OptionPundit

Category: Options Essentials

  • Option Strategy Screener, Position Simulator

    Today I shall be mentioning about a basic option strategy screener and position simulator that helps understand some of the basic strategies. This is very interactive and educates one in a very easy way. The tool also has a position simulator and you can place the legs/spreads in whatever way (of course not too advance) that can help you design your own strategy.

    And btw, did I mention its cost….it’s FREE.

    OptionPundit brings you the best resources available on the net which costs nothing but aid tremendously in making informed and sound trading decisions.

    Stay Tuned,

    Till then, Profitable trading, OptionPundit

  • Standard Deviation : An Option Trader’s Perspective

    Let’s talk about standard deviation that is a basis for some of the my income trades that I play for my personal portfolio.

    Let’s first understand what is a standard deviation, also referred to as “sigma”?Standard deviation is the most common measure of statistical dispersion, measuring how widely spread the values in a data set are. If the data points are all close to the mean, then the standard deviation is close to zero. If many data points are far from the mean, then the standard deviation is far from zero. Say it other way, A standard deviation is a unit of measure for volatility, and measures how tightly data is bunched around a mean, or average.

    In the option trading world, this may be defined as how tightly stock or index prices are bunched around the current price. Some stocks like KO don’t range too much up or down from the current price. Other stock like AAPL can vary hugely. The standard deviation tells you about the potential percentage move or the dollar move a stock or index might make by a certain date. You can say that for a $100 stock, the standard deviation is either 10%, or $10.

    The standard deviation is based mainly on an estimate of future stock or index volatility, a future date, and the current stock or index price. It also incorporates interest rates, but to a lesser extent. 

    • The higher the volatility, the bigger the standard deviation.
    • The further the future date is, the bigger the standard deviation.
    • The larger the stock price, the bigger the standard deviation.

    You may use historical volatility, but in my opinion implied volatility is a better estimate of future volatility. Here is how you can calculate stadard deviation:
    1 standard deviation = stock price * volatility * square root of days to expiration/365.

    Let’s take an example. With SPY trading at 142.00, and March expiration 53 days away, and a volatility of 11.6%, what is the 1 standard deviation range for the SPY at March’07 expiration?         142.00 * .116 * square root (53/365) = 6.27

    The above means 68% of the time, the index will be 142+/-6.27 by Mar’07 expiration. This assumes that stock and index price returns are normally distributed. One standard deviation covers the same percentage number of occurrences regardless of the size of the standard deviation. That is, the $100 stock with a $10 standard deviation will be between $90 and $110 68% of the time. And a $20 stock with at $3 standard deviation will be between $17 and $23 68% of the time.

    For your information, +1/-1 standard deviation covers 68% of occurrences, +2/-2 standard deviations cover 95% of occurrences, and +3/-3 standard deviations cover 99% of occurrences.
    So, how do you use standard deviations to trade? You could create your own trades based on your outlook , risk/reward of the market/Index.

    -Concepts are general and lead thoughts are based on conversation in ToS’s trader’s lounge.

  • BACKSPREAD : Strategy for large moves

    Strategy for unlimited profit on one side, limited on other.
    A backspread is the sale of an option(s) and the purchase of a greater number of the same type of options that are out-of-the-money with respect to the one(s) purchased. For example, an 80/90 put 1-by-3 backspread is long 3*80 puts and short 1*90 put. The Opposite for this trade is called Ratio spread.

    There are several ways to play big moves caused by special events such as Earnings, FDA approval etc. Most common option trading strategies are:

    1. Simply buy a call or put option
    2. Play either bull put, bull call or bear put bear call spreads
    3. Or maybe even a straddle or strangle if one isn’t sure which direction it was going to make the big move.

    Each strategy has its own merits and demerit and one can choose any depending upon his or her trading style. Over a period of time, I have noticed though that I (maybe others too) end up not predicting the direction very well. There are so many factors that play key role in determining the short term movement of the stock after the announcement. For instance, earnings beat estimate, revenue beat estimates but the outlook is lowered or several combination of these three and many more.

    In search of excellence and continuous improvement I tried to learn more and more about it and it was when I came across Dan Sheriden’s free seminar at CBOE…backspread..that has potential to make money in either direction and it won’t cost a nickel to put on the trade as you can always do it for credit….It’s called “backspread… buy x times as many as you will sell….

    Since you will take home more premium than you shell out; hence, you will receive a credit at the beginning of the trade. However, you have to make sure that you meet the margin requirement, if needed. Now, everything sounds good, you make money in either direction…so what’s the catch? The downside to the backspread is that the stock MUST make the big move you anticipated, or else the position will lose money. At the same time implied volatility (IV) also plays an important role. Typically, IV before the announcement is very high (so is the premium), and after the announcement IV will be crushed and back to normal. Hence, you need to do a thorough risk/reward analysis. The profit potential is unlimited, and if your market direction is completely wrong, you can still walk away unscathed.

    Let’s take Apple’s example that I played (details are here). I was bullish on AAPL and expected a significant up-move after the earning announcement on Jan 18th, 2007. Instead of buying straight call, I opened a trade in the form of a call backspread. A typical backspread is usually done in a 1 x 2 fashion. In other words, buy twice as many options than you sell but you can always choose your own ratio. In this example, I sold 3 AAPL January 2007 $95 calls for $3.25 and bought 7 AAPL January 2007 100 calls for $1.18. This gave me a credit of $1.65 per backspread. The margins requirement was about $1365 per backspread. After placing this on 17th, I waited for announcement that was on 17th after market close.

    My break-even point, or where we start to make money on our spread, is somewhere between $95.5 and $103.4, as seen in the “My AAPL Play for tonight” post. Since I was bullish, this type of trade could work extremely well if my prediction is right. One great thing about the backspread is that if I was completely wrong about my prediction and AAPL tanks (as happened) below $95.5, I shall still make money by keeping my initial credit. My danger zone however is in between $95.5 and $103.4.

    If you look at the r/R graph, you’ll see that my maximum potential was at $100 mark. So, in order to use proper money management, we want to be out of the trade as soon as possible if it is around $100.

    Rest you may read on both posts. The backspread is a great trade if you’ve got a real good feeling of a large directional move. You get to initiate the trade for a credit, and relax. However, if you want to maximize the chances of maximum returns, a deep analysis is important to understand where it might go. Even if you’re completely wrong in your directional assessment, you may still make money. But it MUST move. That’s the key.

    When I get time, I shall post on how to select stocks that are poised for big move.

    Till then,
    Profitable trading,
    OptionPundit

  • IMPLIED VOLATILITY EXPLANATION

    How to use implied volatility to estimate how much a stock or index will move.

    When the implied volatility of an option is 35%, what does that mean? Volatility is a measure of how much a stock can move over a specific amount of time, and is defined as the standard deviation of daily percentage changes of the stock price. Implied volatility is simply the volatility that makes the theoretical value of an option equal to the market price of an option.

    Volatility is usually expressed in annual terms, and represents a one standard deviation move in the stock. Dip into any statistics book, and it’ll explain that one standard deviation, up and down, encompasses about two-thirds of all occurrences. So, two-thirds of the time, the stock with an implied volatility will theoretically be between up 35% and down 35% in one year. But how do you convert that to a more useful timeframe, when most of the options you trade expire in the next couple of months?

    If you assume that a stock has an annualized volatility of 35%, how much might it move in 1 day, 1 week, or 1 month? Well, open that statistics book again and see that the standard deviation increases proportionately to the square root of time. So, if there are 252 days in a year, you want to multiply 35% by the square root of 1/252 to get the 1 standard deviation for 1 day. That comes out to about 2.2%. So, in one day, two-thirds of the time the stock will be between up and down 2.2%.

    To get that number for any number of trading days from today, multiply 35% by the square root of the number of days/252. That is, for the range 5 days from now, multiply 35% by the square root of 5/252. For 20 days from now, multiply 35% by the square root of 20/252. So, in 5 days, theoretically two-thirds of the time the stock will between up and down 4.93%, and in 20 days, between up and down 9.86%.

    You can use this data to gauge the risk of certain positions. Let’s look at short call verticals. The stock is $80, and April options have an average implied volatility of 40% and 15 days to expiration. Two-thirds of the time, the stock will theoretically be between up and down 9.76% in 15 days, or between 72.89 and 87.81. So, if you’re thinking about selling the 85/90 call vertical, there’s a pretty good chance that the short 85 calls will be in the money at expiration. If you don’t like that scenario, but still want to be short a call vertical, you may want to consider selling a 90/95 or a 95/100 call vertical instead. You won’t receive as much premium as if you sold the 85/90, but there’s less risk of the short options being in the money at expiration.

    This calculation is no guarantee of what a stock will do, and is susceptible to changes in volatility. But it is one more tool you can use to become a more informed trader. The above extract is from RedOption (RO), one of my favorite sites for option’s education. This was an interesting article that I thought OptionPundit readers may find useful. Thanks to RO.