What Makes a Great Trader Part I

With summer ending and trading volume expected to rise, it might be a good time to give yourself a mental break and reflect on your trading before the fall.  Are you the great options trader you thought you would be by now or have you ever wondered what  truly makes a great options trader? I mean not a options trader that does pretty well, but one that you envy and want to be? Are great options traders just born that way? Does being smarter necessarily give you an advantage in options trading? Is studying charts until you are bleary-eyed from looking at them the secret; or is it just dumb luck on who succeeds and who fails? 

The qualities that you will need to succeed in my opinion are a commitment to success, having a options trading plan and the most important, mastering your emotions-or the psychology of options trading. I believe that options trading is the hardest job in the world (quite possibly the best, but the hardest). That's why it will probably take you a lot longer than you think before you really get a solid grip on it.

So let's first talk about your commitment to success. This essentially sounds like the easiest of the three qualities to master doesn't it? Why does anyone want to become a options trader in the first place? Probably, because they want to become wealthy and very successful. Who isn't committed to that, right? All you need is some money, charts, and a platform and you are on your way. Almost everyone says they are committed but most people are not because when they find out options trading is work-and it is. They tend to lose their focus and their original goals when the going gets though.

If you are committed to success then you must be committed to reaching your goals. The most important part of having goals is to write them down. If you never write them down they are simply just dreams. We don't want to dream we are a great trader we want to realize that we are! Only about 2% of Americans write down their goals. Is it really shocking to know that most people never achieve what they want out of life? As "corny" as it may seem, when you write something down no matter what, your thoughts are transformed from the subconscious to the conscious and are now tangible. Your goals have become something you can see and say out loud. If you never write them down they never exist outside of your thoughts.

Let me leave you with this before I end this introduction on how we are going to build a great options trader out of you. I think everyone can agree whether you are a beginning options trader or a more experienced options trader that there are several key components you will need to do to become a standout. Having said this I also know that most of you will not be committed to do this at first. I know I wasn't. I thought to myself I am too smart and I know how to options trade. I knew it would not be easy but I was unprepared for the results that followed. I'll give you a hint, they weren't good. After I decided to fully commit myself and write down my goals did my results finally change. Let's face it; options trading is a realm like no other. Options trading looks easy and which in turn makes you lazy to work at it. Be committed to your success and write down your goals right from the start will only help you achieve the success you are after that much quicker.

 

 This article is proposed by John Kmiecik - (Senior Options Instructor) at Market Taker Mentoring

The Three (3) Types of Volatility, an explanation...

Understanding The 3 Kinds of Volatility
With recent market activity in assets like Bonds, Gold and Japan, it reminds traders that prices can go down as well as up — and we're suddenly starting to hear more about volatility again.  Today we'll discuss the different types of volatility related to stocks and ETFs.

1) Historical Volatility -  The first type of volatility is Historical Volatility, or HV, which may also be referred to as Realized Volatility.  Historical volatility is something that we can observe and measure based on the past price movements of a security.  It is typically calculated as the standard deviation of the security's daily returns over some lookback period.  For example, the 30-day historical volatility, or HV(30), calculates the standard deviation of the daily gain or loss from each of the past 30 trading days.

Volatility is almost always expressed in annual terms, regardless of the lookback period.  Therefore, if a stock has an HV(30) value of 45, it means that if the stock continued to move as it has for the past 30 days, it would likely experience a total price change of 45% (up or down) over the next year.  If we assume that daily returns are normally distributed, then we can infer that there is approximately a 68% probability of the price landing somewhere in this range.

Although HV is an expression of how much a stock's price may change in a year, it's more typically used as a way of comparing the recent price behavior of two securities.  If XYZ has an HV(100) value of 25 and PQR has an HV(100) value of 75, then we know that PQR has experienced more extreme price changes over the past five trading months.

2) Relative Volatility – Sometimes you'll hear Beta used as a measure of Relative Volatility.  From a mathematical standpoint, Beta is the correlation coefficient between two price series.  The Beta value of a stock or ETF is most often computed relative to the market as a whole, which in most cases means the S&P 500 (SPX) (SPY) for the US market.

A Beta value greater than 1 means that the stock generally moves more than the market, while a value of less than 1 means that the stock typically moves less than the overall market . Negative values, i.e. negative correlations, mean that the stock price has a tendency to fall when the market rises, and vice versa.

3) Implied Volatility – The final type of volatility that we'll address today is Implied Volatility, or IV.
Implied volatility cannot be calculated from historical prices of the stock, but rather is the byproduct of an options pricing model.

In simplest terms, IV is an expression of the market's expectation of the future volatility of the stock price between now and the option's expiration.  Market participants "express" themselves via the prices they are willing to pay for option contracts.  Like HV, implied volatility is always annualized to make comparison of values more straightforward.

Each unique option contract, i.e. combination of put or call, strike price, and expiration date, will generate a different implied volatility value.  These values are often combined to provide some sort of "consensus opinion" of the IV of the stock.  For example, your trading platform may display an IV value for each expiration date, which was likely calculated with some type of weighted average of all the different strike prices for that expiration.  The different IV values for each expiration date will indicate whether the market is expecting more volatility in a specific time-frame, like when quarterly earnings are announced.
You might also see IV expressed over a constant lookahead period such as 30 days.  The CBOE Volatility Index, or (VIX) (VXX), is the most popular metric of this type.  While a full discussion is beyond the scope of this article, the basic idea behind the VIX and similar measures of this type is to use front month and second month option prices to create a synthetic ATM option contract that expires in exactly 30 days.  This synthetic contract can then be used to generate an implied volatility value.  Note that in the case of VIX and related indices, 30 days means 30 calendar days (approximately one month), not 30 trading days.

From Matt Radtke - tradingmarkets.com

The 3000 Year History of Options

A 3,000 year History of Options, Derivatives, and Futures Trading.

1700 BC – The history of derivatives is very long, there is even a reference in the Bible - Genesis 29 where Laban offers Jacob an option to marry his youngest daughter Rachel in exchange for seven years of labor.  After seven years Laban reneged and only offered his eldest daughter Leah.  Luckily for Jacob, polygamy was allowed in those days so he was able to marry Rachel as well later on.

580 BC – The History of Derivatives goes back to ancient times.  Thales of Milesia, a pre-Socratic Greek philosopher and considered one of the seven sages of Greece, was thought to have bought options on olive presses.  His prediction was for good weather and a bumper crop, which ended up making him a fortune.

1637 – One of the celebrated events in the history of derivatives is the Tulip Bubble, which was facilitated by forward contracts on Tulips.  As the price of tulip bulbs increased Dutch dealers also started tulip bulb options trading, so that producers could sell the rights to owning tulip bulbs in Call Options. This means of hedging risk turned into speculative frenzy, as the price of tulip bulbs skyrocketed between the end of 1636 to February of 1637.  The contracts were OTC and in the absence of legal enforcement personal reputation was what the trading was based on.

1697 – Dojima Rice Exchange was the first to to trade standardised futures in the history of derivatives contracts and had two types of rice markets – the shomai and choaimai (spot and futures respectively).  Different grades of rice were contracted with standardized agreements.  No cash or vouchers were exchanged; all relevant information was recorded at a clearinghouse.  The contract period was limited to four months at a time and had to be settled prior to contract expiry.  Settlement of the differences in value between the current spot price and the contract had to be done with cash or an opposing contract position.  With a few interruptions and updates, the rice exchange operated until 1937.  Participants in the exchange were required to establish lines of credit with a clearinghouse.  The clearing house assumed the risk of the various counterparties – very similar to today.

1720 - South Sea Bubble – The South Sea Company was a trading concern with interests in South America, and was important also as an important marker in the history of derivatives.  They had a monopoly on trading in this region after the War of Spanish Succession.  In return for this concession the company assumed some of the national debt of England.  Enthusiasm for the share led to the price moving from $100 to $1000 in under a year.  It also fell back equally quickly when expectations about the company became more realistic.  Options and Futures were used widely during this era in London.

1848 – Chicago Board of Trade created, marking a really important date in the history of derivatives.  Chicago was a hub for the storage and transport of grain from the Midwest.  Grain prices rose and fell sharply seasonally.  Storage was also often at a premium following the harvest.  To cope with all these vagaries the “to-arrive” contract was created.  The idea was that the farmer could lock in the price and the deliver the grain at a future date.  This allowed farmers to hedge against price moves and protect themselves.  The contracts became standardized in 1865 and by 1925 a clearinghouse was formed to take away the credit risk element.  That is pretty much the modern commodity future that we still use to this day.

1872 - Russell Sage created the first OTC options in New York, and is a major figure in the history of derivatives.  His business model relied on using the principles of Put-Call Parity.  He would buy the stock and a put from the customer and then sell them a call back – while fixing the put, call and strike prices.  In effect he was creating a synthetic loan, which allowed him to charge much higher rates of interest that the prevailing usury laws allowed.  What is interesting is that he had in 1867 been convicted and fined for usury, so he had just found a very clever way around it.

1972 – The collapse of the Bretton-Woods System and the advent of free floating currencies meant that currency futures became very quickly a necessity.  This was another step in the development and history of derivatives.  This is when the Chicago Mercantile Exchange created the IMM in 1972.  These were the very first time futures were traded on non-physical commodities.  By 1975 there were Interest Rate Futures, initial attempts (based on the Ginnie Mae) did not succeed until one was created based on a Treasury Bill underlying.  It was not till 1982 that an Index Equity future was introduced (on the S&P 500).

1973 – The Chicago Board of Options (CBOE) was created.  This was the first time standardised options were traded through a central clearing house and the prices were listed in the press.  On the first day of trading there were 911 contracts across 16 underlying stocks.  This could again be pointed to as one of the seminal events in the history of the derivatives markets.

1973 – Fisher Black and Myron Scholes introduced a mathematical framework to price options.  This is what we know today as the Black-Scholes equation and this formed the basis for much of the financial engineering that would happen in the next few decades.  In 1973 the first equity Index Options was introduced following hot on the heels of the equity index future.  Without a doubt, the introduction of the Black-Scholes was one of the crucial points in the history of derivatives as it introduced a more scientific framework for the pricing of options. This was the starting point for further developments in the academic and practical study of options.

40th birthday of options trading

Today (April 26, 2013), we celebrate the birthday of options by looking back at the evolution and game-changing innovation of an industry.

Forty years ago, in 1973, the Chicago Board Options Exchange (CBOE) was founded. The first options traded on 16 stocks -- just 911 contracts, all calls -- on April 26, as market makers watched from the "trading floor," which was actually the 4,300-square-foot smoking lounge of the Chicago Board of Trading (CBOT).

10 Things To Know About the VIX

Here is some introductory material on the VIX, based on common questions from investors:

Q: What is the VIX?
Anwser: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days.  The formal name of the VIX is the CBOE Volatility Index.

Q: How is the VIX calculated?
Answer: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX.  In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number.  For the record, the CBOE does not use the Black-Scholes option pricing model.  Details of the VIX calculations are available from the CBOE in their VIX white paper.

Q: Why should I care about the VIX?
Answer: There are several reasons to pay attention to the VIX.  Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points.  A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.

Q: What is the history of the VIX?
Answer: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed.  The 'original VIX' (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at-the-money options instead of the broad range of strikes utilized by the VIX.  The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker.  VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.

Q: Why is the VIX sometimes called the "fear index"?
Answer: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products.  As the CBOE puts it, "since volatility often signifies financial turmoil, [the] VIX is often referred to as the 'investor fear gauge'".  The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.

Q: How does the VIX differ from other measures of volatility?
Anwser: The VIX is the most widely known of a number of volatility indices.  The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index).  In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.

Q: What are normal, high and low readings for the VIX?
Answer: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers.  On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10.  Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.

Q: Can I trade the VIX?
Answer: At this time it is not possible to trade the cash or spot VIX directly.  The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: (VXX), which targets VIX futures with 1 month to maturity; and (VXZ), which targets 5 months to maturity.  An inverse VIX futures ETN, (XXV), was launched on 7/19/10.  This product targets VIX futures with 1 month to maturity.

Q: How can the VIX be used as a hedge?
Anwser: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile.  For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions.  Similar hedges can be constructed using VIX futures or the VIX ETNs.

Q: How do investors use the VIX to time the market?
Answer: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame.  The devil, of course, is in the details.

Intrinsic or Extrinsic Value

One point not often discussed is the way in which options are priced.  The quoted option price is in reality the sum of two separate components. These are referred to as the intrinsic and the extrinsic portions of the premium.  I think of these as steak and sizzle respectively.

For example, let's say AAPL has closed at around $395.  The January 390 call has 41 days to expiration and could have been bought for $18.90.  Of this sum, $5 represents intrinsic premium and $13.90 represents extrinsic or time premium.

This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility.

The intrinsic premium is subject to change solely due to changes in the price of the underlying security.  There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.

The situation with the extrinsic premium is quite different.  The value changes not only with time to expiration but also with the constantly changing implied volatility.  It is for this reason that an option trader must be very careful with this extrinsic component.

Depending on the specific option under consideration, extrinsic premium may represent all, a portion, or a trivial amount of the entirety of the option premium.

Another important concept is that of the "moneyness" of an option.  An individual option can be classified in one of three categories of "moneyness:"

* At-the-money
* In-the-money
* Out-of-the money

At-the-money options by definition consist of a single strike price.  Both in-the-money and out-of-the-money strikes usually contain several individual strikes within their groups.

In our example of AAPL, the at-the-money strike is the 395 strike. The in-the-money strikes consist of all calls with strike prices below 395 and all puts with strike prices above 395.  The out-of -the-money strikes consist of all calls above the 395 strike and all puts below the 395 strike.

Obviously since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.

The reason for taking the time to discuss in some detail this classification of "moneyness" is that there are important reliable characteristics of each type of option.

 At-the-money options characteristically contain the absolute greatest dollar amount of extrinsic premium.  In-the-money options have the least amount of extrinsic premium.  Out-of-the-money options consist entirely of extrinsic premium, and therefore only contain sizzle . . . no steak can be found there.

Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different "moneyness" to achieve trades with the best probability of success and the highest risk/reward scenarios.

For example, buying an in-the-money call and selling an at-the-money call gives birth to a call debit spread, a high probability trade structure for the trader who is bullish in the underlying.

The Three Most Important Things Affecting Option Pricing

Option pricing is affected by a number of well known variables. Once you have an option position in place, whether it includes calls or puts, that you bought or sold, there are only a few things that can affect the price.
1. Stock Price
This relationship is the simplest concept to understand. The fact that stock price impacts option pricing is obvious and the first concept that is usually understood by people new to options. Calls go up when the stock goes up. Puts go up when the stock goes down. If we are bullish we can buy calls or sell puts. If we are bearish we can buy puts or sell calls. (Important advice: you generally do not want to sell options without having another option or stock to cover it. This is called naked selling. As the saying goes “You can lose more than your dignity going naked.”) Using a combination of stock, calls, and puts we can build an almost infinite number of trades to take advantage of any imaginable trend. This is the power of options.
2. Time Remaining In the Option
It’s intuitively obvious that if you want to have control of something for a longer period of time it will cost more money. Just like that beach house down by the shore. Nightly rentals are going to be pretty expensive, let’s say $750 per night. However, if you want to rent for a week, it’s going to cost $4,550. And if you want to lease for the summer, it’s going to cost you $40,500. If you are one of those people who love the beach year round, you can opt for the one-year lease at $73,000 for the year. On the face, those number look pretty expensive. But, let’s break it down.

Term	Total Cost	Cost Per Day
1 day	$750	$750
1 week	$4,550	$650
1 season	$40,500	$450
1 year	$73,000	$200

We can see that clearly the best deal is the one year option. This is similar to the concept of time value in options. Longer term options cost more over all, but they are cheaper.
This is one of the reasons why we recommend that you use protective options with a longer term. Personally, when I consider protective puts, I am looking at a minimum of 90 days. This gives me protection I need and the time to adjust my trade after the event passes.
As the remaining value of your beach house lease becomes worth less and less over time, so does that value of the options. And just like the time seems on your vacation, the value decays faster and fast as the end approaches.
3. Implied Volatility
For traders new to options, implied volatility is the most difficult factor to understand. There is no corollary to it with traditional equities like stocks or ETFs. However, it’s really a straightforward concept. Simply stated, implied volatility is a measure of the future risk.
I imagine implied volatility as the flame in hot air balloon. The bigger the flame the higher the balloon rises. Implied volatility increases and causes the options pricing to rise. When it cools off the balloon will fall. This is exactly what happens with options. Take the case of RIMM and its upcoming earnings. We are seeing a rise in options pricing that is not related to anything other than the anticipation that stock will move after earnings. This is a well-known and documented phenomena in stocks like RIMM. AAPL, ISRG, GOOG, and SNDK are also known for this. These stocks can make huge movements after an earnings event. This “risk” is what drives up the implied volatility and options pricing up and down. That behavior presents opportunities for options traders.
4. Risk Free Interest and Dividends
There are two other factors which affect options pricing: risk free interest rate and dividends. These are not ignored when we trade options. Generally, these factors do not change dramatically. Therefore, we tend to neglect them. But keep in mind, if a stock changes its dividend (e.g., BP?) or the interest rate changes (e.g., the FOMC ends its “For the Foreseeable Future” policy) you will see options pricing changes. We just do not see these changes very often.
I am writing this article because I often run into people who do not understand the concept of implied volatility. One time, I had a student have the light-go-on. He had the “aha! moment” and proceeded to tell me that “Sometime you run into things in your life and you say to yourself ‘I don’t understand that.’ And somehow you convince yourself that it’s not something that you really need to know and then you just move on. That is the way that I used to think about implied volatility.” That might be true for things like astrophysics or philosophy, but it’s not true for trading options.
The truth is that these three things are essential concepts to understand when it comes to trading options. Once you have your options trade in place, these are the most important factors impacting the value of your trade:

1. Stock Price
2. Time Decay
3. Implied Volatility

How important are these? I would put them on the same level of importance as:

1. Gas Pedal
2. Steering Wheel
3. Brakes

You could never drive a car without understanding these three things. It obvious that you wouldn’t even try. Yet, I run into people who have mastered the concepts of stock movement (Delta) and time decay (Theta) and have essentially no understanding of Implied Volatility (Vega).

Options Trading Volume Continues To Grow

Despite mediocre global economic conditions and lower stock volume at some brokers, the leading options exchange (CBOE) reported some impressive numbers for 2011.  We'll examine their numbers as a proxy for the entire option industry.

With the vast diversity of options in terms of hedging, speculation and leverage, it's not surprising to see this continued growth and increased popularity.

Overall, CBOE.com reported combined options trading volume of 1.20 billion contracts in 2011 vs 1.12 in 2010 (up 7%).  Average daily volume was up 8% to 4.78 million contracts.

The real growth is in trading of Index, ETF, & VIX options — we've previously discussed the growing popularity of ETFs.   2 CBOE flagship products, options on the S&P 500 Index (SPX) and CBOE Volatility Index (VIX), both bosted all-time annual volume records.

CBOE ETF options volume in 2011 was up a whopping 22% over 2010. And VIX options trading (which actually is on the CBOE-owned Chicago Futures Exchange) grew an explosive 174% over 2010.

The many advantages of using options in a portion of your portfolio for any type of investor or trader continues to become more apparent year-after-year, which is seen in the increasing volume and popularity.

Two Approaches to Trading Earnings

It has become common knowledge that implied volatility for affected options rises sharply as an earnings announcement approaches. The effect is especially strong when earnings are released just one or two days before expiration.

WELL-KNOWN EFFECT
Google represents one of the best examples. Its last four earnings announcements have generated at-the-money volatilities of 140%, 120%, 110% and 120% respectively.

But capitalizing on the rising volatility effect can be difficult when it is partially offset by rapid time decay close to expiration. Some positions will lose money if the stock barely moves, and time decay swamps rising volatility. Both distortions – time decay and rising implied volatility – are strongest at the very end. Investors who structure trades that profit from rising volatility often find that most of their profits accumulate during the final few days.

1. YOU COULD : WAIT UNTIL END
There are two very effective approaches to capitalizing on rising volatility before earnings. The first involves waiting until the very end and purchasing straddles or strangles for just a few hours then closing the trade before earnings are announced.

This strategy is effective for stocks like Google that experience the sharpest part of their volatility increase during the final few hours. Implied volatility for Google options has risen 40% on the last trading day before earnings during each of the last four expirations. An increase this large is guaranteed to offset time decay, especially for options that are purchased after the open on the final day.

OR YOU COULD : USE NEXT MONTH OPTIONS
The second approach involves purchasing trades that benefit from rising volatility using next month options that expire a few weeks after earnings. These options also are affected, but the distortions are much smaller. Because the trade is far-dated, time decay is much smaller, and the volatility increase is more subtle.

For example, next month at-the-money Google options experience an average increase around 50%. On the final day, it is common for near-dated options to trade at 140% and far-dated options to peak out around 35%. Both values represent a substantial increase from the more familiar range in the low 20s where Google options normally trade.

ADVANTAGES
Capitalizing on the more subtle far-dated rise in implied volatility is relatively easy, because it favors positions that normally suffer from time decay and benefit from large moves of the underlying stock.
Straddles and strangles are the most obvious example. These trades are best to own during periods of rising volatility. The earnings effect favors such positions by offsetting time decay with rising volatility. More important, it erases the falling volatility that normally accompanies a rally – a problem that often plagues straddle buyers during a bull market.

Some investors try to capitalize on falling volatility after earnings by selling volatility at the very end just before earnings are released. This approach is one of the most dangerous strategies in the option trading world. Google, for example, has moved much more than the amount priced into its options during three of the past four earnings announcements. In October, straddles doubled from $38 to $76. They likewise climbed from $28 to $48 during the July release and $26 to $49 in April. Very few strategies can lose this much money in such a predictable way.

Finally, some investors trade the falling implied volatility that follows earnings. This game is also difficult, because implied volatility tends to fall more quickly than the rate at which the stock calms down. Although it is counterintuitive, the falling volatility environment that follows an earnings release is often a good straddle buying opportunity.

Written by Jeff Augen

Trading with Delta

We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work - implied volatility, time decay, etc. - how can you know how much an option is going to move with respect to said underlying? Very simple - check out its delta.

Delta is arguably the most heavily watched Greek, as it offers a quick-and-dirty way of telling us what to expect from our option positions as we watch the price action of the underlying. Calls have positive deltas, as they typically move higher on a rise in the stock, and puts have negative deltas, as they typically move lower when the stock rises.

While some investors view delta as the percentage chance an option has of expiring in-the-money, it is really more of a way to project expected appreciation or depreciation. A delta of 50 for a call suggests the option should move 50 cents higher when the stock jumps a dollar, and lose 50 cents for every dollar loss in the stock.

But delta is only foolproof when all other factors hold static, which is rarely the case (and certainly never the case for time decay). If an option is moving more (or less) than its delta would suggest, it is likely because other variables are shifting. For example, buying demand might be pushing implied volatility higher, raising the price of the options. Still, this king of all Greeks is a good starting point for gauging how your options are likely to move.

Ce que tout débutant devraient savoir aus sujet des options

What Everybody Ought to Know About Options...the biggest pitfalls rookie Option Traders Make

Two (2) big pitfalls that novice option traders make and easy ways to not make those mistakes.

When an investor realizes the great leverage power of options and begins to dabble (se mouiller) in them in their brokerage account or IRA...we always see them make the same mistakes time and again.

1. Those who are new to options are immediately attracted to the very cheap "lottery ticket" type Out-of-The-Money (OTM) options.

By this we mean the options that are priced at 0.25 ($25) or below, for example. These are the OTM Calls and Puts that can potentially give very big gains, but have a low probability of success. These options tend to have a very low Delta (which is an Option Greek that can be interpreted as a probability of the option expiring In-The-Money (ITM)).

Additionally these options have no "intrinsic value" and are 100% "time premium", so you will lose value on the them due to time decay as the clock ticks towards expiration. And you may also lose value due to decay in implied volatility (Vega option greek).

So you should tend to prefer ITM options. These generally have a lesser amount of time premium and implied volatility built into them and have a higher Delta — so basically you normally get more "bang for the buck" with an In-The-Money option. Additionally your overall volatility should be less when trading these versus very cheap OTM options.

2. Traders enter positions without a gameplan, or specific targets and rules for taking profits and limiting losses.

Letting a winning trade turn into a loser, or letting a small moderate loser become a big loser.

This comes down to discipline and having a organized set of rules. For example, if a trade doubles (goes up 100%), you may have a rule that you exit half of your position immediately, then you basically have a "free trade" on the remainder of your contracts.

You also could have specific targets for the underlying stock/ETF/security and when those are reached you exit part or all of your position, regardless of where the option price is. Another valuable strategy is to have a trailing stop-loss for winning positions, so that you can stay in the winners and let them run, but if it pulls back by a certain amount you still lock in your profits. Or you can have set rules such as taking partial profits at 25%, 50%, etc.

But the bottom line is that without having systems, rules, indicators, and discipline you are somewhat trading "blind".

And for the losing trades…we've all had them. First, I've learned through experience that the best trades tend to go your way quickly. If a "perfect" setup is just sitting there and not going your direction, it may be time to cut bait and move on to the next opportunity.

Next to the problem of "hope and wait" on losing trades (also known as "Hopeium"), this is how a small 15% or 20% loser can turn into a 50%, 75% or even 100% losing trade. And those can put a big damper on your portfolio and create a trading hole that you then have to dig out of.

So limit your losses to small amounts. The goal in general is to have winning trades be 2x to 3x the size of losing trades, depending on the win/loss ratio of your strategy. Have rules and discipline in place on your option trades. For example, have a specific stop-loss, or a technical indicator that when violated gives an immediate exit on the position.

In general, having a clear trading plan with systems, rules, indicators and goals will provide more confident and successful trading results over the long run.

Gamma Boosting

Again what is Gamma? Well as you may know it is one of the 'Option Greeks', mathematical functions that are part of the option pricing formula. Specifically, Gamma refers to the rate of change in Delta in the option per each $1.00 move in the underlying security.

But Gamma has many uses outside of options trading - this ancient Greek symbol is used in probability, engineering, physics and many other sciences. In popular culture, remember that the Incredible Hulk (trademark Marvel) was formed when Dr. Bruce Banner, a mild mannered scientist, was exposed to a "Gamma bomb".

This Gamma exposure brought out a very strong side to Banner in the form of the Hulk; it magnified parts of his personality and basically was a massively "leveraged" form of himself.

Similarly, the way you utilize Gamma in your aggressive option selection is designed to accelerate the leverage for you with as little cash outlay as possible. What is the technique to utilize in order to maximize profits with aggressive directional trade?

Basically, you will focus on the "high Gamma" options in the 1 week to 1.5 month expiration area. These offer the biggest 'bang for the buck' with a relatively small cash outlay. This provides a great risk/reward package.

Normally the Gamma Booster options that you should choose are near-the-money, usually a bit out-of-the-money (OTM) ... although they can also be at-the-money (ATM) or even in-the-money (ITM). But we're finding that the optimal 'sweet spot' between Delta, Gamma, Theta and Vega is often 1 or 2 strikes OTM in the front month options.

Minimiser le "Bid/Ask Spreads"

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Minimize Bid/Ask Spreads to Maximize Your Profits. What is the True Price of an Option ?

 The bid/ask pricing on an equity, index or ETF option can vary from a couple cents to a couple dollars these days.  In general, bid/ask spreads are narrower than in the past due to multiple exchanges, the prominence of electronic trading and market makers competing for retail option order flow.

It’s important to remember that you don’t always have to pay the offer or sell the bid when you trade options.  Especially when the spread between the bid/ask is wide, you can quite often successfully “work” a limit order that is much closer to the option’s true value.

What is an option's true value?  Well … there are theoretical values based upon implied volatility and the other greeks which are readily available on many trading platforms these days — but the rule of thumb I often use is to take the mid-price between the bid & ask as the “fair price” at that moment in time for the option.  Be sure to check a couple strikes around the one you are interested in as well, to make sure that one particular option is not out of line in terms of pricing and implied volatility.

The primary obligation for market makers is to provide a liquid market and fill customer order flow.  The key to remember is that the one of the main profit generators for delta-neutral market makers is the bid/ask spread — because they “hedge off” the deltas that they buy/sell when they take the other side of an order.  For every option buyer, there is a seller, and vice-versa.  The market making firm is on the other side of your transaction.

So the wider a bid/ask spread is, the more the theoretical (and often actual) profit margin that a market maker gains.  For example, if an option is bid 2.00, offered 2.50 … the MM is paying $200 and selling for $250.  In a perfect world, he/she would buy and sell the exact same amount of those options for those exact prices … leaving a net position of 0 at the end of the day and a risk-free arbitrage profit of $50 per contract traded.

In that hypothetical example, the overall profit margin of the bid/ask spread is 25% … also based on the mid-price (aka the estimated fair value) of 2.25, if you pay the straight ask or sell the bid, you’re giving up about 11% “edge” on both sides of the transaction to the market makers.  So as a retail options trader, it’s in your best interest to narrow the spreads as much as possible.

In this example if you paid 2.40 for the option, you’re lowering your cash outlay and maximum risk by $10 per contract, or about 4% from the 2.50 price.  You’re also reducing the edge over fair value you give up to $15 from $25 … down to only 6% profit margin on each side of the trade (much more reasonable in my view).

The good thing is that nowadays with so much competition for option volume (and with $1 strikes, 0.01 price increments, etc), you are much more likely in an example like the above to get filled on a limit order below the ask or above the bid.

In the “old” days of fraction option pricing when I was a CBOE floor market maker, the minimum increment on options was generally 1/8 on options over $3 (1/16 below that) — equating to $12.5 or $6.25 — today you see 0.02 ($2) bid/ask pricing on the SPYders for example, a much better deal for retail investors.

When you are dealing with “multi-legged” trades (those with more than one option involved) such as debit spreads, calendar spreads, credit spreads, butterflies and condors, the effect of the bid/ask spread is multiplied.  You are dealing with 2x the bid/ask spread on most 2 legged trades for example.  So it is even more important there to calculate a fair value and then work your order to not give up too much to those taking your trade.

Let’s look at a case study example of this : We had nice profits on the Regional Banks ETF (RKH) with a bearish Put debit spread.  RKH is one of those equities where the quoted prices on the options are often much more wide than the “real” prices where you can get filled.

In this situation, our 5 point debit spread was priced at 2.80 by 4.00 (our subscribers paid 2.20).  In this case you take the bid/ask average of 6.80/2 or 3.30 to garner what is the estimated real value at that moment in time.  So we issued our exit price alert to sell half the position at 3.20 … giving up only $10 below what looked to be the fair value (additionally this position was fairly deep in-the-money at this time, which made it more likely to be filled near the true value).

We got filled basically instantly at better prices than our limit order and the quoted bid/ask prices narrowed significantly as well for a time.  You may wonder why don’t they leave the bid/ask prices narrower all the time?

Well, on a security like this, it sometimes looks like there may be an unspoken agreement among those who make markets in the options to leave the bid/ask prices wider than they really are (to take advantage of market orders and novice traders).  I’m not saying this is a nefarious conspiracy, it can just be that the primary market making firm has a default bid/ask pricing in the computer with very wide bid/ask spreads.

Generally low volume on either the underlying or its options can contribute to these wider posted bid/ask spreads.  They also don’t want to be caught off guard by a slew of electronic orders that may precede a big move in the stock, so they give themselves more slippage by posting wider bid/ask spreads.  Nonetheless you don’t ever want to give up that much edge when trading.

Competition For Orders Can Narrow Bid/Ask Spreads

Bottom line, more and more options have $1 strike price increments and options that may have only a few cents between the bid/ask spread.  This growing trend is beneficial to the retail trader.  And if a security is moving very quickly (and has narrow spreads) you may not even want to work a limit below the offer or above the bid).   But you must be aware of the bid/ask spread when trading, and don’t be afraid to work an order with limit prices closer to the mid-price, especially when spreads are wide.

Look at it as a % basis of the option’s cost, not the $ amount … for example, 0.40 on a 2.00 option is 25%, while 0.40 on a 6.00 option is only 6.7%.   Keeping in your pocket that extra $5, $10, $20 or more per contract when the pricing seems out-of-whack can add up to $100s and $1000s a year that you will be saving and go to increasing your bottom line.  And with the increased competition among market makers and exchanges, you will get filled at your good limit price much more often that you think.

Utiliser la volatilté

Three (3) Options Trading Strategies to Fight Volatility

One rule of thumb regarding the VIX is that it measures the expectation priced into options for the potential movement of the SPX over the next 12 months (based on 1 month of option pricing).  So a VIX of 36 means that SPX option traders/market makers are pricing that the SPX could move up OR down 36% over the next 12 months quite a high volatility level on both a historical and a real basis, in my view.

Remember that for every option purchase there is a corresponding option sale so with implied volatilities high (which, combined with time value, comprise the premium in option prices), let's take a look at the basics of some option trading strategies that incorporate option selling.  This way you can have a portion of your portfolio that receives time decay and can benefit from volatility going down.

Here are a few strategies that will allow you to sell implied volatility/option premium, as well as buying it:

1.  Selling Covered Calls/Covered Puts
The simplest of these 3 strategies, this is basically selling an out-of-the-money (OTM) Call against a long stock position you may own.  This can be done at the time of the stock purchase (Buy/Write), or against an existing stock position (to protect gains and/or lower cost basis).

On the flip side, against a short stock position, you can sell an out-of-the-money "Covered Put".  In both of these situations, you end up collecting a "credit" for selling an option, putting yourself "short" time premium and implied volatility.  The tradeoff for receiving a credit and lowering your cost basis is that you will limit your potential upside gain to the strike you sold.  You will receive the benefit of time premium decay ("Theta") and also potentially gain if the implied volatility on the option you sold comes down.

2.  Credit Spreads
Without going into too much depth, a Credit Spread (also known as a "Vertical Bull or Bear Spread"), involves selling an option and buying another option of the same stock in the same expiration month, but of a different strike.

Normally on a credit spread we would be selling an at-the-money (ATM) or OTM strike and buying a further out strike.  So, for example, a Bearish December Credit Spread on XYZ stock (with XYZ shares at 52) might be to sell the December 55 Call while simultaneously buying the December 60 Call.

3.  Horizontal Calendar Spreads
The most advanced of the strategies I'm discussing today is Calendar Spreads.  This involves trading an option in the Front or Second month for example, and hedging with an option of the same stock, same strike, but in a further out Expiration month.  The further out option can be as far out as LEAPs out a year or two ahead.

A Calendar Spread can in effect be a "Vega" trade, but it can also be done as a "Theta" collection trade.  The far out options are basically all Vega, so if you are banking on implied volatilities coming down, you would be looking at Buying the Front or Second month option and Selling the Further out option, such as a LEAP.

Another simpler version of a Calendar Spread would be to flip this around by selling a Front Month as it approaches Expiration and buying a Second Month, in order to collect the rapid time decay of the final two weeks heading into Expiration.

These kinds of strategies are fairly complex and should be evaluated in an Options Position Analytic software of some sort (most option brokers offer these in their trading platforms nowadays) – in addition you will want to track how the further out implied volatilities move in relation to the front months, as they will not move at the same rate.

If you are interested in trading these kinds of advanced options strategies and more, you will generally need a Margin Account with your Brokerage House, as well as the proper Options Trading Approval to trade a variety of option strategies.  Contact your Broker for more info.

And as I mentioned, I am just touching on the basics of these multi-leg advanced trading strategies.  There are many other strategies where you can benefit from moves in implied volatility and receive time decay, such as Diagonal Spreads, Ratio Spreads, Butterflies, Iron Condors, etc. 

Most often utilized strategies utilized are Debit Spreads (good with ETF's) and Diagonal Spreads.  Research "white papers" available at no cost on these two specific strategies.