Entries Tagged 'Education' ↓

Failing to Make the LEAP to Long Term Thinking

Is it possible to find an option strategy that delivers a swing at a home run, an 80% chance of 100% and a known limited risk? You bet it is.

While the old lore that 90% of options expire worthless does not give a true picture of the options market, it is true that buyers generally loose more than they win. Option buyers are speculators. There’s nothing wrong with being a speculator, the important point is to recognise that you are engaged in speculation and to make sure that fits with your personality and risk profile. As a general rule I need to win more than I loose so I don’t often buy options. If you buy options you can loose a lot of the time, but still make money. A few home runs can makeup for a lot of losses.

As predominately an option seller I didn’t get the opportunity for home runs. In fact my losses were sometimes other people’s home runs and those big losses sure ate up a lot of my winners. Just like an insurance company, I collected a lot of premium, but occasionally suffered a big loss. The small speculator in me, never got the reward of those cocktail party stories of option trading glory. It soon became ludicrous to have tor refer back to my SAP home run story of ‘95.

I was always searching for a strategy that could give me a shot at a home run and a high probability of profit.

Then one day I found it, the perfect strategy to add to my options armoury, a strategy that delivered a swing at a home run, an 80% chance of 100% profit and a known limited risk.

Are you mentally screaming tell me, tell me what that amazing strategy is? Maybe you’re screaming it OUT LOUD. Or maybe not, I know I wouldn’t have been. I’m sceptical of most things and the hyperbole surrounding options trading made me wary of such claims years ago. The thing is if you’re an experienced option trader or have any read a few books or followed online discussions then you probably know what this strategy is already. You probably knew it when you read the heading.

Read Part Two….

…you really do NOT need to go out to that furthest dated LEAP right away. Up to a certain point, the time decay on the 2010s will be roughly similar to the 2011s so there really isn’t that much of a benefit to buying the 2011s. Once they start to really diverge, then you just roll forward your 2010s to 2011s. Any interim price action really doesn’t matter much either because the deltas for the same strike price are also going to be roughly similar. It is potentially an additional set of transactions, but if you are right on something like LEAPs the commissions should be negligible.

MDCigan TMF Liquid Lounge

Here is the 2011 Leap schedule from CBOE

• January cycle begin trading on September 15 2008
• February cycle being trading on October 13 2008
• March cycle begin trading on November 17 2008

MDCigan’s thesis that time decay and delta on far out Leaps will be roughly similar and thus the higher cost of the longest dated Leaps is not worth paying for sounds plausible due to the exponential nature of time decay. However, I would like to test this thesis. As the 2009 Leaps are now so close and I don’t have easy access to historical LEAP prices I’ll wait until September to start validating this thesis.

I have spot checked some 2009 Leaps/options in comparison to 2010 Leaps and the theta on the 2009’s were 40%-80% higher, i.e. the time decay on the 2009’s is 40%-80% higher.

As LEAPS Trading points out

It will take a LEAP with 3 years before expiration 273 days before it will loose 20% of its value due to time decay. At 180 days before expiration it will take only 65 days to loose 20% of its value to time decay.

For more on LEAPS check out the CBOE Index Leaps primer.

Option Cycles for Beginners

Options trade in one of three cycles; January, February or March. There are at least four different expiration months available for every stock on which options trade. The stock options cycle determines which months will be available.

JAJO - January, April, July, and October
FMAN - February, May, August, and November
MJSD - March, June, September, and December

The CBOE decided that every stock* would have the current and following month available for trade.

It is June now so every stock* will have June and July options available. Then the option cycle determines what other expiration months are available. January cycles will also have October, February will have August and November while March will have September and December.

The easiest way to tell what cycle of options your stock has is to check the expiration months available. Take a look at Amgen options http://finance.yahoo.com/q/op?s=AMGN

It has June, July and October so it must be a January cycle. Hopefully, you realise it was October that told me that, as all stocks will currently have June and July.

As optionsvueresearch.com states

Option expiration cycles for stocks may seem a bit confusing, but if you take a little time to understand them they become second nature. It can be very important to know what expiration months will become available in the future. Many option strategies require you to make adjustments during the life of a trade, and you need to be certain the contracts you will need are going to be available. Understanding the expiration cycles is just one more way to help you increase your success rate when trading options.

* on which options trade

Do the Greeks accurately predict the future?

FDX closed up 1.61 (+1.79%) Wednesday. The 90 Puts bid/ask mean is 2.025 (1.95-2.10) and last trade was 2.00 down .70.
Using the Greeks let’s check to see if what was theoretically meant to happen did transpire.
The delta was -0.4889. Multiply 1.61*-0.4889 = 0.79. Another day has passed so time decay, theta, should have eaten another 7cents for a total of $0.87, yet the bid/ask mean only decreased $0.65 and the last trade $0.70. Where has my 20 cents gone?
First let’s look at the theoretical value which currently stands at 1.5702 and yesterday was 2.3335 for a change of $0.76. Which is closer to my calculation.

The difference between what yesterdays Greeks implied the price should be and the actual option price, is due to change. The Greeks are not static. As the underlying asset price changes so do the Greeks and the option price accordingly.

The Greek most responsible for dealing with change is Gamma.

As discussed yesterday Gamma shows how fast delta will change as the market price of the underlying asset changes. Gamma was 0.0602, multiply that by the price change of 1.16 and we get 0.0969. Subtract that from yesterday’s delta and we get a new delta of -0.3920. The reason that is not exactly the same as the closing delta of -0.3961 is that the Greeks are constantly changing throughout the day to reflect the changes in the underlying. In this case Gamma changed from 0.0602 to 0.0559.
If we take the closing delta and re-run our first calculation. Multiply 1.61*-0.3961 = 0.64. The result is closer to the theoretical change. Add in the 0.07 time decay and the result is close to the actual change of $0.70.

Theta has increased from -0.0703 to -0.0756. So as expected the closer we get to expiration the faster the time decay. Excellent! That’s what we want as option sellers. Volatility has also changed, but I think we have covered enough.

I haven’t included not understanding the Greeks in my 10 Biggest Mistakes in Option Trading series, but as in any endeavour you will do better if you know the tools available to you. I hope this quick overview has helped make the Greeks clearer.

Fusion Investment Fund sold 5 FDX June $90 Puts (FDXRR) at $4.00 on May 22nd. The analysis behind the FDX position was explained on the 21st May.

Fedex closed June 3 at $89.94, the puts last traded at $2.70. My favourite options quote provider, The OIC, shows

As those values are the primary options values and Greeks I’ll mention, let’s quickly recap what they mean.

It’s All Greek To Me

• Bid/ask mean is the average if the current price option traders are prepared to buy (bid) and sell (ask) at. I always use limit orders for options and generally place the sell limit for short term options at around the mid point of the spread or higher. For longer term options I often start with a sell limit above the current ask and adjust as condition warrant.
• Open interest tells you the total number of option contracts that are currently open, doh! I explain open contracts in a second. The important thing to know is open interest is a sign of liquidity, and liquidity in general reduces the spread between bid and ask, so you can get better prices. Now back to open interest. When you place an option trade it is either an opening or closing transaction. You are either opening a new position or closing an existing position. When I entered my FDX order I selected Sell to Open (see the image). Did my trade increase the open interest? I have no idea. Whether a trade increases open interest or not depends on both parties to the trade. If both parties are opening then open interest increases. If one is opening and the other closing there is no change to open interest. If both are closing then open interest in decreased.

• Option value is the option’s theoretical price as determined by the Black-Scholes option model using underlying instruments statistical volatility. I compare the theoretical price with the actual price to see if traders are anticipating increased volatility.
• Implied volatility is the market’s estimate of future volatility and is derived from the option’s last traded price. I use IV in conjunction with option value. In general high IV means fear is rampant as it is a good tell to sell, while low IV implies greed is dominate and it is a good time to buy long term options. At the bottom of the OIC options quote page you’ll see historical and implied volatility including 52 week high and lows. It is important to compare the current IV with historical highs and lows.
• Delta is the change in the price of an option for a small change in the price of the underlying stock. It tells option traders how fast the price of the option will change as the underlying stock/future moves.
• Gamma is the rate of change of the delta for a small change in the price of the underlying asset. It is important because it shows how fast delta will change as the market price of the underlying asset changes.
• Theta shows how much value the option price will lose for every day that passes.
• Vega is the rate of change of the options value with respect to the 1% change in the volatility.

An Example

Let’s use my FDX naked Put for some clarification.

• As you’d expect with a large cap stock there is plenty of open interest. The option value is higher than the theoretical value and the IV is near the 52 week high. This confirms I received a good price and will have no problem with liquidity.
• With 13 trading days to expiration I’m not particularly interested in the delta. At -0.4889 I note that I have around $3 of safety in the underlying. If all else remains the same and FDX falls $1 tomorrow then the option price will be $2.675+0.4889 = $3.15
• With a Theta of around -0.07 with everything else remaining the same then time decay eats 7 cents a day. If all else remained the same and FDX closed at the same price tomorrow then the options would be worth $2.675 – 0.07 = $2.60
• Vega of 0.1269 shows this option is sensitive to moves in the volatility of FDX. Generally Vega is more sensitive with at the money options. As the IV is still high on FDX the price of options has a lot of opportunity to fall due to decreasing volatility. Which is good for me.

Position Conclusion

The trade is working out as planned and there is no need for adjustments. Since I entered my trade Warren Buffett has said that he believe the US may enter a long deep recession. A long deep recession would be the worst case scenario for FDX. As my working thesis is that the US is already in a recession I will continue to monitor this position, but in all likelihood will hold the position to expiration.