The post 2 Essential Options Trading Concepts That You Need To Know appeared first on Options Trading Research.

]]>But, with earnings season upon us, tons of IPOs such as Uber hitting market, and pickup in mergers and acquisition activity such as **Chevron’s (CVX)** $33 billion buy-out bid for **Anadarko (APC)** Today, we can expect volatility to lift from its current low levels.

But how does an increase in volatility, which basically is a measure of the magnitude of price changes within a given time frame impact options’ values.

To understand this, we need to turn to Vega. Options traders sometimes use these terms interchangeably, and while they are related, they are two distinct concepts.

Volatility is one of the five inputs used in the basic Black-Scholes options pricing model.

Higher volatility means higher option prices. That’s because higher volatility means greater expected price swings.

So it follows that stocks like **Netflix (NFLX)** and** Facebook (FB) **have higher volatility readings, and therefore higher-priced options than more mature and stable companies like **Apple (AAPL)**** **and **JP Morgan (JPM)**.

Take a look at this table:

Despite Apple having a higher underlying stock price than Netflix, its at-the-money. The May call is actually much lower in price than Netflix.

And note that both JP Morgan and Facebook are trading around $60. But the latter’s call is nearly five times the price.

This is almost entirely due to the differences in implied volatility. This is because Facebook is far more likely to make a huge move after earnings than JP Morgan.

Last quarter provided a perfect example of this. Facebook rose 14% in one day after reporting earnings. JP Morgan moved just 0.1%.

Vega isolates how a change in implied volatility will impact an option’s price by estimating of how much its value changes when implied volatility moves 1%.

Vega is highest for at-the-money strikes and increases as you go out in time. Notice also that peak vega also moves slightly out of the money as you go out in time. This is because the probability of a given price move occurring increases as the time frame is extended.

For example, if you’re speculating on a $10 price move, you have more of a chance of being right if you have a six-month time frame rather than a one-month time frame.

A directional calendar spread, in which one buys a later-dated out-of-the-money option and sells a near term out-of-the-money option, is a strategy that tries to benefit from this concept.

When it comes to known events such as earnings reports, implied volatility will typically rise ahead of news and decline afterward.

Understanding the difference between historical (or realized) volatility and implied volatility is crucial in determining whether an option is relatively “cheap” or “expensive” and whether you want to be long or short vega.

In this case, one might want to be short vega through the sale of a straddle or iron condor, which would benefit from a decline in implied volatility even if the stock moves sharply following the news event.

Understanding what the options market is expecting, or “pricing in” as measured by implied volatility, will help you determine just how large a price move will be needed for a profit when you are long options. And vega will tell you how much a change in implied volatility, following the report, will impact the price of the options.

Often, a decline in IV (also known as vega risk) will offset the impact of price gains in the underlying stock. This is how you can be correct on a stock’s direction and still lose money on an options position.

Volatility helps define an option’s cost, and vega helps determine a position’s profit or loss. Therefore, it is critical to understand both concepts.

It’s a good idea to use a basic option calculator like this one from the **Chicago Board of Options Exchange (CBOE)** to play around with changes in implied volatility over different time frames and see what the impact on the option’s price will be.

**Note:** This article originally appeared at Option Sensei.

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]]>The post The Inner Workings Of Time Decay In Options Trading appeared first on Options Trading Research.

]]>But, as an options trader, one thing’s for certain: Time never stands still. In trading options, the theta or time decay must be taken into account. Let’s take a look at how it works.

Time is a key component in an option’s valuation. Thankfully, it is applied equally to all options — regardless of the underlying security. But, there is one nuance that needs to be understood. In the options world, time curves, accelerating as expiration approaches. Anyone that’s ever been on a deadline can relate to that. The tool we use to define time is called theta, and it measures the rate of decay in the value of an option per unit of time.

There’s a basic math formula used in the Black-Scholes model that is a good starting point. Basically, we use the square root of time to calculate and plot time decay. The math involved in the nitty-gritty of evaluating theta can be extremely complex, so focus on this: Time decay accelerates as expiration approaches, meaning that theta is defined on a slope.

For example, if a 30-day option is valued at $1.00, then the 60-day option would be calculated as $1 times the square root of 2 (2 because there is twice as much time remaining). So, all else being equal, the value of the 60-day option is $1.41, or $1 times 1.41 (1.41 is the square root of 2). A 90-day option would be $1 times the square root of 3 (3 because there is three times as much time remaining) for an option value of $1.73. (1.71 is the square root of 3).

If you’ll notice, the premium of the 60-day over the 90-day ($0.32) is less than that of the 60-day over the 30-day ($0.41). So again, the important takeaway is to realize that the closer an option gets to expiration, the rate at which time value decays gets faster.

This graph makes the math easier to visualize and also shows that rates of decay are different, depending upon whether it’s an option in-the-money, out-of-the-money or at-the-money.

Another conclusion that can be drawn from the above charts is that, if one sells out-of-the-money options with a slightly longer-term horizon, he might plan on covering them before expiration — perhaps just past the halfway point, or so. He would do this because a large majority of the time value decay would already have taken place, and therefore, the remaining opportunity would not be as great.

For example, suppose XYZ is trading at 100, and you sell the out-of-the-money combo, utilizing the calls with strike 120 and the puts with strike 80. The following table shows how much (unrealized) profit you would have from the naked sell combo if the stock was still at 100 in one month, two months, etc.

Here are some other basic concepts you need to know about theta:

- An options theta can be calculated as follows: If a particular option’s theta is -10, and 0.01 of a year passes, the predicted decay in the option’s price is about $0.10 (-10 times 0.01 is 0.10).

- At-the-money options have the highest theta. Theta decreases as the strike moves further into the money, or further out of the money. In-the-money options are mostly composed of intrinsic value (the difference between the strike price of the option and the market price of the underlying), while out-of-the-money options have a larger implied volatility component.

- Theta is higher when implied volatility is lower. This is because a high implied volatility suggests that the underlying stock is likely to have a significant change in price within a given time period. A high IV artificially expands the time remaining in the life of the option, helping it retain value.

Time is always moving. In our daily lives, some days seem to pass quicker than others — So too with options.

**Note:** This article originally appeared at Option Sensei.

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]]>The post The Options Strategy That You Need To Know appeared first on Options Trading Research.

]]>But suggest selling a put, and those same people will respond, “that’s too risky, I’d never sell a naked put!”

Here’s the thing: The risk/reward profile of a covered call and selling a put (one that is cash secured) are exactly the same. A profit that is capped and a loss could be large should shares decline sharply. Here’s the risk graph for each.

Knowing the risk/reward, similarities and differences, between options strategies is crucial to success. It not only helps you pick the strategy that best aligns with your thesis and risk threshold, but can also provide flexibility in how you approach a position.

Here, Mike Wolfinger drills down into Option Equivalent Positions

One of the interesting features about options is that there is a relationship between calls, puts, and the underlying stock. And because of that relationship, some option positions are equivalent – meaning identical profit/loss profiles – to others.

Why is that important? You will discover that some option combinations – called spreads – are easier, or less costly to trade than others. Even with today’s low commissions, why spend more than you must?

The basic equation that describes an underlying and its options is: Owning one call option and selling one put option (with the same strike price and expiration date) is the equivalent to owning 100 shares of stock.

*S = C – P; where S = stock; C = call; P = put*

*If you want simple proof that the above equation is true, consider a position that is long one call and short one put. When expiration arrives, if the call option is in the money, you exercise the call and own 100 shares. If the put option is in the money, you are assigned an exercise notice and buy 100 shares of stock. In either case, you own stock.*

Beware, if the stock is at the money when expiration arrives, you are in a quandary. You don’t know if the put owner is going to exercise and therefore, you don’t know whether to exercise the call. If you want to maintain the long stock position, the simplest way out is to buy the put, paying $0.05, or less, and exercise the call.

There is one equivalent position that you, the options rookie, should know because these are strategies you are likely to adopt.

As shown above, writing a covered call is equivalent to selling a naked put. This is not a big deal to anyone who is an experienced options trader. But to a newcomer to the world of options, this can be a real eye-opener.

The more you trade options, you will become more aware of other equivalent positions. You may even decide to play with the equation yourself and discover others.

If you are new to the world of options, today’s discussion may appear to be a bit confusing. But, if you go slowly and re-read the linked posts, you’ll understand the discussion.

If you’ve been trading options for a while and never bothered to learn about equivalent positions, this post contains information that can make your trading more efficient.

**Note:** This article originally appeared at Option Sensei.

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]]>The post Using Cash-Secured Puts: The AT&T Example appeared first on Options Trading Research.

]]>Alternatively, investors can boost the average yield of the portfolio in order to generate more income from the portfolio on a relative basis. Investors can do this with a variety of instruments including high-yield debt, preferred stock, high-yield dividend stocks, and the focus of this article, cash-secured puts. We’ll take a look at how the strategy works and how investors can employ it with a real-world example in order to boost their average portfolio yield, thereby generating higher levels of income.

Cash-secured puts are a way for investors to agree to buy a stock at a later date for a set price in exchange for what is called option premium. In other words, when an investor sells a put option – which is the right to sell a stock at a defined price on or before a defined date – the investor is essentially agreeing to buy that stock at the prescribed date and price. This generates option premium, which is income for the investor selling the put. One of the reasons investors sell put options is to generate income on a stock the investor is interested in owning anyway. We’ll take a look at how it works with an example on a high-yield dividend investor favorite, AT&T (T).

AT&T is a telecommunications giant that recently purchased Time Warner in order to boost its content library and diversify away from wireless service. The stock offers investors a 5.9% dividend yield, making AT&T one of the highest-yielding common stocks in the mega-cap space, and thus making it an income investor favorite. AT&T’s dividend yield is certainly quite high and the payout is safe, but investors can generate even more income than they would by just owning the stock. That is where cash-secured puts would come into play.

This is how a cash-secured put works: an investor sells the put option, agreeing to buy the underlying stock at a specified time and price, called the “expiration date” and “strike price”, respectively. The profit for the investor selling the put looks like this:

Profit is capped at the total amount of the option premium received by the investor at the time of the sale and in this example, would be $2. Profit declines down to the point where the investor is exposed to theoretically unlimited downside risk as the underlying stock price declines, similarly to if the investor had simply bought the stock. Selling a put offers a variety of advantages over simply buying a stock, including being able to dictate the price one is willing to pay – often below the current price – generating income and reducing risk. The investor is exposed to potential losses if the share price falls but gets to keep the premium generated by the put sale should the share price rise.

In a real-world example, we can see AT&T’s option chain for the December 21, 2018 strike price. This chain shows both calls and puts, and we are interested in the right side of the chain, which is the put side.

The yellow strike prices are “in-the-money”, meaning the share price is already under the strike price. Those that are white are “out-of-the-money”, meaning the share price is above the strike price; the opposite is true for the other side of the chain, which is for call options. The strike price is in the middle of the table and in this example, ranges from $31 to $37. Investors selling puts need to select their desired strike price after selecting the preferred expiration date. Lower strike prices offer lower premiums but also have a higher probability that the stock price won’t reach that level by expiration. The opposite is true of higher strike prices; more premium is generated but a higher probability the share price will finish under the strike price, thus assigning the shares to the investor at the strike price, regardless of the price the stock is trading for at assignment.

Let’s say this investor wants to generate significant income with a moderate risk of being assigned and selects the $33 strike price for December 21, 2018 expiration. That put option is trading for 81 cents today but since the put option is for a lot of 100 shares, the premium to the investor for selling the put is $81. For the put to be cash-secured, the investor needs enough cash in their account to cover the shares should they be assigned at expiration, which is the strike price ($33) times 100, or $3,300. In other words, by selling this put, the investor needs to hold $3,300 in their account to “secure” the put with cash in order to collect the premium.

The payoff here for the investor is that they collect the 81 cents immediately upon the sale of the put. The investor collects the 81 cents, which is 2.5% of the strike price, making this the absolute yield. However, in annualized terms, the put expires just 73 days from the time of the sale, meaning that if one annualizes that return, it is in excess of 12%. An investor could theoretically do this multiple times per year, generating $3 to $4 of option income per share, which compares favorably to the $2 per share dividend for AT&T using the same amount of capital. This is the power of selling cash-secured puts; yields can be much higher than simply owning high-yield dividend stocks or other income instruments.

Selling cash-secured puts isn’t necessarily for everyone. This strategy should be employed on stocks the investor wants to own anyway as the risk of the share price falling below the strike price means the investor may be assigned the stock. In addition, the investor is open to unlimited downside risk, as they would be if they simply bought the stock itself. However, taking these into account, investors can significantly boost their portfolio’s average yield by prudently selecting stocks on which to employ this strategy and actively managing their portfolio. In our example, AT&T shares yield just under 6% while the cash-secured put strategy yields in excess of 12% on an annualized basis. For sophisticated investors, this strategy can help generate more income from a portfolio without having to invest more capital in boosting the size of the portfolio itself.

**Note:** This article was contributed to Modest Money by Sure Dividend.

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]]>The post The Dummies Guide To Option Greeks appeared first on Options Trading Research.

]]>Turns out these terms are all mathematical calculations having to do with options pricing and risk, with the calculated result represented by different (mostly) Greek letters – Delta, Gamma, Theta, Rho, and (not a Greek letter) Vega. They’re collectively referred to as the “Greeks.” It all goes back to risk. The Greeks are measures of the different option dimensions, or sensitivities, to price, time, and volatility. They’re commonly referred to across the internet when talking options trading – but that talk is typically focused on stock options.

That’s all fine and good, but there’s a whole subset of the managed futures space who trade futures options. These are mostly on the S&P 500 futures, but the point is – there’s a lot of Greek letters flying around these days when analyzing managed futures programs. So, just what does each of these terms mean in relation to futures options and what’s a typical futures option trade that should be paying particular attention to each?

Not the airlines, of course. Delta represents the amount an option price will change given a $1.00 change in the underlying asset price. A Delta of 1.00 meaning the option price will go up $1.00 when the underlying’s price goes up $1.00, a Delta of 0.50 meaning the option price will go up $0.50 when the underlying goes up $1.00, and so on (all else being equal… which it never is). This number can be both positive and negative and always falls between -1 to 0 and 0 to 1. We like to think of it as the amount of directional risk one is taking on in the option, which leads to the related concepts of “delta neutral” and “delta hedging.”

A delta neutral strategy attempts to remove all directional exposure/risk by being in both puts and calls, or by owning the underlying asset against the option strategy. In that manner, a trader can target just an options time or volatility decay and not worry about which way the market is moving, again, all else being equal. Trick is – the delta’s aren’t constant, they change depending how close or far away the underlying asset’s price is to the option strike price. As it gets closer to the strike, the option will trade more like the underlying, which can cause delta neutral strategies to employ “delta hedging,” where they purchase futures to take on directional exposure in the opposite direction of the “delta” on their option trade, thereby reducing the delta of the overall position.

Quick on the heels of Delta is Gamma. We talked above about Delta being dynamic and changing as the underlying asset’s price gets closer to the options strike price – and Gamma is the Greek which measures Delta’s sensitivity to that price movement. Gamma is how fast the Delta changes after a 1 point movement in the underlying, and the key to understanding it is that the Delta doesn’t change the same amount for every option based on a given futures market. Delta may accelerate faster for options closer to the money, shorter duration, and so on. Gamma is the measure of that acceleration factor.

When we hear of a trader being “short gamma,” that’s saying they’re betting against a sharp move happening sometime soon. They are betting the underlying doesn’t quickly approach their strike prices, forcing their deltas higher and eating into their short option position. Being short gamma means the closer prices get to your underlying price, the worse things get.

Options are unique from buying outright stocks or futures, because there’s a time component to them. You’re investing in something moving such and such amount by such and such *time*, versus just moving a certain amount when doing outright investments in the underlying. And what’s more, it’s a binary event for the options value at the expiration date on whether the option has value or not, leading to the concept of time decay in options – where every day closer to the expiration date the option should lose some value because it has less time to move the distance required for the option to finish in the money. The amount of decline each day in the option’s price due to this time factor is Theta.

Vega is the only one of the Greek terms that isn’t part of the Greek Alphabet. Maybe they called it Vega because it starts with a V, and volatility starts with a V? With that weak setup, you can guess that Vega has to do with the option price’s sensitivity to the volatility of the underlying asset. Vega measures how much the option’s price will move given a 1% move in volatility, and is quoted as such, with a Vega of $0.25 meaning the option should rise $0.25 for every 1% rise in volatility of the option’s underlying asset. And just like Gamma is a sort of qualifier for Delta; Vega can be thought of as related to Theta. That is, the more time left til expiration, the greater the Vega of the option. Imagine the cone of uncertainty they show when tracking hurricanes. That cone is the Vega of the option, and is greater the further out in time you go, as volatility today can push further out ranges even wider.

Rho is the least used of all the option Greeks in our experience, measuring the sensitivity of the option pricing to interest rates. Interest rates? What? Well, consider that buying an option means tying that money up until the expiration date, and selling it likewise means the ability to earn the income on the proceeds until the expiration date. Given these factors, option pricing models consider the cost of money, or interest rates. Rho works like the rest, essentially being quoted as the amount an option will move given a 1% change in interest rates (it was obviously conceived of before interest rates sat at zero for half a decade).

These definitions can get tricky. It’s important to not get lost in the weeds, and hopefully with a brief understanding of them all, it won’t trip you up during your next meeting with pro traders.

**Note: **Article contributed to ValueWalk.com by RCM Alternatives.

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]]>The post Mean Reversion: What Stocks And NFL Teams Have In Common appeared first on Options Trading Research.

]]>It’s easy for sports fans to assume a championship team will continue its stellar performance into the next season. It’s equally easy for investors to extrapolate a stock’s recent performance into the future.

It’s often assumed a winning stock will keep rising and a losing stock will keep falling. The reality is that back-to-back championships are rare occurrences, and all stocks turn around eventually.

On February 1, 2015, the Seattle Seahawks were competing to win the Super Bowl for a second straight year. On 2nd & goal from the one yard line, the Seahawks were down by four points with 27 seconds left in the game.

The only thing standing in their way from becoming back-to-back champions was the New England Patriots defense. In what immediately became one of the most controversial play calls in sports history, Seattle’s QB Russell Wilson took the snap and threw a quick slant to WR Ricardo Lockette in the end zone.

In the spilt second after the ball left Wilson’s hand, Patriots’ DB Malcom Butler stepped in front of Lockette and intercepted the pass. Butler’s amazing play crushed the Seahawks chances of being only the ninth team ever to win the big game two years in a row.

Although it’s most likely no consolation to Seahawks fans, being only one yard away from holding the Lombardi trophy in consecutive seasons is a highly improbable accomplishment. Only eight teams in the last 50 years have been able to hold onto the title of Super Bowl champs for two straight years.

Great NFL teams have a hard time remaining great due to a phenomenon called *mean reversion*.

The mean reversion hypothesis says that over time, results of any kind will move toward an average. Tobias Carlisle, in his book *Deep Value*, quotes Michael J. Mauboussin’s explanation of mean reversion’s effects on anything in the natural world:

“The basic idea is outstanding performance combines strong skill and good luck. Abysmal performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods, luck evens out across the participants, pushing results closer to average.”

This is the same universal wonder that Nobel Prize winner Daniel Kahneman came to understand while speaking to a group of flight instructors. Carlisle recounts a time Kahneman was confronted by an instructor regarding the effectiveness of punishment over praise. After Kahneman mentioned that praise was more effective, an instructor countered with the following:

“On many occasions I have praised flight cadets for clean execution of some aerobatic maneuver, and in general when they try it again, they do worse. On the other hand, I have often screamed at cadets for bad execution, and in general they do better the next time.”

It instantly became clear to Kahneman that the reversal in flight performance had nothing to do with praise or punishment but was the result of mean reversion.

Mean reversion is just as much a factor in economics and public markets as it is in sports outcomes and flight performance.

In business, this implies that a company that is currently earning abnormally high or low operating profits will eventually produce results more in line with historical norms. Another quote from *Deep Value* is Benjamin Graham’s warning that business results don’t last forever:

“Abnormally good or abnormally bad conditions do not last forever. This is true of general business but of particular industries as well. Corrective forces are usually set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital.”

Investors in the stock market tend to ignore Graham’s wisdom in the above quote and irrationally overreact to “good” or “bad” conditions. This causes stock prices to at times stray far from the underlying value of the companies.

Not only does mean reversion state that a business’s profitability will return to normal, it also implies that mispriced stocks will eventually align with what the business is worth. Investors can be certain that the underlying value of a company will be the ultimate factor in a stock’s price.

It should be reassuring to know that no matter how wildly stock prices swing, they will inevitably revert towards the company’s fair value.

**Note:** The author of this article is Mitchell Mauer. He is a contributor to ValueWalk.com.

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]]>The post Key Metrics: Price To Sales Ratio appeared first on Options Trading Research.

]]>The price to sales ratio, or P/S, is one of the most basic ratios out there. It’s also considered a relative valuation metric since you need to compare one company’s with another, or to its own historical ratio, to find out whether the firm is under, or overvalued.

This metric is exactly what is sounds like, price divided by sales. Or more precisely, price divided by sales per share. In other words, what you’re paying for ever $1 of sales the company makes. A P/S ratio of 2 means you’re paying $2 for every $1 of sales while a P/S of 0.5 means you’re paying 50 cents for every $1 of sales.

**Calculation **– Let’s use Apple as an example. Apple’s current share price is right at $100. And we see their TTM revenue is 227,535 while their TTM shares outstanding equals 5,648.

- To obtain Apple’s P/S ratio divide share price by sales per share
- 100 / (227,535 / 5,648) =
**2.48**

- 100 / (227,535 / 5,648) =

One of the great things about the P/S ratio is that it looks at sales rather than earnings. This is beneficial in 2 ways in particular. One is you don’t have to deal with the accounting tricks and manipulation that comes with earnings, one of the shortcomings of the P/E ratio. And two, you can value companies who aren’t currently profitable rather efficiently. There are 3 primary instance where the P/S ratio comes in handy:

**Cyclical companies**– In cyclical industries, there are often years when only a few companies are able to turn a profit. In these instances the P/S ratio is very useful in determining value. An increased P/S can warn the investor of overvaluation while a decreasing number may point to a recovery.**Growth companies experiencing temporary setback**– Growth stocks are notoriously tough to value since earnings are often spotty at best. Just look at Amazon as an example. It seems they can turn a profit at the flip of a switch but are often reinvesting so much that it makes it hard to be consistent. In this instance you can use the P/S figure as a valuation tool.**Turnarounds**– With turnarounds earnings are almost never present, hence the name. However, as is the case with cyclical companies, a decreasing P/S ratio may indicate a rally is near.

While there is probably no screener out there the P/S ratio wouldn’t make better, there are a few drawbacks the investor should be wary of. For starters, sales don’t always translate to earnings. While you can certainly use P/S instead of P/E in certain instances, all things being equal you should definitely choose the *company with higher margins*. Which is why gross and net margins should always be viewed with P/S. For instance, if company A and company B each have similar P/S ratios, but company A has 40% and 15% gross and net margins, respectively, while company B has 10% and 5%, company A should be the obvious choice. I only bring this up because companies with increasing profitability margins will tend to have higher P/S ratios.

Secondly, low P/S ratios often accompany firms with increasing debt. This is due to the sales being converted into paying off debt rather than the bottom line. This ultimately hurts the shareholder because sales and share price are not decreasing while the company may be inching closer and closer to bankruptcy. In instances where debt is a factor you would be better off using *Enterprise Value to Sales, or EV/S*, since this metric incorporates long-term debt into the numerator.

Even with its limitations, the P/S ratio has proven to be a formidable valuation tool in the long run. James O’Shaughnessey, money manager and author of *What Works on Wall Street*, performed a study stretching from 1951 to 2003 and found the P/S ratio to be the most consistent and best valuation metric available. His low P/S stock basket ended up beating the market in 88% of the rolling 10-yr periods. The next closest… P/B ratio, which beat the market in 72% of rolling periods.

Another study (performed between 2000 and 2010) found that companies with a P/S of less than 4 significantly outperformed those greater than 4, as the chart illustrates. As you can see, a P/S of less than 2 increases your odds of success even greater, while a P/S of less than 1 produced the best returns at 17.8%.

In my opinion, the best way to use the P/S ratio is in a stock screener that includes gross and net margins as well as current and debt to equity ratios. We’ve seen that P/S is a fairly reliable and consistent predictor of value, but since it tends to lean towards less profitable, debt-holding companies, we need to include metrics that warn us of these potential traps. **Any P/S under 3 is generally acceptable to me**. *Depending on the type of company, I may go over 4 but it has to be great firm with great management*.

Another great way to incorporate the P/S ratio is by utilizing it in as an intrinsic valuation method… with the Median P/S technique. Simply take the company’s 5 year P/S average and multiply it by its current sales per share. In Apple’s case it would look like this:

- (227,535 / 5,648) * 3.3 =
**$132.94**

While I wouldn’t use this as the only number, it certainly tells you a decent amount about the company’s current valuation. According to Apple’s 5 year average price to sales ratio, the share price should be trading somewhere around $132 rather than the current $100.

**Note:** The author of this article is Chris Gilbert. He is a contributor to ValueWalk.com.

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]]>The post Option Basics – Debit Spreads appeared first on Options Trading Research.

]]>The first strategy that we will look at is the *bull call spread*.

Fig.1 Bull Call Spread

To start with, I’ll give the standard definition seen in most options books or websites, as underscored by the abstract above: This spread involves buying an at-the-money (ATM) call, and selling an out-of-the-money (OTM) call, resulting in a *net debit*. Time is of the essence here. Maximum risk is capped at the net debit, and maximum reward is capped at the *difference in strikes less the net debit.* We have one break-even level — the long call strike plus the net debit.

The bearish counterpart is the *bear put spread* — same type of structure, except this time you’re betting on a decline in prices. It’s composed similarly to the bull call spread but this time we’re buying and selling puts.

Fig.2 Bear Put Spread

More specifically you buy an ATM put and sell an OTM put, thus again resulting in a net debit. Maximum risk is capped at the *net debit*. And maximum reward is, again, equal to the difference in the two strikes less the net debit. The *breakeven* is the long put strike price less the net debit.

Alright now hold on. I can literally see your eyes glaze over already. In order to really develop a deeper understanding of how option strategies work it is crucial that you are grasp how two or more options interact and how they may help you to limit your risk and also increase your odds of expiring profitable.

Just imagine for a second you are buying an at-the-money (ATM) call. What just happened? Well, for starters you are now in a battle against time. An option by definition is a wasting asset and as such its premium will decay in value every single day, all the way into expiration. If you buy a put you are short price movement of the underlying (i.e. short delta – we cover the greeks another day) but you are still long an option and as such there’s no difference when it comes to time value (i.e. theta in the greeks). As a matter of fact it is time depletion (a.k.a. theta burn) that most option sellers rely on for profitability. They care a lot less about market direction and only to some extent about volatility.

Recall from our first installment that an option’s premium consists of two component: intrinsic value and time value. You just bought an ATM call, so the intrinsic value of that option is going to be barely above zero and over 90% of its value will be purely extrinsic (i.e. time value). Which also means unless price starts to move strongly in your direction your ATM call is going to lose a little bit of its premium every day. And that makes complete sense as an option to buy the Spiders at 200 isn’t really worth anything or much unless the Spiders are actually trading far above 200.

As you can imagine it’s even worse for OTM calls. All their value is purely time based as their premium does not contain any intrinsic value. Of course naked OTM calls have their place in trading as they are great for insurance if for example you want to hedge a short position in the underlying instrument. But buying OTM calls in anticipation of higher prices is usually a losing proposition as price would have to rise far above that call, and that soon, in order for that option to substantially increase in price.

Which is the reason why a lot of professional option traders engage in selling you those OTM calls, full well knowing that they will expire worthless most of the time. Of course that’s the rub – *most of the time but not always*. Sometimes, perhaps only once every few years, we see a big move that nobody expected. And that is when many naked short option sellers get taken to the woodshed. Because the biggest problem with selling naked short options is that the loss potential is unlimited. Which is the one time retail traders get to enjoy their day of glory (e.g. fall of 2008) as on the flip side their profit potential, as option buyers, is also unlimited.

But ask yourself – how often does that happen? Actually more often than even many professional traders think. There is roughly a 75% chance of one sigma 5 event per year given leptokurtic distribution models which apparently most closely resembles real world models (normal distribution vastly under estimates it by the way, which suggests only every few hundred years). The thing is this however – timing that one day per year plus minus is next to impossible. And that is what option sellers bank on.

There is one key consideration regarding debit spreads in that they involve limited moves. By selling an option at a strike that’s further out of the money, we technically give up certain profit potential. However, since we’re predicting that the move is limited, we’re not really giving up anything, all the while reducing cost. And actually in the vast majority of cases we are actually increasing our profit potential due to much the much reduced cost. Let’s look at an example:

A lot of guys are licking your chops about going short the S&P cash right. Admittedly we are starting to push into monthly resistance but I want to be clear that this is not spot where I would attempt to be short. However if have money to burn and would like to lock in some profits then perhaps buying puts here is not the worst idea as momentum seems to be slowing down a little.

So assuming the Spiders close around 209 today and expect the market to go down soon we’re going to look at a few possible put option scenarios. The three profit targets for all of our scenarios are going to be:

**Reasonable**at 200**Aggressive**at 190**The Hail Mary**at 180

I have actually had to increase the probability from 1 sigma to 2 in order to expand the odds of closing ITM even near 180. Please keep that in mind as we analyze various options and their respective profit potential.

With the Spiders near 209 the 216P is considered a deep ITM option. You may note its vega which is currently -99.10, and that means it’s tracking the underlying ETF almost at a 1:1 ratio. Here is the possible return on your investment, which most likely underestimates an increase in vega, but at any rate:

Next we’re dropping down a few strikes to an ITM put at 212.5 with a vega of around 75. Once again here’s the profit projection:

Not too shabby, so the profit margin on the way down in pure percentage terms is increasing.

Most option traders usually go for ATM options due to the lower price and as expected vega near ATM is at 0.5 which means they are going to start tracking the SPY at 50%. The profit potential:

Another reason why option buyers usually go for ATM options is the perceived profit potential. For under $300 the profit curve here looks very delicious.

But does it really? In my not so humble opinion even a drop to 200, given the bullish advance of previous weeks, probably is pretty aggressive. Odds have it that the bulls would defend the recently reconquered 2k mark on the S&P cash aggressively. So statistically speaking our profit potential starts to diminish rather quickly as we’re approaching the SPX 2k mark. And that means an ATM put costs us $289 but only gains us a little over 200%. Hey, that’s a 2R gain, which sounds great but it’s a position you’ll have to hold for almost a month and a lot can happen until then.

If you recall our lessons on system trading then you know that the lower the win/rate ratio the bigger your winners have to be just to get to break even. A significant number of long options (especially puts) expire worthless each month, which represents a 1R loss. Do you recall how to calculate the break/even point?

n = Success Rate in %

b = Break Even Risk to Reward Ratio

Alright, let’s be generous and say that 60% of all put options expire OTM, that would mean n (the success rate in %) equals 40. And 60 / 40 = 1.5. So just in order to break even over let’s say 100 of your put transactions you would have to bank 1.5R at minimum. I think the win/loss rate is actually lower but perhaps you’re better than most and even then you require at least 200% winners just to eek out a respectable profit of 0.5R over 100 campaigns. It’s not a bad system but let’s not forget another inconvenient fact that most option traders are oblivious to – the odds for consecutive losers:

For a win rate of only 40% the odds of experiencing 9 consecutive losers over 100 campaigns statistically speaking has a chance of about 60%. Given 250 campaigns it’s 91% and given 500 campaigns it’s 99%. Most retail traders do not abide to proper position sizing and regularly risk quite a lot more of their assets to one campaign than just the 3% I selected as 1R. And if you hit 9 consecutive losers at 3% it means you lost almost 25% of your trading capital and have to make 130% just to recoup your losses. If you trade 5% position sizes then you lost over 35% of your assets and need to make 155% to get back to where you started.

I think you are starting to get my point, which is that in order for you to make money with naked options you must a) either bank 2R winners on average or b) increase your win rate substantially above 40%. You think you can do that?

And this exactly the honey trap that newbies tend to fall into. You want cheap options with outlandish returns, but in reality, this unlimited return will happen only very rarely (e.g. 1 out of 100 times). You know how this goes and I’m sure you’ve been there yourself in the past. You pick up an ATM option with an intention of making a quick money, but the moment you get in, the market starts to go against you. You don’t want to get out of the position until you break even, so you decide to hold on to your position.

A couple of weeks passed by, and SPY comes back to your entry price. In the meantime, you’ve lost a ton of money on a time decay and wind up getting out of your position with a loss, instead of taking an “unlimited” gain. So, while I’m not totally discarding naked puts as a strategy, I think in most cases there is a better long term approach which may not bag you the 10-fers you dream of but put you on the path to banking consistent coin via a systemic approach that clearly defines a win/loss range and is less sensitive to theta burn or gyrations in vega (topics we have not even discussed in the context of naked options).

So what we’re doing here is to buy a put at 209 and at the same time sell one at 200, which establishes a debit spread. The cost of this campaign is 2.13 which is lower than that of a naked ATM put. So that alone reduces your cost of entry and especially if you have a smaller trading account allows for more precise position sizing. If you want have a $100k account and only want to risk 1% (advisable) on this then you would be able to 9 of those suckers.

On the ROI projection we see that getting to the 200 mark nets you a little under 180%. Yes, that’s less than for the naked put but remember that after about 205 time decay (i.e. theta) actually starts helping instead of hurting you. The longer it takes to get to 200 the more you make on theta. It is true that a rise in volatility will hurt you a little but unless you timed your purchase perfectly a lot of that is most likely offset by the lack of theta burn. Only an almost instantaneous drop would make a naked option the right choice here. So if you have a crystal ball at home then that’s most definitely the way to go

You’d be surprised to learn that most professional option traders rarely glance at a chart. Well, at least not the type of chart you are used to looking at. Instead they look at what’s going on in the option chain, so let’s see what’s going there:

And here it is – we’ve got the calls on the left and the puts on the right. Now look at the open interest columns. Despite current bullish tape we’re seeing some pretty significant activity around the 205P and the 200P. So quite a lot of market participants seem to be putting money on a bet that prices will drop toward either 205 or 200 in the next month. That is quite an aggressive assessment if you ask me, especially given all we learned about theta burn in the last month of an option’s lifetime.

But without even looking at a chart you are able to get a pretty good assessment of price levels that market participants perceive as being significant. If you can line them up with technical support levels on your charts then even better. However given the lack in technical context on my own charts, meaning according to my personal lens of the market, I must conclude that even a vertical put spread right now right here has only limited odds. In addition I don’t see too much clustering on the put side of the option chain. It’s understandable that we have a more significant OI around the 200 mark but it’s only about 150k and that’s not a hell of a lot. There is barely anything around 201 or 202 and that IMO is a bit suspect and suggests that the 140k is mostly composed of retail traders.

What have we learned today? First of all before even thinking about trading naked options or directional strategies such as vertical spreads we should make a realistic assessment of the current trading environment. What are the odds of a reversal and how deep do you expect this reversal to be? What is your conservative/moderate/aggressive price targets?

We have also learned that buying options in general has a low win/loss rate and that a significant number of them expire worthless. That in turn affects our minimum win/loss rate and as such we need to increase our odds of success as much as possible. Unlike being long in the futures or forex markets buying options puts us into a race against time. And that means our position loses money every single day in sideways tape. A vertical spread keeps us out of the time race and actually helps us assuming that prices move at least somewhat in the direction of our price targets. Which may allow you to get out at or near break/even should market behavior indicate that the odds of reaching your target are diminishing. So in other words choosing vertical spreads instead of naked options offers you more flexibility as market conditions change.

Finally from a purely systematic perspective vertical spreads allow us to more precisely evaluate our benefit to risk ratio. It’s just not realistic to think in terms of ‘open ended’ returns – when trading any systems, options included, you must know what your targets are. Without profit targets you don’t know when to exit your campaign and one of our prime directives here at Evil Speculator is that you never enter a trade without knowing where/when you will exit it. If you choose for example to take partial profits at 2R and keep the rest until 3R then that is a system you can factor and statistically analyze over time. Which will allow you to track your win/loss rate, your average expectation (or SQN), your standard deviation, your consecutive losses/wins, average loss vs. average win, etc. etc. Which are topics I almost never see addressed when it comes to trading options. It is quite possible to trade a system of options instead of just trading options. The difference between the two is profound and we will spend quite a of time on this in the weeks and months to come.

Want to learn more about trading and get access to powerful trading tools? Check out Evilspeculator.com for more great insight into trading the markets.

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]]>The post Option Basics – The Greeks appeared first on Options Trading Research.

]]>To set the stage let’s recall some lessons from our first tutorial:

- Options are a wasting asset. You buy one today and unless price moves heavily in your favor it will continue to lose extrinsic value every single day all the way into expiration. Given an ATM or OTM option extrinsic (i.e. time) value represents the entire premium.
- The premium of an option has two components:
- Intrinsic Value
- Time (or Extrinsic) Value

- Intrinsic value is only accumulated once price moves above the strike price of a call option or below the strike price of a put option.
- An option’s time value is equal to its premium (the cost of the option) minus its intrinsic value (the difference between the strike price and the price of the underlying).
- Time value decreases over time, eventually decaying to zero at expiration, a phenomenon known as time decay.
- Time decay is not linear – it is exponential. As a rule of thumb an option roughly loses 1/3 of its time value during the first half of its life, and the remaining 2/3 of its time value during the second half.
- Option premiums (i.e. the cost of an option) change based on:
- Changes in the
**price**of the underlying. **Time**remaining until Expiration.- Increase or decreases in
**implied volatility (IV)**. - Interest rates (not a big issue in the QE era).

- Changes in the

We covered all of the above except the third one – implied volatility, but we’ll get there soon enough. What’s important to remember for now is the trifecta of an option’s value: *Price*, *time*, and *volatility*. And when it comes to volatility we are only interested in *implied* *volatility*, which is not to be confused with *price or realized volatility*. We have covered the difference on several occasions here in the recent past and if you missed those then please point your browser here.

The option greeks you will mostly be dealing with are: *Delta, gamma, theta, *and* vega.* So if you never actually went to college and during the admission ceremony to your favorite secret society the high priest asks you what your fraternity/sorority was then just use a combination of any of those four and you should be able to avoid the black pit of pain.

Yes, I know – there’s rho but it’s only related to interest rates and we don’t really have to worry about those much since 2008, do we? Alright, let’s dive right in:

*The price sensitivity of an option to changes in price is expressed by delta*. Right from the get-go we need to understand that nothing in the options world changes on a linear basis. Delta is no exception there and it fluctuates constantly as it is also influenced slightly by another option greek – vega, which expressed volatility. Delta gives us a measure of the probability that an option will expire ITM. So an option with a 0.1 delta can be thought of having a 10% chance of expiring ITM – and an option with 0.9% delta is interpreted as having a 90% chance of expiring in the money – simple.

Still don’t get it? Alright, let’s use a popular analogy:

A car’s speed tells us how far a car will travel after during the period of one hour. If the car is going 60mph, it will have traveled 60 miles. Now a car’s speed is similar to an option’s delta – just replace the time component (i.e. hour) with price. An option’s delta tells us how far the option’s value will go after a one handle move in the underlying. If an option’s delta value is 0.50 and the underlying increases in price by $1.00, the option value will increase by $0.50. *So a good way to think about delta is value per dollar* (instead of miles per hour for a car).

But what if we ran out of gasoline and there is no price movement? If the underlying price does not move as time continues to pass (remember delta describes value per dollar – not value per hour), then option’s chances of expiring ITM starts to diminish rapidly. Which means that at expiration, all OTM deltas fall to zero. So between now and the expiration date, the delta of an option diminishes simply because time continues to pass relentlessly.

ATM options for example have a delta of roughly .50. This makes complete sense as statistically they have a 50 percent chance of going up or down. Deep ITM options have very high deltas – as high as 1.00, which effectively means that they will trade on par with the underlying instrument. Some traders use these as stock substitutes but clearly it’s not the same as holding the underlying.

Inversely deep OTM options have very low deltas and therefore change very little along with the underlying. When you consider cost like commissions and the often wide spread, low delta options are not expected to make much or any profit even despite large moves in the underlying. And that is an important consideration because c*omparing the deltas along the option chain is a great way of measuring the potential returns on a trade*.

Option sellers (a.k.a option writers) for example regularly use option delta in order to estimate the probability that they will be assigned. Writers of covered calls do not want to be assigned and therefore use delta to assess that probability in relation with the potential return from selling an option.

The delta of an option ranges in value from 0 to 1 for calls (0 to -1 for puts) as it reflects the increase or decrease in the price of the option in response to a 1 point movement of the underlying asset. Far OTM options have delta values close to 0 while deep ITM options have deltas that are close to 1 (or -1 for puts as they gain inverse to price movement of the underlying).

As the time remaining until expiration diminishes, the *time value* of the option evaporates and therefore the delta of ITM options increases while the delta of OTM options decreases. You may be wondering why the delta (i.e. sensitivity to changes in price) of ITM options expiring sooner is higher than that of the same strikes expiring several more months out.

The simple reason for that is because ITM options have more intrinsic value than time value – deep ITM options have almost no time value at all, they are all about intrinsic value. So the ITM option that is closer to expiration (red line) will have a higher premium and thus be *more* sensitive to price movements in the underlying.

As price rises, and the option goes deeper ITM, delta typically approaches 1.00 because of the increased likelihood the option will be ITM at expiration. As expiration approaches ITM option deltas are also more likely to be moving slowly toward 1.00 because *at expiration an option either has a delta of either 0 or 1.00 with no time premium remaining*.

Here’s an example: If the current price of the underlying is $50 and you are long a call with a strike price at $48 expiring in July then obviously it should track the underlying more closely than a call with the same strike price but expiring in December. The former has less time value, which in this case is considered a benefit as its odds for expiration ITM are high.

When it comes to the greeks I suggest that you worry less about the things like Black-Scholes pricing models and more about applying plain old common sense. Because it is the latter that drives the former when it comes to the proper pricing of options. That said – sometimes it can get confusing and when in doubt then come back and consult this guide

You probably noticed that the only crossover of the three expiries occurs at the ATM point – as you recall the delta of an option with a strike price ATM is exactly 0.5. Moving higher into the money starts to produce intrinsic value which is a constant (i.e. market price – strike price) and does not change over time.

Here’s a memory crutch for you, or should I call it memory *crush*: Imagine time decay as the big bully who just jumped onto the opposing end of your balance swing back when you were pondering plans for dominating the local candy distribution racket. Your end represents ITM option delta and the bully’s end represents OTM delta being crushed – ATM options are at fulcrum of the balance swing. As time progresses your end (ITM) lifts higher and the other end is being flatted – only the delta at the fulcrum remains unaffected by time.

Gamma is delta’s little brother as they are linked intrinsically. Whereas delta measures the* speed* of an option (increase in value per handle or dollar), gamma can be thought of as its *rate of change or acceleration*. It expresses the *sensitivity of delta* to changes in price of the underlying asset. The more gamma the more sensitivity. Alright once again I can literally see your eyes glaze over already, so let’s go back to our car analogy:

When driving a car we don’t always go at the very same speed – it constantly varies based on road conditions and traffic, and sometimes we need to take a break. When we accelerate the car, the speed at which we are traveling increases and when we step on the brakes it reduces the speed. Imagine you are driving 60mph and you put your foot on the gas and increase the speed to 65mph. The speed of the car has now increased by 5mph from 60mph to 65mph.

The acceleration of the car’s speed, that increase of 5mph, is similar to gamma changing an option’s delta value. Acceleration for a car tells us how much the speed will change (5 mph) and gamma for an option tells us how much an option’s delta value will change. That acceleration of 5mph is the moving car’s gamma – the increase in speed. Just like a car, an option never travels at the same delta during a particular trip. It accelerates and decelerates on a variety of factors. That rate of change (ROC) in delta in an option is expressed by gamma.

A car that has a lot of horse power will be very sensitive to movement. If you step on the pedal of a Ferrari or Tesla, the car will increase in speed rather quickly. So another way of thinking of gamma is horse power. An option with a high gamma value will also be very sensitive to movement. If the underlying changes, the option’s delta will change significantly.

As gamma expresses the ROC of an option’s price, it is most closely watched by participants who *sell*options as gamma tells us a lot about the risk potential if the underlying moves against our position. By the way, just as delta, gamma is also influenced by implied volatility (IV). More on that further below.

Option sellers love their theta and by now you probably can guess why. *Theta is a direct measure of an option’s sensitivity to time decay*. As always a picture speaks a thousand words:

As a direct measure of time decay theta is giving us the value of decay per day. This amount of value lost (in Dollars usually) starts as the proverbial trickle but slowly grows over time, until it is falling more and more rapidly the closer it gets to expiration day. As you can see from the graph shown above, the greatest loss in time decay is observed in the last month of an options life. I have copied the red lines depicting each quarterly time decay of an option to the bottom of the graph in order to better visualize the increasing loss of theta. You should burn this image into your mind so that next time someone mentions the words *theta burn* you know exactly what he’s on about.

Option sellers use theta to their advantage, collecting a little bit of time decay every day. Whereas option buyers hope to bank mighty coin by landing 10-bagger winners in a matter of days, the sellers are happy with collecting a few measly pennies every day but over extended periods of time. The same happens to be true for credit spreads, which are selling strategies we will cover in the future. You may have also have heard or read about calendar spreads (a.k.a. horizontal spreads), which involve buying longer-dated options and selling nearer-dated options in expectation that the nearer dated ones will lose theta faster as the longer dated ones. Again, we’ll cover all that fancy stuff in future installments of this series.

And of course I had to keep the best one for last. *The vega of an option expresses the change in the price of the option for every 1% change in underlying volatility*. It is important to understand that a rise in IV produces a rise in option premiums across both sides of the option chain. It doesn’t matter if you’re long a call or if you’re long a put – when IV climbs your premiums are going to get more expensive, and if IV falls then the premiums of all options fall along with it.

Many novice call buyers have learned that lesson the hard way after foolishly loading up on naked calls after a big move to the downside. As prices often snap back temporarily inflated IV will drop fast and produce a phenomenon referred to as ‘vega crush’. Although you may have picked the right direction (i.e. getting positioned long calls ahead of an appreciation in price) your may have purchased overpriced premiums which, due to a massive loss in vega, will not appreciate in value along with the underlying as expected, or perhaps even lose value.

In general the rule is that the more time remaining to option expiration, the higher the vega. This makes sense as extrinsic value makes up a larger portion of the premium for longer term options and *it is the time (or extrinsic) value that is sensitive to changes in volatility. *Obviously the more time remains the more risk that an even more adverse price move can happen.

To demonstrate this I have produced a graph depicting the effects of vega on options at various strikes expiring in 3 months, 6 months and at 9 months. I’ve shifted current trading price (i.e. ATM) a bit to the left to demonstrate how vega peaks around it at three months until expiry (red line). How I wish I could do that in real life!

For options with expiries six months as well as nine months out that peak is shifts a bit toward the OTM call range. Vega distribution across the vertical chain is more rounded in nine month options (orange line) than in six months options (blue line) where it rises to a peak and then kind of drifts off.

And that’s it – all there is to know about vega.

Yes of course I was kidding there, we’ve barely scratched the surface. Volatility also happens to affect option delta, because as volatility rises (orange line), the time value of the option goes up *as time combined with volatility becomes more risky*. I hope this makes sense. Because this is what causes the delta of OTM options to increase and the delta of ITM options to decrease. Just imagine the wings of the delta flyer I posted above and how they interact with air. As the airflow moves around the wing it increasingly produces *upward* pressure in the front (i.e. the OTM strikes in the option chain) and *downward* pressure in the back of the wing (i.e. the ITM strikes in the option chain). The neutral point is near the center of the delta’s wing which is the ATM spot.

Remember that gamma expresses the *sensitivity of delta* to changes in price of the underlying asset – we can think of it as an option’s acceleration. When volatility is low (the blue line) the gamma of ATM options is high while the gamma for deep ITM or OTM options approaches zero. This phenomenon arises because when volatility is low the extrinsic (or time) value of such options are low. However it goes up dramatically as the price of the underlying approaches the strike price. Again this makes sense because in sideways tape the odds that either sides of the extremes are going to be touched before expiration are pretty low.

When volatility is high, gamma tends to be stable across all strike prices. This is due to the fact that when volatility is high, the extrinsic (or time) value of deeply ITM as well as OTM options is already quite substantial (remember – vega inflates time value). Thus, the increase in time value of these options as they go nearer the money will be less dramatic and hence the low and stable gamma. I know this may sound somehow backward but think about it this way: In highly volatile tape the ROC or *acceleration potential* (or gamma) of an option is considered to be much lower. And why is that? Because you are already flying along at 140mph – that’s why. Get it now?

The graph above illustrates the relationship between an option’s gamma and the volatility of the underlying. You can see that there’s a significant difference with high volatility (blue line) producing a more platykurtic distribution curve and low volatility (orange line) producing a strongly leptokurtic curve.

If those terms just triggered a short circuit in your brain then here’s another simple memory crutch for you: Imagine gamma to be the nose of the delta plane I mentioned above. As it volatility (i.e. air flow/speed) increases it starts pushing against the nose of the plane, thus flattening it. Yes of course all delta planes are made of industrial high tensile wax, you didn’t know that?

So now you can perhaps appreciate why I mentioned above that gamma is most closely watched by option sellers. If you’re selling options near or ATM for example then this is where the risk potential is concentrated in low volatility. However in high volatility gamma is more evenly distributed and you will be most affected by a drop in volatility the closer your sold option is to the strike price. Which is why option sellers are effectively short gamma.

To wrap up volatility let’s see how it affects the option’s theta although we already mentioned this in the sections above. In the graph above you can see that options traded during high volatility periods have higher theta than options traded during low volatility periods. This is because the time value on these options are higher (vega pushes time value) and as such they have more to lose per day. As a rule of thumb: Options are historically cheap during low IV and expensive during high IV. Most likely that is one of the first things you ever learned about options.

As if you haven’t suffered enough – I have prepared a handy cheat sheet I want to share with you before I send you on your way to option trading glory. At this point you probably understand that being long both calls or puts puts you into the negative (i.e. short) theta department. Being long calls or puts also makes makes you positive (i.e. long) vega. But mix in some of the other greeks and things can get confusing rather quickly. So I put together a little memory crutch for you guys and if you can remember that one you’ll be able to reside the proper greek polarity without any problem.

- First up let’s just
*forget about rho*which is rarely considered there days (yes, purists will disagree). - Our baseline for our memory crutch is the
*long call*, which is*positive everything, except theta*. That makes a lot of sense as we talked about depletion of theta and if you’re long anything on the option side you are on the hook for theta burn. - Inversely the
*short call*is*negative everything except theta*. Also makes a lot of sense. - Now for the long put all you need to do is to change delta from positive to negative. Repeat the words gamma/vega about 20 times and you’ll remember that
*long puts are only positive gamma and vega*. Another neat trick is think about which greeks have the letter ‘g’ in it. There you go – that’s the long put: positive [*g]amma and ve[g]a*. - And that only leaves the short put. Well that’s easy now. If the long put is positive gamma/vega then the short put must be negative gamma/vega. And of course it’s positive all the others, delta, theta, and even the mysterious rho.

When you started reading this post the topic of option greeks may all just have been, well… ‘greek’ to you. But if you made it all the way to here then you actually understand them better than 99% of retail traders. Congratulations – you are now considered armed and dangerous by TDA and other retail option brokers. I however recommend you revisit this post every once in a while for a little refresher. In particular the impact of volatility on its other greeks is an acquired taste and either necessitates repeating or regular use. Frequent consumption of single malt Scotch may help as well – or least that’s what my local barkeep keeps telling me. Anyway, after a few weeks/months what once as dry theory should all become second nature to you.

Make no mistake – although cryptic to outsiders a deep understanding of option greeks opens up a whole new dimension of profit potential. At minimum it can keep you out of trouble ahead of or during volatile market periods; and I have an inkling we are going to see quite a bit of that in the years to come.

Want to learn more about trading and get access to powerful trading tools? **Check out Evilspeculator.com for more great insight into options trading and trading the markets.**

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]]>The post Option Basics appeared first on Options Trading Research.

]]>- A
**call**option offers the holder the right (but not the obligation) to**buy**an underlying asset at a specified price (the strike price), for a certain period of time. If the underlying fails to meet the strike price before the expiration date, the option expires and becomes worthless. A trader may buy a call option expecting that the price of the underlying instrument will rise, or optionally sell one if anticipating prices will fall. - A
**put**option gives the holder the right to**sell**an underlying asset at a specified price (the strike price).*The seller (or writer) of the put option is obligated to buy the stock at the strike price*. Put options can be exercised at any time before the option expires. A trader would buy a put option expecting that the price of the underlying instrument will fall, or optionally sell one if anticipating prices will rise.

So basically the stock, index or future that you buy the option for is known as the underlying instrument asset. Options are bought and sold to take advantage of price movements in the underlying. There are several benefits to buying stock or index options for example as opposed to buying the underlying outright. For one options are relatively inexpensive, particularly when compared to the cost of the underlying instrument. Right now today as I’m typing this you or I can buy 100 shares of the Spiders for roughly $206 per share. That means buying 100 shares of SPY will set you back a princely $20,600 plus commission.

Instead of doing that you could just buy an option instead and control the same 100 shares for a fraction of the price. The SPY June option trading at-the-money (ATM) at the 206 strike price right now runs about 5.16 points. So by purchasing one single option you spend only $516 plus commission instead of over $25k to control 100 shares of the Spiders. However keep in mind that you are *not* buying the Spiders, *you are merely leasing their profit potential for a given amount of time. *And that privilege expires the very same day your option does.

The second reason to buy options is because they are very flexible. By purchasing a *put* you can easily profit from options even if the stock goes down. And doing that is a lot easier/quicker than borrowing and selling shares in order to establish a short position, which also is a potentially very risky proposition if Yellen for some reason once more surprises the market with even more dovish monetary policies.

The third advantage to buying an option is that *you can never ever lose more than what you paid for that option – period*. Your maximum risk exposure is clearly defined and represents the premium you paid when you purchased your option. This does not mean that there is no risk in trading options at all. If you are writing (i.e. selling) naked options then you are in fact assuming *unlimited* risk, which is why I strongly advice anyone against doing that. For mere mortals like us writing options is tantamount to picking up pennies in front of a steamroller. It works fine for a long time until you accidentally trip one day and watch your account being flattened in mere moments. So leave *selling options* to the professionals – you’ll sleep a lot better knowing that are not risking your entire account over one open position.

The fourth benefit to buying options is that they offer a lot of leverage. Should the Spiders continue to appreciate then my measly $516 could easily multiply by a factor of two or more. But beyond mere profit potential there is a more subtle advantage to option leverage that many retail traders have a hard time grasping – position sizing. On the futures or forex side for instance I rarely devote more than 1% of my account principal to one single position. As a matter of fact we employ risk calculators for both forex and the futures to ensure that our campaign’s stops limit us to as close to the desired R size as possible. The concept of R is explained here and I strongly suggest you understand absorb it before reading on.

The fifth benefit to trading options is more subtle and one many retail traders are blissfully unaware of. When buying or selling shares of a stock I am facing a liquidity problem. Stock is commonly traded in blocks of 100, so if I want to buy 100 shares of IBM at $50 then I will need to devote $5,000 of my assets for that position. Of course that $5,000 does only theoretically represent my full risk. In my time as a trader I have seen stock shares drop all the way to zero, but outside of 6 sigma events my stop loss is hopefully going to kick in way before that. But the main issue that remains is that of *availability of trading assets*. I may only have $50k in my account and that means that a full 10% of my assets will now be locked into one single position. That affects my ability to devote funds to other campaigns and also implicitly impairs my ability to diversify across various asset classes or markets.

So clearly there are many good reasons for buying an option, however there also some against it. As you already learned options are a wasting assets, which means that from the day you buy one it will slowly lose some of its time value until expiration. Time value is represented by theta – one of the famed option greeks.

*An option’s premium is comprised of two components: its intrinsic value and its time value (or extrinsic value)*. The intrinsic value is the difference between the price of the underlying (for example, the underlying stock or commodity) and the strike price of the option. Any premium that is in excess of the option’s intrinsic value is referred to as its time value.

Now the option’s time value is equal to its premium (i.e. the cost of the option) minus its intrinsic value which is the difference between the strike price and the price of the underlying instrument. I just glanced at the option chains and the Spiders are currently selling for 216.31 which that means my 216 June option I mentioned above at $516 has an intrinsic value of exactly 0.31 points or 31 Dollars! If I deduct that from the full premium of $516 I arrive at $485 and that, as you probably guessed it, is the time (or extrinsic) value of my option. The further price moves above my call’s strike price the higher the option’s intrinsic value and the lower its time value.

As a rough guide – the maximum time value of an option is when it’s trading ATM, above and below its option chain time value gradually decreases each strike. The more time that remains until expiration, the greater the time value of the option.Time value decreases over time, eventually decaying to zero at expiration, a phenomenon known as time decay. This is because traders are willing to pay a higher premium for more time since the contract will have longer to become profitable due to a favorable move in the underlying.

Now loss of time value is the main reason why* a significant number of options expire worthless*. Here are some recent statistics I lifted off of the CBOE:

- 10% of option contracts are exercised.
- 55% – 60% of option contracts are closed out prior to expiration.
- 30% – 35% of option contracts expire worthless.

Now that’s quite a lot less than some people claim but if you look beneath the numbers you must also recognize the fact that many people buy options not just for speculation but for protection/hedging. If you’re holding 100,000 shares of IBM then buying 1000 puts to ahead of an anticipated volatile move makes complete sense. And that put can easily be sold again a day or two later once markets have quiet down a little again. It will have lost a bit of time value but that’s a small price to pay for downside insurance. [caveat: selling your puts into falling vega (i.e. volatility) may cost you a pretty penny and we’ll be covering that in the future in some detail.]

Some people actually speculate doing the inverse – they may *sell 1000 calls* against their 100,000 shares which is called* writing a covered call*. It’s not something I do but investors often use it for generating a bit of extra income. It’s basically a way of locking in your existing profits, but we’ll cover that another time.

Now the reason why I mentioned the statistics above is that there is another way to trade options which has better much odds but retains our ability to limit our risk. And that, as you may have guessed already, is via the trading option strategies, which involves the simultaneous buying and/or selling of one or more options.

Options strategies not only allow you to profit from bullish or bearish price swings, but they also enable you to profit in sideways tape. One way of doing that is in leveraging *volatility* – expressed as *Vega* in our options greeks. Neutral strategies can be further be classified into those which are bullish on volatility and those that are bearish on volatility. Traders can also profit off time decay when the stock market have low volatility as well usually measured by the greek called *Theta*.

Option strategies is where the real fun begins but in order to use them effectively it is important that we understand them thoroughly in order to anticipate the impact of market moves on our profitability as well as our risk exposure. We will be covering that in much detail in further installments of this series.

Want to learn more about trading and get access to powerful trading tools? **Check out Evilspeculator.com for more great insight into trading the markets.**

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