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April 3, 2012

Option Synthetics Quiz Answers

Quiz Answer

Quiz Answer

How did you do taking the quiz on Option Synthetics? In case you want a refresher, here’s an article I wrote about them that is a good summary: What everybody ought to know about Option Synthetics. We can use an easy equation to remember the synthetic relationships:

C = U + P

The relationships can be summarized in this short table:

1. Long Call = Long Stock + Long Put (C = U + P)
2. Short Call = Short Stock + Short Put (-C = -U – P)
3. Long Put = Long Call + Short Stock (P = C – U)
4. Short Put = Short Call + Long Stock (-P = -C + U)
5. Long Stock = Long Call + Short Put (U = C – P)
6. Short Stock = Short Call + Long Put (-U = -C + P)

Armed with this information, let’s go through the quiz:

1. How would you create a synthetic SHORT CALL?
That’s #2 on our summary: Short Stock + Short Put

2. How would you create synthetic LONG STOCK?
That’s #5 on our summary: Long Call + Short Put

3. How would you create a synthetic LONG PUT?
That’s #3 on our summary: Long Call + Short Stock

4. How would you hedge an out-of-the-money SHORT CALL with a synthetic position?
To completely hedge the position, use a synthetic LONG CALL at the same strike as your SHORT CALL.
Buy LONG STOCK and a LONG PUT at the same strike as your SHORT CALL.
You now have zero risk and are perfectly hedged.

5. If your underlying is near your upside expiration on a butterfly trade, how would you reduce your delta risk with a synthetic position?
If you are near the upside expiration of a butterfly, you have negative Deltas.
New need to crease your deltas. Positive delta synthetics are #1, #4 and #5 on our summary list above. Any of them should give you more positive delta. If you need a fine adjustment, use #1 or #4 as #5 (Long Stock) is +100 deltas, which might be too much, depending on your butterfly size.

6. How can you completely neutralize a 100/110 call credit spread with puts?
Create a box spread. The 100/110 call credit spread is -1 100C and +1 110C. If you add +1 100P and -1 110P you would have synthetic Short stock at 100 and synthetic Long stock at 110. This position has zero risk.

7. You are long a futures contract at $100. The contract is now at $125. How can you lock in the $25 profit without selling the futures contract over the weekend with a synthetic option position?
To lock in the $25 profit, you just need to add a synthetic short future with futures options:
-1 125C and +1 125P should give you a synthetic short future contract, which will neutralize your long future.

I hope you enjoyed the quiz. It’s good to know these relationships and practice from time-to-time with a quiz like this!

March 30, 2012

Options Synthetics Quiz

Multiple Choice Test

Option Synthetic Quiz

A friend was taking an exam to get Customer Portfolio Margin for his option trading account recently.  He showed me the exam and I noticed that 20% of the exam were questions about option synthetics!  If it’s that important to an option broker, it should be important to us.

My two youngest children attend the German school system.  There are no multiple-choice exams: they are all essay questions.  You have to show your work.  Let’s do the same thing.

Write down your answers for each question.  
Explain WHY the answer is what you say it is.  Don’t just say, ___ .  Show your work…you’ll learn a lot more.   This is an open book exam since I can’t watch you, but try to answer the questions without looking anything up.  You’ll get more out of it.

Here we go

1. How would you create a synthetic SHORT CALL?

2. How would you create synthetic LONG STOCK?

3. How would you create a synthetic LONG PUT?

4. How would you hedge an out-of-the-money SHORT CALL with a synthetic position?

5. If your underlying is near your upside expiration on a butterfly trade, how would you reduce your delta risk with a synthetic position?

6. How can you completely neutralize a 100/110 call credit spread with puts?

7.  You are long a futures contract at $100.  The contract is now at $125.  How can you lock in the $25 profit without selling the futures contract over the weekend with a synthetic option position?

 

Good luck with the quiz!  I’ll post the answers next week.

 

April 27, 2011

4 Steps You Can Take for More Profitable Trading

Trading Plan
You’ve just put your first live trade on in your broker account.

The market is moving against your position.

You aren’t comfortable as your position starts losing money.

You hope the market will come back in your favor but it keeps moving against you.

Fear starts to grip you and you begin to panic.

You don’t know what to do and the position keeps getting worse.

Finally you can’t stand it and close your position for a big loss.

Soon after you close your position, the market reverses direction.

You would have gained back all that you lost and ended up having a profit.

What went wrong?
You didn’t have a trading plan. You traded with your emotions. The key to being a successful trader is treating it like a business and controlling your losses. How do professional traders avoid trading with emotion? They define three objectives for each trade:

1. Set a profit target
2. Have a maximum loss
3. Define adjustment points and actions
4. Define how you will exit the trade

Let’s look at each one of these.

1. Set a profit target
It is important to get paid to trade. You need a clear idea in your mind when or where you will take profits in your trade. There are many ways to define your profit targets. It could be as a percentage of a spread credit received, or a percentage yield on your required margin. It could be based on movement of the underlying instrument. Whatever method you use, have a clear target. Don’t approximate it. Be specific and take profits earlier rather than later. If you take partial profits, take the lion’s share out quickly to lock in a profitable position.

2. Have a maximum loss
This is very difficult for most traders, yet it is probably the most critical to follow. You can’t have a profitable trading business if your losses exceed your profits. That’s simple mathematics. The biggest problem with large losses is it takes a larger percentage profit to get back to even. Professionals are fanatical about keeping losses small. You should be too.
Once you set a maximum loss, never exceed it. Take steps to reduce your risk as your position nears the maximum loss. You can do this normally by neutralizing part of your delta. A long put or call can help you stay in a position longer and give you a chance for the market to come back to your position. If you do hit maximum loss, exit the trade unless there is a very good reason not to.

One reason could be if volatility spiked against you and you are in a trade with all options in the same expiration month. If you were still in the middle of your expiration profit zone, and only at maximum loss due to volatility, I would typically stay in the trade. With this unusual exception, exit the trade if it hits your maximum loss. Survive to trade again the next month.

3. Define adjustment points and actions
The market will test your positions. Have clearly defined points where you will adjust your position and what you will do at that point. This helps you avoid freezing up with fast moving markets. If you know what to do ahead of time, you will be much less emotional about your trades. Have your adjustment rules and stick with them.

4. Define how you will exit the trade
If you reach your profit target or maximum loss, you will exit your trade. Your trading plan may include taking partial profits. Have this pre-defined of exactly how you will implement this. For example, at +10% profit, take 60% of the trade off and set a trailing stop of 5%.

Another type of exit is a time stop. Trades don’t always go in your favor right away. If it takes too long to start generating a profitable position, consider exiting based on poor price movement. This type of exit is based on how long you intend on staying in the trade. If you have a 30-day butterfly spread, you may set a rule if it is not profitable after 10 days, to exit the trade.

The market keeps changing too much to have a rigid plan
The markets do change, but your trading plans should change too. Keep track of your trades in a trading journal so you can see how you are doing over time. Successful traders keep good records.

Having a trading plan helps you trade without emotion
Setting a profit target, maximum loss and knowing how and when you will adjust a position and when you will exit are essential for all of your trades. If you don’t do these steps you’ll see profits slip away, losses grow too large and your trading account will shrink instead of grow. Treat your trading like a business.

Create your trading plan and start a trade journal
Set a profit target, maximum loss, adjustment where’s and how’s and how you will exit each trade. Document each trade and start tracking your trading performance. You’ll be glad you did.

April 18, 2011

What Options Broker do You Use?

I asked a one question survey to see what the most popular options broker was.

Here are the results now with 234 people responding:

For primary options broker
69.6% ThinkOrSwim
12.1% Interactive Brokers
9.4% OptionsXpress
4.5% TradeMONSTER
3.6% OptionsHouse

For Primary or Secondary Broker
64.0% ThinkOrSwim
12.6% Interactive Brokers
12.6% OptionsXpress
6.8% TradeMONSTER
5.2% OptionsHouse

The rest combined were under 2% of the results.

 

Forest, Hauptstuhl, Germany

August 13, 2010

Do Weekly Options Have Too Much Risk?

I read a blog post today about the weekly options and how the risk was too high. The article was trying to explain that the wings are not priced correctly, which I agree with. The problem was the statement about risk vs time was incorrect.  To quote part of the article:

“…the July weekly in 25% of the time has a standard deviation that is over 1/2 the size of the month out.  For those that would think the expected movement of the weeklies would be 1/4 or less this is a big burst to your bubble.  This basically says the trader is taking on over 50% of the risk in a trade that has only a week to develop.  Many do not realize standard deviation is not linear!”

The assertion that standard deviation is non-linear is correct; however, to say that this relationship proves risk is too high just because of the time to expiration doesn’t make sense to me.Watch movie online The Lego Batman Movie (2017)

He compared a monthly option to a seven day option.  The seven day option was about 50% of the risk of the 30 day trade in 25% of the time.   He was comparing 25% to 50% and saying it’s too much risk!

Horse feathers

Horse Feathers

Horse Feathers

The author forgot to look at the equation for time decay as it is a square root of time function.

Just a quick refresher… the square root of 4 is 2 and the square root of ¼ is ½.

So applying it to this idea of time decay,  comparing ANY two options that have a ratio of 1:4 days to expiration will have a 1:2 ratio of time decay.  So:

7 days  vs  28 days

30 days vs 120 days

90 days vs 360 days

These are all 1:4 ratios so the risk should be 1:2 for all of them.  If so, then the pricing models are fair and work for ALL option time frames.  There’s no black hole where weekly option are mis-priced.   If they were, they would be arbitraged back to the fair price right?  That’s the argument Market Makers make to defend how the markets are priced fairly.  You can’t have it both ways.  Markets can’t be fairly priced for only part of the market right?

OK.. so let’s get back to our example.  Let’s use AAPL and look at different 250 Call prices. Unfortunately we don’t have exactly 1:4 ratios of time, but we can still estimate the predicted price vs the actual market price to see if the relationships hold across all time frames.

Expire Days to
Expiration
Price
8/21/2010 8 $5.175
9/18/2010 36 $10.65
10/16/2010 64 $14.975
1/22/2011 162 $25.175
1/21/2012 526 $48.50

Square root of (8/365.25) divided by square root of (36 / 365.25) = 47.1%

Therefore I would expect the 47.1% of the 36 day option to be roughly the 8 day option:

47.1% times $10.65 = $5.02 predicted price vs $5.175 actual price

Applying this same math to the rest of the combinations we find:

Dates Ratio Predicted
Price
Market
Price
Predicted
Option
8 days vs 36 day 47.1% $5.02 $5.175 8 days
36 days vs 64 days 75.0% $11.23 $10.65 36 days
36 days vs 162 days 47.1% $11.87 $10.65 36 days
64 days vs 162 days 62.9% $15.19 $14.975 64 days
162 days vs 526 days 55.5% $26.92 $25.175 162 days

Of course this assumes constant volatility and no interest or dividends, which is NOT real world; however, it’s close enough for our purposes.  The longer term options are affected proportionately more for these factors so we would expect more error with them.

Overall I think it’s clear the markets are fair FOR ALL TIME FRAMES, INCLUDING WEEKLY OPTIONS! If you used my friends logic, you would only trade the farthest out in time LEAPS.  Weekly options are fairly priced from what I can see.   I’m not a Market Maker so perhaps I’m missing something.  Please let me know what you think in the comments section.

I wrote an article on the benefits of weekly options.  I was going to write the dangers of weekly articles next but I saw that post on another site and I had to add my $0.02.  The dangers of weekly options will be next… I have it mind mapped already 🙂

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