OptionPundit

Category: Option Trading Strategy

  • This is how you trade Market Uncertainty

    This is how you trade Market Uncertainty

    Valeant Pharmaceuticals Intl Inc (VRX) dropped over 50% on Tuesday trigerring billions in losses for Hedge funds including the famed investor Mr Bill Ackman of Pershing Square. Is there a way you could have profited while big funds lost billions? Straddle spread is one such strategy that can be used in such instances.

    It was a public information that VRX will be announcing ernings before Market opens on 15 Mar 2016. The results are usually 50/50 i.e. we don’t know whether the stock will go up or down after earning announcements. And it is this type of uncertain situation which makes it difficult to structure a pure directional trade. A straddle spread is market neutral trade and thus it benefits from either direction move.

    STRADDLE SPREAD

    Straddle is an option trading strategy which involves buying or selling both call option and put option simultaneously. Both call and put options we purchase (or sold) have to be of the same underlying stock, and same expiration date. Both options will be bought/ sold at-the-money (ATM) strike. (Strike that is nearest to Current stock price).

    Let’s use an example to understand how a long trade could have been placed. Just before the market close, the options were pricing a $9+/- move post earning announcement and VRX closed at $69.04 on 14 Mar 2016.

    Here is how to structure a straddle spread:

    • Nearest Strike – $69
    • Expiration – Mar 2016 Monthly (expiring in just 3 days)
    • Buy One Call Option : $4.55
    • and Buy Equal Amount of Put Option: Cost $4.45
    • The net debit for Straddle Spread is $9 (or $900 as 1 option controls 100 shares)
    • The breakeven are – $60 and $78

    Let’s see how this look like on a stock price chart-

    VRX Pre-earning Straddle

    Let’s talk about various “What-if” scenarios-

    Scenario 1: Assume that the Stock is trading at $80 at expiration date.
    In this case the trade is going to be nicely profitable. The Put Option will be worthless while the Call Option will be worth $11 ($80-$69=$11), thus netting a +22.2% gains (excluding commissions).

    Scenario 2: Stock is trading at $58 at expiration date.
    In this case, the Put Option will be worth $11 ($69-$58=$11) and the Call Option will be worthless. Thus the gains are going to be similar as in the first case i.e. +22.2% gains.

    Scenario 3: Stock is trading at $69 at expiration date.
    This is the absolute worst case scenario that assumes stock staying at $69 after earning announcement. In this case I would incur maximum loss, which is the actual size of the initial debit I paid for the purchase of options. Maximum loss is therefore $900.

    Let’s also note that 52wk, High/Low range for VRX is $263.8-$59.8.

    Just as with any other strategy, there is risk of loss of entire capital in case VRX doesn’t move at all (scenraio #3). However, based on past 12 median earning moves, VRX does move about 4-5% (thus about $3+/-) thus we might lose about 50% if the move is in accordance to the past.

    The stock has been very volatile recently and it moved from $250+/- to $70+/- in the last 6 months alone, thus making it high risk/high reward play on every earning announcement recently.

    WHAT ACTUALLY HAPPENED

    VRX dropped almost $35.5 (or 50%) to close at $33.51!!! The value of the spread soared to almost $35!! Resulting into +288% gains in a single day.

    VRX Post earning Straddle Spread result

    LEARNING & WATCH OUT

    Should you use this strategy for all the companies that are going to announce earnings? Absolutely not.

    The options premium is very high before earnings announcement and soon after the announce those premium will crash due to implied volatility drop. Proper preparation and planning is required to understand implied move in the current options prices, how much has it moved during the past, say 8, quarters and what’s the level of curent uncertainty.

    Once you understand the risk, allocate money diligently and understand the risks completely, straddle spread can be a good non-direction spread to profit from uncertainty.

    Your Turn

    What do you think of this strategy? What issues do you see? How can you make it work for you? Can you propose or define a criteria so that it could become a consistent strategy?

    Profitable Trading, OP

  • Bear Vertical Spread Explained

    Bear Vertical Spread Explained

    What is a Vertical Spread? We explained this at great length in the previous article using an example of Bullish Vertical Spread. We explained all the basics of vertical spread, how to structure it, how to analyze its risk reward profile and how to interpret profit & loss of a bullish vertical spread. This article is now focused to explain what is Bear Vertical Spread.

    Before analyzing bearish trading strategy using verticals, let’s review what is a Vertical Spreads strategy:

    • Vertical spread is an option spread trading strategy in which trader purchases a certain number of options and simultaneously sells an equal number of options. Both sold and purchased options have to be the same class (i.e. Call or Put), same underlying security, same expiration date, but at different strike prices.
    • Since purchased and sold options are of the same class (either puts or calls), a trader’s positions are hedged against each other – while one option is making money the other option is losing money.
    • By setting up (structuring) options in this manner, trader limits the risk involved, but at the same time trader limits the profit potential too.

    Vertical Spreads can be either Debit Spread or Credit Spread, and can be created with either all Call Options or all Put Options and can be created for Bullish or Bearish directional view.
    Vertical Spread Starter Guide

    What is a Bear Vertical Spread?

    Bear vertical spread is an options trading strategy designed to profit from a decline in prices. It is constructed by purchasing a certain number of options and simultaneously selling an equal number of options. Both sold and purchased options have to be the same class (i.e. Call or Put), same underlying security, same expiration date, but at different strike prices.

    It can be structured (set up) in two ways:

    • By using Put Options – “Bear Put Spread” – also called a Put Debit Spread.
    • By using call options – “Bear Call Spread” – also called a Call Credit Spread.

    When constructed with similar strike prices and similar expiration dates, both Bear Put Spread and Bear Call Spread have almost the same risk/reward profile, as we will show in our chart/graph example. A Trader may choose either of the two vertical spreads for trading his directional view. However, it is much better to structure a trade based on:

    • Bid/Ask slippage
    • Ease of fill

    Generally speaking, it is better to structure a trade using “out of the money” options as it will be easier to fill.

    Using a hypothetical example of a stock, which is trading at $50 at the moment, we will now review Bear Put Spread and possible outcomes (profit/loss). Let’s assume-

    • We are bearish on this stock, for whatever technical or fundamental reason, and we assume it will decline in price moderately by the end of this month.
    • Let’s suppose our bearish signal occurred today (Jan 18th for example) and Bear Put Spread is the strategy of our choice. Important note is the expiration date of our Put Options, which is Jan 31st.
    • On Jan 18th we decided to go with our strategy, having in mind the expiration date is Jan 31st.
    • Stock is currently trading at $50.00 per share.

    How to Set-up Bear Vertical Spread Using Put Options?

    Here is the price chart marked with entries for structureing bear spread using Put Option:

    Setting Up a Bear Put Vertical Spread

    How to Structure A Bear Put Spread?

    • As shown in the chart, first we will buy 1 Put Option with a strike price at $48.00, which is trading at $0.40 per share (for example) – since 1 options controls 100 shares, we will spend $40 for this put ($0.40 x 100 = $40).
    • At the same time, we will sell 1 Put Option with a lower strike price of $46.00, which is trading for $0.10 per share – for this sale we would receive $10 ($0.10 x 100 = $10).
    • By setting up two options in this manner, we have constructed (purchased) a Bear Put Spread which costs us $30. We spent $40 for buying the $48.00 strike put, while we received $10 for selling the $46.00 strike put ($40 – $10 = $30).

    Since it costs us to open this spread, it is called a Debit Spread. In this case, our Initial Debit is $0.30 per spread. ($30/100 = $0.30).

    Let’s take a look at the same chart with profit/loss areas when price moves in different directions as the expiration date draws near.

    Bear Put Spread

    The price at $47.70 represents our breakeven point, and any price move below that value would result in profit.

    • Our options (long put and short put) are hedged against each other – the $48.00 strike long put starts to make money as soon as price falls below the $48.00 value. At that time our short put is still “out of the money”, but as soon as price falls below $46.00 value, that short put starts working against us (remember, we sold that put to somebody). Since these options are the same class and in same number, and price may fall significantly lower than $46.00 – it won’t have any effect on our profit. Thus maximum profit will be realised when stock price drops below $46.00.
    • Price at $47.70 is our breakeven point, and price movement below that point will lead us to profit (“partial profit”), as shown in the chart. It will do so until $46.00 strike price is reached, which represents our maximum profit price.
    • In case price stays above $48.00 value, we will lose only the initial amount we spent for this investment (Bear Put Spread Debit) – $30.

    Here is the visual representation of the risk/reward profile at expiration to explain what we just described above:

    Profit Loss Profile of a Bear Put Spread

    As you can see, the price can be at any value above $48.00 – it will not affect our loss which is capped at $30 – which is the actual amount of our Debit. Moreover, the price of this stock may even go to $0 – it will not affect our maximum profit which is capped at $170.

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    Geek’s Notes: Detailed calculations of the Risk/reward

    Here are the detailed calculations of our Bear Put Spread, with regard to different stock price scenarios at the expiration date (Jan 31st).

    Scenario 1: Stock is equal to or below $46.00, let’s say at $44.00

    In this case we would make maximum gain. Profit would be calculated based on intrinsic values of Put Options at expiration.

    • Intrinsic value of purchased Put Option ($48.00 strike), Ip= $48.00 – $44.00 = $4.00.
    • Intrinsic value of sold Put Option ($46.00 strike), Is= $46.00 – $44.00 = $2.00.

    Profit/loss = Ip – Is – Initial Debit = $4.00 – $2.00 – $0.30 = $1.70. Since options come in lots which represent 100 shares, our profit will be $170.00 ($1.70 x 100 = $170.00). Compared to our initial investment (Debit) it is a 566% gain ($170/$30 = 566%).

    Scenario 2: Stock is equal to or above $48.00, let’s say at $52.00

    In this case we would make maximum loss. Let’s show the exact calculation based on intrinsic values of Put Options at expiration.

    • Intrinsic value of purchased Put Option ($48.00 strike), Ip= $48.00 – $52.00 = $0.00 (since it can’t have negative value).
    • Intrinsic value of sold Put Option ($46.00 strike), Is= $46.00 – $52.00 = $0.00 (since it can’t have negative value).

    Profit/loss = Ip – Is – Initial Debit = $0 – $0 – $0.30 = -$30.00 ($0.30 x 100). Our maximum loss in this case is $30 – which is the amount we “spent” for purchasing this Bear Put Spread.

    Scenario 3: Stock price is somewhere in between our Put Options, let’s say at $47.00

    We will calculate our profit/loss based on intrinsic values of our Put Options at expiration.

    • Intrinsic value of purchased Put Option ($48.00 strike), Ip= $48.00 – $47.00 = $1.00.
    • Intrinsic value of sold Put Option ($46.00 strike), Is= $46.00 – $47.00 = $0.00 (since it can’t have negative value).

    Profit/loss = Ip – Is – Initial Debit = $1.00 – $0.00 – $0.30 = $0.70. Since each option controls 100 shares, our gains would be $70.00 ($0.70 x 100). That is 233% gains ($70/$30 = 233%).

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    Try now. Use any of the free finance portal e.g. Yahoo Finance, choose an underlying e.g. Apple (Symbol: AAPL), find option prices and construct a Bear Put Spread. Let me know (via comments below) what you did and I will be happy to share my thoughts if you got it right.

    Vertical Spread Starter Guide

    How to Set-up Bear Vertical Spread using Call Options?

    Now, let us set-up the same trade using Call Options. We shall use same set of assumptions i.e. based on same hypothetical stock example we used when we constructed Bear Vertical Spread with Put Options i.e. stock is trading at $50.00 at the moment, and expiration date is Jan 31st.

    First we will buy 1 Call Option with a strike price of $48.00. Simultaneously, we will sell 1 Call Option with a strike price of $46.00. Let’s assume the credit we received with these combined options is $1.70. Since each option controls 100 shares, we would receive $170 credit.

    The goal of this strategy is to benefit from the decline in the stock prices to potentially below $46.00 enabling us to keep the $170 credit premium.

    Here is the chart with Bear Call Spread Set-up:

    Bear call spread

    • Our both sold and purchased call options are “in the money” since at the moment of setting up this trade, the stock price is above them.
    • The $48.00 strike price Call Option starts working against us as soon as stock price declines to or below the $48.00 strike price. But as stock price declines, the Call Option we sold (strike price $46.00) is working for us the whole time – options are hedged against each other.
    • If price declines below $46.00, both options would expire worthless, and we would get to keep the premium we received as our maximum profit, which is $170 ($1.70 x 100 shares).

    Let’s show the profit/loss graph which is practically same as with Bear Put Spread, the only difference being in the purchase/sale of the respective calls.

    Bear Call Spread Profit Loss Profile

     

    Why buy higher strike and sell lower strike in case of Bear Call Spread?

    It is because we are comparing the risk/reward profile with respect to Bear Put Spread and we are using the same strikes. And since we are constructing this trade using Call Options, it will be opposite of Bear Put Spread.

    By setting up two options in this manner, we have constructed (or sold) a Bear Call Spread and we collected $170 credit. Since it gave us credit to open this spread, it is called a Credit Spread. In this case our Initial Credit (Ic) is $1.70 (or $1.70 x 100 = $170).

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    Geek’s Notes: Detailed calculations of the Risk/reward

    Detailed calculations of risk/reward are explained below:

    Scenario 1: Stock is equal to or below $46.00, let’s say at $42.00

    In this case we would make maximum profit which can be calculated with intrinsic values of both calls at expiration date.

    • Intrinsic value of purchased Call Option (strike price at $48.00), Ip = $42.00 – $48.00 = $0 (since it can’t have negative value).
    • Intrinsic value of sold Call Option (strike price at $46.00), Is = $42.00 – $46.00 = 0$ (since it can’t have negative value).

    Profit/loss = Initial Credit + Ip – Is = $1.70 + $0 – $0 = $1.70. Since each option controls 100 shares our profit would be $170 ($1.70 x 100). In this case we would get to keep all the credit we collected by opening this kind of spread. We would achieve maximum reward of 566% ($170/$30).

    Scenario 2: Stock is equal to or above $50.00, let’s say at $52.00.

    In this case would make maximum loss which can be calculated with intrinsic values of our options at the expiration date.

    • Intrinsic value of purchased Call Option(strike price at $48.00), Ip = $52.00 – $48.00 = $4.00.
    • Intrinsic value of sold Call Option (strike price at $46.00), Is = $52.00 – $46.00 = $6.00.

    Profit/loss = Initial Credit + Ip – Is = $1.70 + $4.00 – $6.00 = -$0.30. Our loss would be $0.30 per share, and since each option controls 100 shares, our maximum loss would be $30.

    Scenario 3: Stock is in between our strike prices, let’s say at $47.00

    In this case we would make partial profit – which will again be calculated based on intrinsic values of options at expiration date.

    • Intrinsic value of purchased Call Option (strike price at $48.00), Ip = $47.00 – $48.00 = $0 (since it can’t have negative value).
    • Intrinsic value of sold Call Option (strike price at $46.00), Is = $47.00 – $46.00 = $1.00

    Profit/loss = Initial Credit + Ip – Is = $1.70 + $0 – $1.00 = $0.70. Since each option controls 100 shares, our profit would be $70. Reward in this case is 233% ($70/$30).

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    As you may notice, in both cases, the profit/loss (risk/reward) was same whether you chose Bear Put Spread or Bear Call Spread using the same strikes. However, as mentioned earlier, it is much better to structure a trade based on bid/ask slippage and ease of fill which, generally speaking, is good for out of the money options.

    Bottom line, it will be much better to use Bear Put Spread vs. Bear Call Spread (in this example) as Puts will be much easier to be filled vs. Calls which are deep in the money.

    Vertical Spread Starter Guide

    Be Patient with Yourself

    In this post I covered BEARISH VERTICAL SPREADS using both put options and call options. In the earlier post, I covered BULLISH VERTICAL SPREAD in a very comprehensive manner. The nature of this strategy is LIMITED RISK, LIMITED PROFIT. Use this spread to trade directionally to minimise your risk.

    Finally, I have to remind you to be patient with yourself. This isn’t all going to fall into place tomorrow. My goal is to give you a roadmap and a bunch of examples, so you see where you want to go with your options trading and have the skills to get there day by day.

    How do you like it? What additional thoughts or questions do you have? I will answer every question, no strings attached. Make sure to leave your comments or questions so you can make the most of your learning.

  • Don’t make these costly mistakes in the current market

    Russell 2000 (RUT) just crossed 1,000, the highest point ever for RUT; even surpassing the dot com bubble, the credit bubble and so on. S&P is cruising every day higher. Dow is making all time high almost every day. Nikkei is up almost +80% since Abenomics started spreading its wings in Nov’12. Advisors’ bullish sentiments are hitting and higher. Yields are near or all-time lows.

    Everything seems fantastic. Central banks are on Bulls’ side. Nothing can wrong!

    Apple (AAPL) was market participants’ darling (even today it is for many). The cracks were starting to surface about a year ago; it continued to make higher high. Everything seemed fantastic. There were price targets for Apple to cross $1,000, Apple was THE market and it was expected to be the first company to cross a trillion dollars market cap in modern history. It was almost impossible to imagine S&P500 making all time high while Apple will be 40% lower!

    But here we are, Ouch!

    Here are 7 mistakes that I think a trader should avoid, especially in the current markets-

    1. Confusing momentum with value:
    Facts and Values are still relevant. Even though markets can remain irrational longer than traders can remain solvent, your portfolio doesn’t need to be irrational. If you made those purchases based on appropriate “margin of safety” and the intrinsic values are already recognized in this rally, you need to re-evaluate your holding and financial assumptions behind those. Is it still offering a margin of safety? Will you make a new purchase at this price?

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  • How Can You Trade AAPL WWDC Next Week?

    Apple (AAPL) World Wide Developers Conference (WWDC) for 2012 is scheduled for Jun 11-15 in San Francisco. This is probably the most followed, most awaited developer’s conference in the world and there is plenty of excitement already. The opportunity to benefit from such an event exists not only for the developers but also for Option Traders. What? Yes, you could trade and benefit from this most awaited event. Though some gains have already been made, still there is plenty of juice.

    Here is how?

    There are two things-

    1. Most of the time, AAPL starts to go-up 8-18 days prior to conference leading to the 1st day of conference. Here are past dates for your reference to back test for determining optimum entry points.
    1. Once conference starts (especially when Steve Jobs used to come on stage), AAPL starts to pullback.

    Here are the actual results of REAL Trades by REAL Traders since 2008 upto last year. We have been trading it year after year.  Will this happen again? There is NO guarantee. Is there a possibility of happening it again, past experience says “yes”. As a full time option trader, for me it is all about probabilities and risk management. Probability seems to favor similar scenario this year as well.

    Just in case if you would like to see AAPL price chart. There are two powerful bullish patterns. Inverse Head & Shoulder and a Bull Flag.

    2 Powerful Patterns on AAPL price Charts

    Options offer the flexibility of making money even if you are wrong but if you know how to quickly adjust your position and manage risk. You may choose to open a Bull Call Vertical spread (your risk/reward will be limited) and then on the day itself, you may either want to convert into an strangle or bear call spread. There are many ways to play it. Here is an example for your reference.

    (If you would like to sign-up for OP Income Newsletter, please click here, NO Wait-list Fee for a limited time. First month is FREE if OPN doesn’t make money)

    Please note, this AAPL post is NOT about predicting long term direction of AAPL. This is ONLY about trading this special EVENT.As an option trader, I am also not looking for massive movements in the stock. Just the pattern leading into/out of the conference is good enough.

    When I open trade on the conference day, I shall post it as well. You may want to stay in touch via following my updates here on seeking alpha or twitter.

    Profitable Trading, OP

  • Protect Your Portfolio Before AAPL Falls Further

    Apple (AAPL) closed below 50dma level again. Apple has pulled back almost $53 from the high since latest earning announcement. When a company announces earnings that almost doubled smashing even the most bullish expectations and the stock was already selling well below the average P/E ratio of the market, how can it continue to fall day after day?

    After pulling back ~$80, there are a lot of theories supporting why AAPL has been falling. Some of those are-

    1. This is profit taking as stock has almost doubled from lows since November.
    2. AAPL shares are being unloaded to generate cash for Facebook (FB) IPO and once FB starts trading, money will flow back to AAPL.
    3. Options are driving AAPL share pricing depending upon where market makers’ interest lies.

    Whatever be the reason, do take a note that it is down just a 15% from the top on April 10th. Usually when a stock drops 10-15% from the high, it doesn’t create as much buzz. However, since AAPL is in completely different league thus everything around AAPL creates buzz.

    So, where is it headed next? No one knows. And those who do don’t talk about it. This article is not to predict where AAPL is headed but rather to give you few “what if” scenarios which might potentially help you in preparation should that “what if” comes true.

    First here is a chart summarizing daily price action of AAPL shares during recent past-

    1. The Highest level is $644
    2. Recent low prior to earnings is $555
    3. On May 5th, AAPL closed at $565.25

    (click to enlarge)

    [Source : TD Ameritrade Charts]

    After a 15% pullback, the key question now is where it can go next? There are three possible scenarios- (more…)

  • Trading Monster Beverage’s Boom And Bust, All In A Day

    Monster Beverage Corp (MNST) recently traded in a very volatile manner. Just before lunch on April 30th, MNST spiked sharply due to an M&A rumour that The Coca-Cola Company (KO) was in talks to buy Monster. As a result MNST spiked almost +30% to $83.96 from ~ $64

    Later, for several hours it then traded around $75 level before giving back all the gains when Coca-Cola denied discussions to acquire Monster Beverage. During last 10mins of trading, MNST shares dropped to close at $65. This kind of volatile, uncertain situation can be rewarding for traders who are day trading options and are equipped with proper strategies to trade such opportunities.

    There are three ways to trade options on M&A plays

    1. Pre- announcement (rumors)
    2. During announcement (when a news surfaces in mainstream media but is not yet confirmed) and
    3. When news is confirmed but M&A is not yet approved.

    In this article, I shall show you how one could have profited from in situations like the one Monster’s stock experienced.

    (more…)