how far the stock falls).

Call buyers also get to enjoy the benefit of leverage. This means they stand to collect gains that are many times greater than their initial investment.

On the other hand, selling a put is technically considered to be a neutral-to-bullish strategy. You don't necessarily expect the underlying stock to rise significantly, but you at least expect the shares to hold steady above the strike through the lifetime of the trade. Depending upon strike selection, you may be able to profit with a sold put whether the stock rallies, edges higher, remains flat, or even pulls back slightly.

When you sell a put, you collect a premium for the sale upfront. This is your maximum possible gain on the trade, even if the stock triples in value prior to expiration. This strategy offers a very limited profit potential, as compared to a purchased call.

Put sellers do benefit from time decay, which erodes the option's value as expiration approaches. Conversely, time decay is a negative for call buyers.

However, a sold put carries a significantly higher risk profile than a sold call. If the stock price declines and your sold put goes in the money, you could be assigned -- or you might end up buying to close the put at a loss, which can be steep if the shares take a serious hit.

It's also worth noting that many beginning option traders may not be approved to sell naked puts right away, due to the increased risk profile. Additionally, put sales typically carry a margin requirement, which means you'll need additional capital to dedicate to the trade.

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