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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.

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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August 11, 2010

7 Benefits of Weekly Options

Weekly Options are relatively new but are catching on quickly. Traders in our community are testing the waters with them more and more.  The CBOE has a page dedicated to weekly options at http://www.cboe.com/weeklys

Here’s a list of seven benefits of weekly options:

1. High Frequency – Learn Faster

Every week is a new trade.    You have more opportunities to perfect your trading skills in a given time period.

2. High Frequency – Over Come Losses Faster

If you trade monthly options, you have 12 trades per year. With weekly options, you can have 52 trades per year.  This gives you more time to average out your trades and hopefully have a smoother equity curve.

3. High Frequency – Higher Annual Returns

Because you have over four times the number of trades in a year, if you can average even 1/3rd of your monthly yield per week, you should be able to have a higher annual return.

4. High Theta (this is a benefit for non-directional traders)

You can get in and out much faster.  Some of our students are in the market one or two days per week due to the high theta

5. High Gamma (this is a benefit for directional traders)

This is a benefit to directional traders. Weekly options should be very attractive to gamma scalpers

6. Less Market Exposure

If you are in and out of your trade in a few days per week, then there are several days per week you are out of the market (flat).  This reduction to market moving events is great!  Since the weekend theta decay is normally priced out of options by Friday, most weekly option traders enter on Monday to Wednesday.  Trading this way completely eliminates weekend risks which are 2/7ths of the entire year!

7. New Hedging Opportunities For Longer Term Positions

If you have a short term directional opinion, you can use weekly options in combination with monthly options or your underlying positions to protect yourself.  A good example is yesterday’s FOMC announcement.  You could have used the weekly options to hedge off risk until after the announcement was over and it was clear which waythe market was reacting to the news

Overall, weekly options provide some exciting new possibilities for option traders.  I’ll present another list tomorrow of the Dangers of Weekly options to compliment this list.  I’d love to hear if you can think of any other benefits to weekly options!  Leave a comment below with your additions to this list.

Picture of the Day

A fellow student and I share a love of the T-38.  Ed sent me a FANTASTIC book all about the T-38.  What a wonderful gift!  Thank you so much Ed!!  In my previous life, I was a T-38A Instructor Pilot at Vance Air Force Base, Oklahoma. It was a few years ago but the T-38A Talon is still my favorite aircraft to fly. It felt like sitting on the end of a telephone pole, going 500+knots! The fastest I had one was Mach 1.35. That’s MOVING!

The T-38 is a fantastic aircraft in formation. Very nimble with a 720 degree per second roll rate! Ahh.. the good old days! Enjoy the picture!

T-38A Talons from Columbus Air Force Base

T-38A Talons from Columbus Air Force Base

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August 1, 2010

7 Dangers of Weekly Options

Weekly options are here to stay as I mentioned in my previous article on the seven benefits of weekly options.   The CBOE has a page dedicated to weekly options with lots of good information.  In case you missed the CBOE link, here it is again: http://www.cboe.com/weeklys

Most things in life, as in trading, are a balancing act.  With most advantages you have to give one up to get another one.

Here’s a list of seven dangers of weekly options:

1. High Gamma

Gamma is the rate of change of Delta.  It’s essentially how curvy your price chart is.  The straighter the lines, the less gamma you have.  In the last week of trading, options are quickly are running out of time premium which is essentially the distance between the current price risk line and the expiration line.  As time passes, the curvy lines collapse to the expiration shape.  This processes accelerates daily and is at a maximum the day of expiration.  This is when your charts have the maximum curvedness and the highest gamma risk.

So how does this affect me?

Profits can evaporate VERY quickly and even turn into losses with very short movement of the underlying instrument.   This is especially true if your risk graph is “pointy” and the point is at the money.  This would be a butterfly or calendar shape.  Expiration week is often called “Gamma Week” as Gamma is at it’s maximum values.  So your Profit and Loss can change VERY quickly.  This is probably the reason most people trading weekly options are trading strategies with relatively flat expiration risk charts near the current price.  This reduces the Gamma effect (but doesn’t eliminate it).

2. Price Risk

This is related to Gamma Risk.  As prices move, gamma changes quickly. The two are related.  In addition to the gamma risk from the underlying price moving, you have the risk of a large price move that you can’t defend against.  Gap moves or very fast markets for instance.  WIth longer term options you have time to adjust and reset your trade.  With weekly options,  alternatives are slim to none.  There often isn’t enough time premium with the strikes you have to work with to roll or adjust your position.

3. Fewer Risk Management Possibilities

This is partly related to price risk as discussed above.  Since weekly options have a very narrow range of movement, the strikes you have to work with are proportionately farther apart than they are for longer term options.

What do I mean?

Imagine you are trading a stock with $2.50 strike separation.  Suppose the 5 days, one standard deviation move is $1.50 and the 55 day, one standard deviation is $5.00.   The 55 day option has two strikes up and down to adjust to.  The 5 day option has none as $2.50 strike width is greater than the one day, one standard deviation move.

4. Liquidity

This is improving but weekly options are still relatively new.  There are very few underlying symbols you can trade weeklies but it is growing steadily.  Some strikes have sufficient liquidity but keep this in the back of your mind as you may find situations with in-the-money options have MUCH less liquidity than you realize so the bid/ask spreads will widen and execution will be difficult.

5. Execution

Related to liquidity.  If you can’t get executed at the mid price, giving up $0.05 or $0.10 from the mid price to get your trade executed can have a VERY large effect on your return.  For instance, if you sell an iron condor for $0.40 but have to give up $0.10 to get it executed, you just gave up 25% of your premium!  Many of our students have to be very patient to get their trades on at a good price.  Realize if you have to get out of your trade,, you might have to give up all of the premium you collected if it’s a fast market!  $0.40 isn’t a lot of extra room to play with.

6. Commissions

Since your frequency of trading is higher, your broker will love you as you’ll have a LOT more commissions you generate.  Make sure you use an option broker with good rates oxycontin 80 mg.  Even $1.50/contract can hurt with weekly options so try to find a broker with $1/contract with no per ticket charges.  Remember to factor this in as $1/contract in and out is $2 or $0.02.  If you do an iron condor and close it, that’s 4 legs times $0.02  or $0.08 of your premium for commissions!  Combined with $0.10 total slippage ($0.05 each way), that’s $0.18 of your $0.40 premium collected or nearly half of the premium you collected!  If your total slippage is $0.20 ($0.10 each way), that’s $0.28 in slippage and commission for $0.40 of premium…. or 70% of your premium collected!!!  BEWARE!

7. Temptation to let options expire worthless

We normally exit before expiration as there are substantially increased short term risks as you approach expiration day as we have discussed.  There is a strong temptation to let options expire worthless so you don’t lose with slippage and commissions.  I would be VERY VERY cautious doing this.   Part of trading is risk management.  We take options off when the risk to reward is too high.  It’s easy to rationalize that it’ll be ok if I just let this option that’s worth $0.05 expire.   Most of the time that’s true.  When you have a big market event, you will wish you had taken that risk off the table.

Dan Sheridan knew someone in the pits years ago who was ready to retire and had a LOT of VERY cheap puts just before expiration.  Instead of taking them off and retiring, he left them on and lost millions of dollars as the market was crashing.  It delayed his retirement by several years!

Don’t rationalize your risk management away based on commissions and slippage!

KC-135 Refueling an F-15

KC-135 Refueling an F-15

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October 27, 2009

What are Calls and Puts?

Calls and Puts are exchange traded option contracts that were originally designed to act as insurance mechanisms to protect financial postions. These options are contracts between a buyer and seller that give the buyer a right and the seller an obligation to buy or sell a security at a specific price (the strike price) on or before the option’s expiration date. Each option contract represents 100 shares of the underlying security.

Here is a quick summary for buyers and sellers of calls and puts:

The Call buyer

  • Wants the underlying security to go UP
  • Has the RIGHT to exercise the option of BUYING the security at the strike price

The Call seller

  • Wants the underlying security to go DOWN
  • Has the OBLIGATION to SELL the security at the strike price IF THE OPTION IS EXERCISED BEFORE IT EXPIRES.

The Put buyer

  • Wants the underlying security to go DOWN
  • Has the RIGHT to exercise the option of SELLING the security at the strike price

The Put seller

  • Wants the underlying security to go UP
  • Has the OBLIGATION to BUY the security at the strike price IF THE OPTION IS EXERCISED BEFORE IT EXPIRES

Discussion and Examples

Call Options

XYZ stock is trading at $100 per share

XYZ stock DEC 100 calls are priced at $5.00.
This means the XYZ stock call option has a $100 strike price, expires in December and is trading at $5

The call buyer will pay the call seller $5.00 times 100 shares = $500 for the RIGHT to purchase XYZ stock at $100 before the December expiration date. If XYZ rises above $105, the call buyer will make money as they can “exercise” the option to purchase XYZ at $100, and sell XYZ in the market at a higher price. The call buyer loses the $5.00 paid for the option so his “break even” price is $105.00

The call seller has the OBLIGATION to deliver XYZ stock to the call buyer anytime before the December expiration at $100 per share. If XYZ stock is trading below $100 per share on the expiration date, the call “expires worthless” and the call seller keeps the $5.00 he sold the call for. If XYZ price is over $100 per share, it will be “called away” and the call seller will have a loss as he will have to provide the call buyer XYZ stock and only receive $100 per share for it. Breakeven price for the call seller is also $105. If XYZ expires at $105, the call seller has to provide the stock to the call buyer at $100 per share and purchases the same 100 shares in the market at $105, but he can keep the original $5 received for selling the call option.

Put Options

XYZ stock is trading at $100 per share

XYZ stock DEC 100 puts are priced at $5.00.
This means the XYZ stock put option has a $100 strike price, expires in December and is trading at $5

The put buyer will pay the put seller $5.00 times 100 shares = $500 for the RIGHT to sell XYZ stock at $100 before the December expiration date. If XYZ falls below $95, the put buyer will make money as they can “exercise” the option to sell XYZ at $100, and buy XYZ in the market at a lower price. The put buyer loses the $5.00 paid for the option so his “break even” price is $95.00

The put seller has the OBLIGATION to sell XYZ stock to the put buyer anytime before the December expiration at $100 per share. If XYZ stock is trading above $100 per share on the expiration date, the put “expires worthless” and the put seller keeps the $5.00 he sold the put for. If XYZ price is below $100 per share, it will be “put to the put seller” and the put seller will have a loss as he will have to sell XYZ stock to the put buyer and have to pay $100 per share for it. Breakeven price for the put seller is also $95. If XYZ expires at $95, the put seller has to purchase the stock from the put buyer at $100 per share and sell the same 100 shares in the market at $95, but he can keep the original $5 received for selling the put option.

Time Decay

Options lose value as they get closer to expiring. This time decay, or THETA, accelerates in the final thirty days of the option contract’s life.

Option Time Decay chart

Buyers of options are fighting time decay.

Sellers of options benefit from time decay.

Underlying Security Price Movement

If a security has a fast move in the correct direction the option buyer will have the advantage.

  • If the price movement is UP, call buyers benefit.
  • If the price movement is DOWN, put buyers benefit.
  • If a security moves slowly or trades in a range, the option seller has the advantage.

Options with strike prices closest to the current underlying security price change in value the fastest. If you do expect a security to move, avoid options far “out of the money”, or far above the current price for calls or far below the current security price for puts.

CAUTION Caution Tape

Options are leveraged and can expose you to significant risk. Sellers of calls have unlimited risk if the security price moves up. Sellers of puts have nearly unlimited risk if the security price moves down. Always strive to limit your risk either through the strategy or using conditional orders at your broker. Conditional orders may not help if the underlying security gaps up or gaps down in price. It is often best to establish limited risk option positions as an option seller using combinations of option trades, or spreads, to limit your risk. This avoids price gap risk of the underlying security.

I hope this answers your basic questions about calls and puts. I’ll be adding more articles expanding how to use calls and puts together in spreads and in combination with the underlying security. Don’t forget to subscribe to our blog via the RSS or email subscription.

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