Tuesday, March 31, 2009

SPX Market Recap

Despite today's intraday strength, the sell off in the last 30 minutes of trading resulted in the formation of a lower pivot high on the 60 min. chart of the SPX (click on charts to enlarge).

The significance?

Well, it means the hourly chart is still in a downtrend, suggesting that we could continue this retracement on the daily chart, which to my line of thinking could be a good thing.

The ideal retracement (as I've mentioned in prior posts) is 3 or more days because its easier to find a 2 to 1 reward to risk ratio. Most of the time 1 or 2 day retracements just don't cut it. In terms of fibonnaci retracements, the ideal retracement would be 38.2 to 50. Unfortunately the two day pullback we got on Friday and Monday failed to reach either retracement level.

So personally I'd welcome a bit more downside to give a better setup for bullish trades.


Now, as far as this continued retracement goes, all bets are off If the market takes out today's high, because that would turn the hourly chart into an uptrend. So watch 810 going forward.





Tyler-

Monday, March 30, 2009

Blood Sucking Politicians

Interesting news today with GM, and the ousting of CEO Rick Wagoner. I thoroughly enjoyed Glenn Beck's spin on it and couldn't help but share a few of his comments as well as this hilarious picture from the movie Twilight, modified to portray the governments newfound role in capitalism.


"Well, President Obama, Tim Geithner, Chris Dodd, Barney Frank, Nancy Pelosi and other lawmakers are going after the blood of our businesses — big and small — and absolutely nothing will quench their thirst. The latest feast is the Obama administration forcing GM's top guy — CEO Rick Wagoner — to step down as a condition of their continued support.
You've got to be kidding me!
...

I'm not defending GM here as much as I'm defending a free-market economy. The vampires in government are not only telling companies who they should or shouldn't do business with, setting caps on compensation and using the IRS as a weapon, but now they're also making individual personnel decisions?
Excuse me, but isn't that what the board of directors is for?
...
But there's another striking similarity between these vampires and those in the movies: Not one of them has any experience running any actual business and many of them don't have any private sector experience whatsoever. They're either professional politicians or, in the best case (and I use that term very lightly), they're lawyers.
What's another name for lawyers? Hmm. Oh, that's right, bloodsuckers. Have you ever worked at a company run totally by lawyers? These vampires are not going to be satisfied by just sucking the blood of GM's top guy, the AIG executives or any other business or businessperson.
Their thirst for power and control is unquenchable and there are only two ways for this to end: Either the economy becomes like the walking dead or you drive a stake through the heart of the bloodsuckers."

Tyler-

Charts don't lie, people do!

Today's video reviews $SPX, $XBD, GS, USO... Enjoy!

Tyler-

Sunday, March 29, 2009

Your Weekly Dose of Options Action!

I was able to tune into Options Action on Friday night. Over the past few weeks they’ve done small segments on options education in each episode. They typically give an overview of specific option trades and this Friday was no exception as they reviewed bull put spreads.

I was quite pleased with the succinct overview and wanted to elaborate on a few of the points they mentioned. On the show they referred to the strategy as “selling a put spread”. Selling a put spread is also often referred to as a bull put spread. “Buying a put spread”, on the other hand, is also considered a bear put spread. Option spread trades are commonly classified into three different categories:

Vertical Spreads: Buy and sell different strikes in the same expiration month
Horizontal Spreads: Buy and sell same strikes in different expiration month
Diagonal Spreads: Buy and sell different strikes in different expiration month

Because the bull put spread consists of simultaneously buying and selling different strike put options in the same expiration month, it is a vertical spread.

Structure:
Sell a higher strike put and simultaneously buy a lower strike put of the same expiration month.

Time Frame:
The suggestion made was to go far out enough in time to bring in an adequate credit – and I whole heartedly agree. I generally enter put spreads around 4 to 6 weeks to expiration. Although shorter term put spreads experience more time decay (due to a higher theta), there is less extrinsic value remaining in the options, resulting in less credit received. You’ve got to be the judge as to whether there is enough premium, and that brings us to the next subject…

Risk-Reward:
When assessing any potential put spread, it is essential to ensure the risk-reward fits your comfort level. The recommendation was to seek a risk-reward of 3 or 4 to 1. For example, if I enter a $5 wide spread, I would want at least $1 credit (risk $4 to make $1). If I entered a $10 wide spread I would want around $2.00 credit (risk $8 to make $2). I’m not as much of a stickler on the ratio being 4 to 1. I commonly enter $10 spreads for a mere $1 credit. Generally shooting for $1 credit allows me to sell further out-of-the-money puts, than if I tried for $2 credit. These further out-of-the-money options have a lower delta, which translates into a higher probability of profit for me.

Risk-Reward Formulas:
Max Reward = Net Credit
Max Risk = Difference between long and short put strike prices
Breakeven = Higher strike put – net credit
Probability of Profit = 1 – delta of short put

Bull Put Spread example:
One of the members of the round table discussion suggested an Aug 30-25 bull put spread on Caterpillar (CAT). Let’s check out the risk-reward characteristics and risk graph:

CAT is currently trading at $30.35 and the expectation was for CAT to exhibit neutral to bullish price action over the next 5 months.
Sell to Open Aug 30 put for $4.50
Buy to Open Aug 25 put for $2.50
Net Credit = $2.00
Max Reward = $2.00
Max Risk = $3.00
Breakeven = $28
Probability of Profit = 1 - .39 (delta of 30 put) = .61 or 61%

I tend to think 5 months is a bit too far out for bull put spreads, particularly when the stock is already through the spread (above $30). Because the stock is already above $30, to net our maximum reward, we're really just waiting for extrinsic value to decay out of the option premiums. An Aug put spread isn't going to realize near as much time decay as a shorter term spread. That being said, you may consider the May 30-25 put spread. That cuts the time to expiration from 5 months to 2 months. The net credit is about $1.72, a mere $.28 less than the Aug spread.

-Tyler

Friday, March 27, 2009

Markets I Love to Hate

Of all the market environments I’ve traded in, I’d have to say that overbought rallies and oversold selloffs seem to be the hardest for me personally to trade…. And unfortunately the SPX is in the midst of an overbought rally. I’m the type of trader that hates being a “late to the party Charlie”.

From a swing and position trading perspective if I’m not in on the first few days of a swing, then I usually wait for a retracement before entering new directional trades. Usually the retracement comes, but there are always the few exceptions where the market is able to rally a ridiculous amount without putting in a decent retracement. I’ve done a rather poor job of taking advantage of this recent market strength. Allow me to walk you through my thought process… (I've also shown a 30 min. chart so you can see the intraday action)

1. Strong rally signals a potential intermediate bottom in the SPX at 666, thereby putting me in “buy the next dip mode!” In other words, I’m anticipating the market putting in a higher pivot low, making me want to be a buyer (read: enter bull put spread).
2. Ah yeah…. come to papa! As the market started to pullback last Thursday and Friday, I was hoping for a continuation of the retracement the following Monday to give us at least a 3 day retracement. The ideal retracement for me is usually around 3-4 days.
3. Gap up on Monday. #*%!... so much for my retracement!
4. Tue & Wed retracement was jacked up by the HUGE rally in last hour of trading on Wed. which continued on Thursday.

So, in hindsight what could I have done better? Well, perhaps I could have at least scaled into some bull put spreads on the two day retracements. For example, let’s say I normally enter 10 contracts when trading put spreads. I’m ideally looking for a nice clean 3 day retracement prior to entering the put spreads, but as we all know sometimes all we get is a 2 day retracement (see #2 above), or a 1 ½ day retracement (see #4 above). Perhaps I could have entered ½ or 1/3 of my position on those 2 day retracements. Then:

1. If market moves straight up after the 2 day retracement, at least I’ve got some put spreads!
2. If market retracement continues a third or fourth day, I can use that as an opportunity to add in the rest of my put spreads at a better credit.

Tyler-

Thursday, March 26, 2009

Trading Lab Recap- Part II Exercise and Assignment

Option Buying:
Call option owner's have the right to buy 100 shares of the underlying
Put option owner's have the right to sell 100 shares of the underlying

When an option owner exercises their option, they are exercising their right to buy or sell the underlying stock.
When an option is exercised the option owner loses all the extrinsic value. Consider the following scenario:

Stock XYZ @ $50
I own a 45 call option currently worth $6 ($5 intrinsic value, $1 extrinsic value)
To exit the trade I could do either of the following:

1. Sell the call to bring in $6
2. Exercise the call, buy stock at $45, then sell stock @ $50, thus bringing in $5

Scenario 2 brings in $1 less due to the loss of the extrinsic value.

Option Selling:
Call option sellers have the obligation to sell 100 shares of the underlying
Put option sellers have the obligation to buy 100 shares of the underlying

Investopedia defines assignment as follows: "When assigned, the option writer has an obligation to complete the requirements of the option contract. If the option was a call (put) option, then the writer would have to sell (buy) the underlying security at the stated strike price."

At expiration all out-of-the-money options expire worthless, all in-the-money options are automatically exercised and assigned.

Just remember, if you own an in-the-money option and ride it to expiration, the option will be exercised resulting in you being long stock (call) or short stock (put)

If you're short an in-the-money option and ride it to expiration, the option will be assigned resulting in you being long the stock (put) or short the stock (call)

American Style options can be exercised early (the majority of stock options)
European Style options can't be exercised early (some index options such as SPX, NDX, RUT)

I know my odds of assignment are higher when:
1. Short option is in-the-money
2. Short option has little to no extrinsic value left ($.25 or less)
3. Stock is getting ready to go ex-dividend

To avoid assignment, we could buyback any in-the-money options when there is little to no extrinsic value remaining.

Let's review how a bear call spread could play out if held to expiration:
95-100 March bear call spread on GS
Short 95 call I have to sell 100 shares of stock @ $95
Long 100 call I can buy 100 shares of stock @ $100

GS is at $97 at expiration:
Short 95 call will be assigned, resulting in 100 short shares @ $95
Long 100 call expires worthless

GS at $105 at expiration:
Short 95 calls get assigned - Short 100 shares @ $95 / Long 100 call is exercised - Long 100 shares @ $100
The result is a wash!

Remember this table for delta hedging:
Positive Delta: Buy stock, Long Calls, Short Puts
Negative Delta: Short Stock, Long Puts, Short Calls

Wednesday, March 25, 2009

Trading Lab Recap- Part 1 Bear Puts

In tonight's trading lab, Bear put spreads and exercise and assignment were the topics of discussion. Part I of the notes will cover Bear Puts, Part II will cover exercise & assignment.

Signs of a Top:
These price patterns can develop on any time frame:
Slowing Momentum (distance between pivot highs starting to compress)
Double Top (equal pivot highs)
Head & Shoulders (lower pivot high in the midst of an uptrend)

Bear Put Spread
Vertical Debit Spread
Market Outlook: Bearish
Structure: Buy a higher strike put and simultaneously sell a lower strike put in the same month
I generally use 2 month or longer options to allow the stock adequate time to reach the short strike price-

Advantages:
Drastically reduce the cost and risk of the trade
Higher Breakeven (stock doesn’t have to move as far)
Higher probability of profit than outright put purchase

Disadvantages:
Limited yet substantial reward
Debit spreads are considered more position trades

Risk-Reward Characteristics:
Net Debit = price of put bought – price of put sold
Max Risk = Net Debit
Max Reward = Spread between strike prices – net debit
Breakeven = Higher strike put – net debit
ROI = Reward / Risk

Target:
Technique One:
Hold to expiration to net the max reward
Technique Two:
Exit when I’ve achieved 40-60% of the max reward

Trade Management:
Technique One:
Exit if stock breaks above resistance
Technique Two:
Exit when I lose 50% of max risk

Put vs. Bear Put Spread
ISRG @ $96
Buy May 95 put for $9.00
Max Risk = $9
Max Reward = unlimited

Buy May 95 put for $9.00
Sell May 90 put for $6.70
Net Debit = $2.30
Max Risk = $2.30
Max Reward = $5 – 2.30 = $2.70
ROI (return on investment) = $2.70 / $2.30 = 117% return

Long 95 put, I have the right sell the stock @ $95
Short 90 put, I’m obligated to buy the stock @ $90

Expiration – stock is at $80
95 put is worth $15 (Profit $15)
90 put is worth $10 (Loss $10)
Net Profit = $5 - $2.30 = $2.70

I can eliminate the chance of whipsaw by proper position sizing: If enter (1) bear put spread on ISRG with a max risk $230, I don’t have to use a stop loss, as long as my risk management rules allow me to risk more than $230 a trade.
I'll post the notes on Exercise & Assignment tomorrow.

Tuesday, March 24, 2009

Show & Tell: USO

In January USO was exhibiting slowing momentum in addition to a steady increase in volume, potentially implying institutions and big money stepping into the market and beginning to accumulate shares. Implied Volatility was also rather high, juicing up option premiums. Because I expected the stock to begin to bottom out, and didn’t mind getting long the stock if it continued to decline, I sold naked February 26 puts. For simplicity purposes, let’s assume I sold 2 contracts.

When selling naked puts, I generally sell 3-6 weeks out to exploit the time decay of short-term options. At the time we were about 5 weeks out from February expiration. In choosing which strike, I generally go as far out-of-the-money as possible while still receiving an acceptable credit. For me, that’s usually around $1.

Trade Inception:
Jan 13 – sell (2) February 26 puts for $1.00
Max Reward - $100 x 2 = $200
Theoretical Max Risk = $25 x 2 = $5000
At February expiration, USO was trading at $24.35 causing the naked puts to expire in the money. Remember, all in-the-money options are automatically exercised at expiration. Consequently, I was assigned on my short puts, requiring me to buy 200 shares of USO at $26. Although I bought the shares at $26, I was able to keep the $1.00 of premium, dropping my cost basis to $25.

Once I’m assigned the stock on a naked put trade I usually consider the following 3 actions:

1. Sell the stock to close the trade (if bearish)
If I was going to just sell the stock when assigned, I probably would have simply bought back the short puts prior to expiration to avoid assignment.


2. Stay long the stock (if bullish)
If I’m bullish on the stock, I’ll simply stay long the shares to participate in any upside movement in the stock.

3. Sell covered calls to further reduce your cost basis (if neutral to mildly bullish)
By selling covered calls, I can continue to lower my cost basis and risk in the position.


In the USO trade, I decided to sell March covered calls against my stock position. Rather than selling both covered calls at once, I scaled into different strike prices. Within a few days of being assigned the stock, I sold a March 26 call option for about $1.50. This further lowered my cost basis from $25 to $23.50. After the USO rallied a few days, I then sold a March 28 call option for $1.50, bringing my cost basis on all 200 shares to $23.50. Take a look at the numbers below:


Long 200 shares at $23.50
Short (1) March 26 call
Short (1) March 28 call
If USO were to rally above $28 by March expiration, I stand to profit $250 on 100 shares and $450 on the other 100 shares.

At March expiration USO closed at $30.76, causing the short call options to be automatically assigned and my long 200 shares to be sold at $26 and $28, resulting a total accumulated profit between the naked puts and covered calls of $700.

A few observations:
1. At trade inception (Jan 13th), the USO was trading around $31. About 2 months later at March expiration the USO was right back around $31. Had I simply bought the stock at $31 and held for 2 months, not only would I have had $31 at risk, I’d also have nothing to show for it after 2 months.


2. By using options (naked puts, covered calls), I was immediately able to lower my cost basis/risk to $25, and then later to $23.50 (a whopping 24% less than $31), as well as rake in a tidy profit over 2 months.
USO has had a nice little run up as oil has popped above $50 a barrel. A pullback in USO may provide an opportunity for some type of bullish play for April…

Tyler-

Monday, March 23, 2009

Survive the Slaughter

Bulls make money, bears make money, pigs get slaughtered!

This market adage has become increasingly popular in recent years as it’s been a favorite mantra used by a famous, and to some infamous, market pundit who often bellows, “Bulls make money, bears make money, pigs get slaughtered!”, after which he hammers a button which squeals like a hog. Entertainment aside, there is value in understanding why pigs get slaughtered and learning how to avoid becoming someone else’s side of bacon.

It’s crucial to understand that the participants of the financial markets aren’t objective, emotionless robots, but human beings. Thus, the subjectivity of people’s perceptions, beliefs, and emotions often drive the market, rather than the objectivity of reality and the fundamentals. We could purport that there is often times a gap between what the stock market *should* be doing based off of reality and the fundamentals, and what the stock market actually *is* doing. Therefore, truly understanding the market isn’t as simple as learning economics and fundamental analysis, rather it requires a solid understanding of human psychology and how it’s intertwined with the financial markets.

There is a spectrum of emotions that we as human beings can experience, such as happiness, sadness, panic, regret, embarrassment, etc… However, when dealing with money, greed and fear tend to be the most powerful emotions influencing your decisions. Unfortunately these emotions wreak havoc on your trading performance. We’re all in a constant battle striving to overcome these emotions and eliminate their ability to lose us money. One of the most common phrases used to help discourage greedy behavior is, “Pigs get slaughtered”. This helps to convey the notion that greed is your enemy, not your ally. Being greedy would perhaps be beneficial if the market moved straight up, as staying in longer would always result in more profits. However, the unfortunate reality is that the market moves in swings and cycles, often causing your unrealized profits to turn into realized losses. The 2007 market top and subsequent bear market serve as a prime example of what can happen when greed controls your actions.

Consider those who bought in 2002 or 2003 and participated in the bull market run from 2003 to 2007. The S&P 500 nearly doubled within that 4 ½ year time period, moving from sub 800 to over 1550. Now, what do you think is the prudent action to take given a colossal gain in any position? While the greed of the moment may be enticing you to kick back, relax, and watch the money flow into the coffers, the disciplined investor would be tightening up stops, placing hedges to lock in gains, or taking partial profits. Although the prime time to take profits on long term holdings was the 2007 market top, there have been subsequent opportunities to exit bullish positions. These bear market rallies of 10, 15, and sometimes more than 20%, have provided an opportunity for savvy traders to exit bullish positions at higher prices.




Since the beginning of the 2008, the S&P 500 has experienced seven different bear market rallies of 10% or more.

Although each has varied in length and magnitude, the sad conclusion to each of these bullish forays is the exact same; a failure of the short term uptrend and subsequent resumption of the bear market. The same greed that prevented investors from taking profits at the peak of the market, is the same little devil that has probably prevented them from exiting their bullish trades on these bear market rallies. In other words, rather than unloading their bullish positions once the short term uptrend has exhausted itself, many investors have allowed their greed and hope of more profits to cause them to remain in their positions too long, thus missing these opportunities. Then, as the bear market rolls forward these investors learn firsthand what “pigs get slaughtered” is all about!

Shun the Slaughter House:
Here are a few techniques that will aid in controlling greed and curtailing your inner pigness.. oink oink.

Develop a Target: Lacking a trading plan may just be the cardinal sin when it comes to trading. If you lack a trading plan you are bound to be driven by emotions, tossed to and fro by whatever your feelings of the moment may be. If your approach is one of shooting from the hip, then you’re never going to experience consistent results. Ironically the only consistent thing you’ll probably experience is inconsistency. Building a trading plan consists of determining where to enter a trade and where to exit. You should establish a plan A for how to react if the stock rises in value, and a plan B for how to react if the stock declines in value. We can decrease the effects of greed merely by establishing pre-set targets to serve as benchmarks for when to take action to lock in profits. Setting a target will depend on a myriad of variables, such as your style of trading, strategy, and personal preference. There isn’t one right method in establishing targets; the key is to make sure it’s realistic and fits your comfort level.

Scale Out: A dilemma that always presents itself when you have a winning trade is that of deciding when to take profits. When sitting on a profitable trade, fear and greed will begin to create some inner turmoil. Picture yourself in front of your computer with two little demons, Fear and Greed, perched on either shoulder, ranting in both your ears in an effort to incite you to action. While Fear is urging you to exit the trade to lock in the gain before you lose it, Greed is whispering promises of windfall profits and goading you to stay in the trade. Rather than fully satisfying one emotion or the other by staying all in or getting all out, we could compromise and sell a portion of our position (such as half), thus partially appeasing Fear as well as Greed.


Scaling out can be considered a win-win technique. If after selling half, the stock moves adversely, resulting in giving back some of your gains, you will be glad that at least you exited part of your position with profits. On the other hand if the stock continues to rally after scaling out, you will be relieved that you still have a portion of your position enabling you to continue to profit.

Friday, March 20, 2009

Retracements

We may be seeing the start of a multi day pullback. The 50 MA on the S&P has held strong as resistance so far. Generally when a stock gets overbought and reaches resistance you see 1 of 2 corrections.

1. Price Correction - Prices retrace part of the prior move as the market absorbs the supply (sellers) entering the market at resistance. Generally this will occur when there is a disequilibrium between buyers and sellers (more selling pressure than buying). Whereas deep retracements signal more of a weak market, shallow retracements signal a stronger market. Think of it this way: Deep retracements are a result of a lot of selling pressure and an absence of significant buying - The bulls are allowing the market to drop significantly before they step up to the plate and start buying to put a bottom in the stock. Conversely, shallow retracements occur when the bulls step up to the plate quicker, thus causing the stock to form a small retracement before bottoming. These shallow retracements help convey more of an underlying bullish tone with market participants.


Deep Corrections (retracements) = weak market


Shallow Corrections (retracements) = strong market

2. Time Correction - Prices begin to consolidate at resistance as the market absorbs the supply entering the market at resistance. Generally this will occur when there is an equilibrium between buyers and sellers. With a time correction, the stock generally doesn't retrace much, if any, of it's prior move. Thus, it could be said that time corrections are generally more bullish (or bearish if in a downtrend) than price corrections.




To find likely areas of support on the S&P 500 we could draw a fib retracement over the last upswing (664 - 803). The 38.2% retrace resides around 750, 61.8% retracement is at 718. I'll be watching this zone on this pullback for potential support. It will be interesting to see how deep of a retracement we get...
Tyler -

Wednesday, March 18, 2009

Trading Lab Recap- Bottom Spotting

Identifying Overhead Resistance:
Prior Pivot Highs or Lows (support/resistance)
Moving Averages
Fibonnaci Retracements
Trend lines
Overstretched (Date & Range)

3 types of bottoms or pivot lows:
Minor
Intermediate
Major

Signs of a Bottom:
Reverse Head & Shoulders
Slowing Momentum (cupping or saucer pattern)
Double & Triple Bottom
Moving Averages switching directions help confirm

Remember, bottoming is a process not an event. It takes time to heal the market as well as the economy. The 2000-2003 bear market bottom serves as a prime example.

Trading Vertical Credit Spreads:

Market in a downtrend: Stick primarily to bear calls
Market turns more neutral: Consider entering both bear calls & bull puts

Trailing Stops:
Trail by $ amount (points)
Trail by a % amt.

Buy stock @ $50
Trail stop of $5 ($45 at start)

stock goes up to $53
trail stop will move to $48

Trailing stops ratchet up, not down.
Can be useful if you're not going to be able to monitor the market, but I prefer to manual move my stop based on support/resistance, rather than an arbitrary number.

Tyler -

You Know What They Say About Assumptions...

Wowza! You gotta love that reaction to the FOMC announcement. In today’s earlier post on GLD, I said, “Assuming we don’t see a huge intraday reversal, GLD will end the day breaking its 50 MA, and primary trendline.” Well, at the time I thought it was a pretty good assumption….lol. So what can we learn from this?

First, it’s sometimes tough to pass judgement on a daily candle prior to the close, because sometimes you get these crazy intraday moves that completely reverse the candle: (chart)

Second, the FOMC announcement is always a wild card, often causing huge swings in the market. Thus you better be prepared and not be overleveraged one way or the other, unless you’re willing to deal with the occasional thumping!

With the post announcement bull madness, the $SPX has now reached the 800 level, as well as its declining 50 MA. It will be interesting to see how far the bulls can take this rally before we finally get the inevitable multi day pullback. We’ve moved up about 20+% now over the last week and a half. That’s starting to sound overstretched to me, but with news driving a lot of the movement an overbought rally is still within the realm of possibility.

Tyler -

Fools GLD

The weakness in gold continues... Assuming we don't see a huge intraday reversal, GLD will end the day breaking it's 50 MA, and primary trendline. Could be an ominous sign for the gold bulls.


I highlighted an April 100-105 bull call spread on GLD in this post, which needless to say has not worked at all. One of the benefits of using an OTM debit spread is it has small, defined risk (the 100-105 Apr had $1 risk) which can be greatly beneficial when the underlying stock undergoes an adverse move.

Remember gold has long been considered a safe heaven and inflation hedge. Therefore it tends to go up as inflation becomes more of an issue or when people lose faith in the equities market and feel gold may be a better investment. So one could argue that generally if gold is falling (money is flowing out of gold), that should be bullish for equities (part of money coming out of gold could be moving into equities).






The FOMC announcement comes out here in about 30 minutes, so we'll see what affect that has on the market....

Tyler-

Tuesday, March 17, 2009

Well that didn't last long....

So yesterday's short term top turned out to be short term indeed. This could serve as an example that candlestick patterns aren't the end all be all in predicting future market moves. Generally when you see a bearish reversal candle like yesterdays you anticipate a continuation to the down side. This just turned out to be one of those instances where what *should* of happened, didn't. Despite today's strength, nothing has really changed from the overall outlook. There's still a huge amount of overhead resistance around 800, so we'll see how the market digests all that selling when and if we get there. Tyler-

Theta

Theta, the eighth letter of the Greek Alphabet, is another commonly used Greek which enables us to quantify time decay.
Theta quantifies an option’s sensitivity to the passage of time. Simply put, theta tells me how much money I make or lose due to the passage of one day. Options are a decaying asset and thus lose value as time passes. This is commonly referred to as time decay. Theta is a negative number when we’re long an option and a positive number when we’re short an option. Another way to look at option trading is that when we buy options (calls or puts) we’re essentially buying time and when we sell options (calls or puts) we’re selling time. Because of this time component, the more time we buy the more expensive the option.
In most option chains theta is listed as a decimal (-.45). At first glance, this may make you assume that the option is only losing $0.45 a day. That would be an incorrect assumption! The majority of option chains list theta on a per share basis. If I were to buy a call option with a Theta of negative .45, I would be losing $0.45 per share per day. Remember, one option contract controls 100 shares, thus a negative theta of 0.45 means that theoretically that one option contract will lose $45.00 per day. OUCH!
Theta gets higher as an option gets closer to expiration. In other words, theta isn’t linear, but exponential. We can look at a time decay curve to illustrate the rapid increase in theta as expiration nears.
This is primarily why we avoid owning an option over the last 30 days of its life. To minimize our loss due to theta, we buy longer term options. To maximize our gain due to theta, we sell shorter term options. This is primarily why the majority of option selling strategies involve selling front month options (Naked puts/calls, credit spreads, Covered Calls, LEAPS Covered Write, etc…). As you can see below in Figure 1.1, the front month option (June) is losing over 7x the amount that the back month option (Oct) is losing. If my goal were to minimize my loss due to time decay, I would buy the October call option. On the other hand, if I were looking to short a call option and wanted to maximize my gain due to time decay I would most definitely sell the June option.
The Jun08 call option has 4 days to expiration and is losing $67 per day. The Jul08 option has 32 days to expiration and is losing $18 per day. The Oct08 call option has 123 days to expiration and is losing $9 a day.

Theta is highest for At-the-Money options and gets lower as you go further Out or In-the-Money. By buying At-the-Money options we’re placing ourselves in a position to lose more money per day than if we were to buy In the Money or Out of the Money options. This is illustrated in Figure 1.2.
The At-the-Money option has a Theta of -.149. If we move three strikes In the Money (160 strike price) theta is -.114 and three strikes Out of the Money (190 strike price) Theta is -.125

Gaining a proper understanding of the Greeks has been quintessential in my own trading and developing a better understanding of them will put you one step closer to mastering options!

Monday, March 16, 2009

Short term Top

Market's staged an intraday reversal here. 5 & 15 min. charts have rolled over into downtrends. This could signal the beginnings of the pullback mentioned in this morning's video. So far today's candle has a decent sized topping tail, which as many of you know is not bullish (at least in the short term).

Tyler-

Market Preview

Tyler-

Thursday, March 5, 2009

Delta and Probabilities

I had a really good question in response to my post on delta that I wanted to highlight today.

"This is a great post......i really like it. It’s a lot of different ways of interpreting Delta that I was unaware of. My question is why does it imply the chances of the option expiring in/out of the money? I like the concept and think it’s great to determine trades, but am confused as to why Delta means that it has a % chance of expiring out of the money etc. Can you elaborate more on this?"

Elaborating on delta and probabilities requires delving into a bit of option theory. I’m not an expert on statistics by any stretch, but hopefully the following explanation helps.

Option pricing is based on the likelihood of an event occurring (such as the stock reaching a certain price).

When we discuss the odds of the stock reaching a certain price, we use terms such as likely, unlikely, probable, improbable, possible, etc… The one problem with this is it’s not specific enough. In other words, it’s not enough to say it’s likely or unlikely for stock XYZ to reach $100 by expiration…. We need to be able to quantify how likely or unlikely it is. When pricing an option, the Black-Scholes Model assumes that stock prices are random and that there is just as much of a chance of the stock rising as there is falling.

In other words, if stock XYZ is trading at $100, then there is a 50% chance of us being above $100 in a month and a 50% chance of us being below $100 in a month. Thus the 100 call or put (at-the-money), should have a delta around 50. When explaining this, some option theory books show a picture of a bell curve to illustrate the likely outcomes of random events. Some brokers, such as Optionsxpress, display bell curves within their analytical tools.

Now, assuming there is a 50% chance of the stock residing above $100 at expiration, what is the probability of residing above $90? Well, it would have to be greater than 50%, so let’s say 65%. Thus, its delta should be around 65. What about being above $80 at expiration? Well it’s going to be higher than 65%, so let’s say 75%. Thus the 80 call option will have a delta of around 75. Hopefully you get the picture, the deeper in-the-money we go, the higher the delta, reflecting the higher probability of remaining above these strike prices.

What if we look at out-of-the-money calls? If the stock has a 50% chance of residing above $100, then it stands to reason that there is less of a chance of residing above 110, and even less of a chance of residing above 120 in a month. Thus, the delta of the 110 call will be less than 50 (let’s say 30) and the delta of the 120 would be even lower (such as 20).

If you want to read more on options theory, I'd recommend Option Volatility & Pricing by Sheldon Natenberg.

Wednesday, March 4, 2009

Trading Lab Recap - Volatility

In tonight’s trading lab Historical and Implied Volatility were the topics of discussion:
Statistical or Historical Volatility (HV) as defined by Investopedia:

“ The realized volatility of a financial instrument over a given time period. Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period. Standard deviation is the most common but not the only way to calculate historical volatility. ”

Historical Volatility is the equivalent of looking in the rear view mirror at the past price action of a stock.
Stocks with High HV tend to have a lot more movement in their price
Stocks with Low HV tend to have a small amount of movement in their price

One important caveat to Historical Volatility:
Large gaps (due to news events, such as an earnings announcement) can skew the Historical Volatility to look as if the stock is way more volatile than it usually is. For example PSYS has a 20 HV of 186. This high 20 HV is due in part to the enormous gap that occurred within the last 20 days. As soon as the gap day drops out of the equation, the HV will drop significantly
Other Indicators that measure a stock’s volatility:
Bollinger Bands
ATR (Average True Range)

Implied Volatility
The amount of future volatility expected in the market (derived from current option premiums)
The level of volatility the underlying needs to exhibit to justify current option premiums.
HV is backward looking, IV is forward looking

Generalizations about volatility:
Implied Volatility is mean reverting (it oscillates around its mean or average)
When IV is high, options are relatively expensive and potentially overpriced (I'd rather be an option seller)
When IV is low, options are relatively cheap and potentially underpriced (I'd rather be an option buyer)

The following patterns often occur at market bottoms:
Slowing Momentum
Double Bottom/ Triple Bottom
Reverse Head & Shoulders
Capitulation

Target for long stock trade:
Sell at 1 ATR profit
Sell at resistance
Sell at projected target:
"If in doubt, scale out!"

Monday, March 2, 2009

Trading Naked Responsibly

On Friday’s options action, selling naked puts was in the spotlight. I wanted to throw in my own $.02. Selling naked put is considered a stagnant to bullish strategy. I’ve already highlighted naked puts in a few posts/videos, so you can check those out under the labels section of the blog. In the show they highlighted three considerations for selling naked puts:

1. Price you want to own the stock: Let’s first point out that not everyone that sells puts really wants to buy the stock. Some sell puts simply as a bullish strategy and will always avoid assignment by closing out a losing naked put before it moves in-the-money. Now, assuming your purpose at trade inception was to potentially get assigned and go long the stock, then yes, you most definitely should make sure that you really are willing to purchase the stock at the strike price. This is a bit counterintuitive, as when a stock is trading at $30, it seems like anyone would be willing to buy it at $25… until it actually trades down to it that is. In other words if the stock ends up trading below $25 before expiration, most traders regret having sold the 25 put. So make sure you’re really willing to buy it.

2. Premium: I’m a stickler on this one. I really don’t advocate selling naked puts for pennies. I think the following phrase is applicable here: Don’t pick up pennies in front of a steam roller! In other words, if I were to sell a naked put for $.20. Even if I won 9 out of 10 trades. If on the 10 trade, I end up having to buyback the put at a $1.80 loss, I essentially gave back ALL the gains from my prior nine trades. That being said, make sure you’re bringing in enough premium to make it worthwhile. It’s really personal preference, but for me I like to bring in around $1.00 premium. If the stock is in the teens I may be willing to accept less.

3. Time line: They mentioned (and I agree) selling short term options. First off, it better exploits time decay than long term options. Simply put, short term options have a higher rate of time decay than long term options. Second, shorter term trades afford the stock less time to run amiss.


Tyler-

Delta


Delta, the fourth letter of the Greek alphabet, is one of the most commonly used Greeks. Delta can be used as follows:

1. Rate of Change
2. Equivalent Underlying Position/Hedge Ratio
3. Probability of an option expiring in-the-money



Rate of Change:
This is the characteristic of Delta, most people are familiar with. Delta measures an option’s sensitivity to movements in the stock price. More specifically it measures the change in an options value given a $1 increase in the underlying. Bullish positions have positive delta, bearish positions have negative delta. Remember the following table:

Positive Delta = Long stock, Long Calls, Short Puts
Negative Delta = Short stock, Long Puts, Short Calls

Delta ranges between 0 and 100. However, most option chains list delta on a per share basis, thus a positive 50 delta will be listed as .50 and a negative 50 delta will be listed as -.50.

In-The-Money options generally have delta greater than 50
At-The-Money options generally have delta about equal to 50
Out-of-the-Money options generally have delta less than 50

Knowing the relationship between delta and strike price, if we want to buy an option with a higher delta, we buy deeper in-the-money. Conversely, if we want to buy an option with a lower delta, we buy further out-of-the-money.

Understanding delta as the rate of change enables us to forecast our potential risk and reward given a certain price movement in the underlying stock. Let’s look at an example:
Suppose stock XYZ is currently trading at $50 and we buy a one month 45 strike call option with a delta of 60. Let’s further assume that our target on the stock is $55 and our stop loss is below $48. Using this target and stop, we can see that our potential reward is $5 (55-50), and our potential risk is $2 (50-48). The 60 delta implies that we make $60 for every $1 move in the underlying. Therefore, our potential reward on the option is $300 ($60 x 5) and our potential risk is $120 ($60 x 2).

Equivalent Underlying Position:

Equivalent Underlying Position: Suppose I own a call option with a delta of 50. If the stock increases $1, I will profit $50, and it the stock decreases by $1 I will lose $50. Therefore, my call option is the equivalent of 50 shares of the underlying.

Long Call with delta of 50 = 50 shares of stock

Suppose I own a put option with a delta of -50. If the stock rises $1, I will lose $50, and if it falls $1 I will profit $50. Therefore, my put option is the equivalent of shorting 50 shares of the underlying

Long Put with delta of -50 = short 50 shares of stock

Understanding this correlation should help you see how options can be used as a substitute for purchasing shares of stock. Furthermore, it helps to illustrate how options can be combined with stock to create delta neutral positions.
Suppose I had on the following positions in my portfolio:

Long call on XYZ with delta = +50
Short call with XYZ with delta = -75
Long 25 shares of XYZ

Combining these three positions on XYZ gives me a net delta of “0”. Although the call spread (long & short calls) has a net delta of -25, it is hedged by the long 25 shares of stock. Thus, theoretically whether XYZ rises or falls $1, I shouldn’t make or lose any money due to delta.

Hedge Ratio:

Hedge ratio simply refers to how many shares of the underlying you would have to buy/short to delta hedge an existing option position. As we’ve already established delta measures an option’s sensitivity to a $1 increase in the stock price. If you have a large delta position, then you have large exposure to price movement in the underlying. Conversely, if you have a small delta position, you have minimal exposure to price movement in the underlying. Suppose my delta position was “0”. Would my position be sensitive to movement in the stock price? Not really. In other words, whether the stock rises or falls, because my position is delta neutral I shouldn’t be making or losing any money. This can be quite beneficial on trades that are theta positive because you can somewhat eliminate your exposure to stock movement and still make money due to time decay.

Let me give you a quick example: Suppose I have an Iron Condor on stock XYZ. An Iron Condor is a positive theta trade that looks to exploit market stagnation and decreasing volatility. At trade inception the condor is usually delta neutral, but over time if the stock rises or falls too much, the trade can become delta positive or negative. If I wanted to, I could buy or short shares of stock every time my position delta got too positive or negative (such as 100 or -100), to adjust the position back to neutral.

One of the caveats with delta hedging is that delta is in a constant state of flux. In other words, it continually changes, requiring me to constantly monitor the position and readjust (e.g. buy or short more shares of stock) to stay delta neutral.

Probability of an option expiring in-the-money:

Delta calculates the probability of an option expiring in-the-money. For example, AAPL is currently trading at $89. The one month 80 strike call option has a Delta of 79. This means that there is a 79% probability that the 80 strike call will be in-the-money at expiration. Put another way, there is a 79% probability that the stock price will be above $80 at expiration. Now, we can use a little arithmetic to calculate the probability of an option expiring out-of-the-money. We can all agree that there is a 100% probability of the stock price residing somewhere at options expiration. If there is a 79% chance the stock will be above $80 at expiration, then it stands to reason that there is a 21% chance that the stock will reside below $80 at expiration. If the 80 strike call has a delta of 79, then the 80 strike put should have a delta close to 21. Generally the same strike call and put deltas should add up to 100. The formula for calculating the probability of an option expiring out-of-the-money is: 1 minus Delta.