OptionPundit

Category: Option Trading

  • 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

  • Don’t Trade Options If…

    Don’t Trade Options If…

    Don’t trade options!

    Yeah, you are reading it right. We at OptionPundit, a premium Option focused website, are telling you not to trade options!! In fact don’t trade stocks, forex or commodities also if you can’t put your heart-n-soul into it to understand how it works and what does it take to succeed in that business. Trading Financial markets isn’t easy and it will never be easy as it directly deals with money and the competition will always be tough. This is even more relevant in case of financial markets as market participants are now even more sophisticated than ever.

    If you can’t afford the time and resources to prepare, persist and persevere, you will be disappointed with Options trading. Let’s dive into the details.

    Options Are From Mars

    Just like one has to understand A, B, C of a language before he could read, write or create beautiful stories, it is important to understand the language of options. At the end of the day, Options are just another trade tools with pros-n-cons.

    Compared to stocks, which is extensively discussed and taught through traditional education system, options’ are not widely known. Most people learn about options after completing traditional education and by that time theoritical understanding of stocks is deeply rooted. It is evident in practical conversations with beginners. Almost everyone understands BUYING A CALL OPTION very easily vs. BUYING A PUT OPTIONS. And the moment, you talk about SELLING A CALL or PUT OPTIONS, the same people start looking around.

    Yes, there are just two type of options CALL OPTIONS and PUT OPTIONS, and yes there are just two transaction BUY and SELL, and yes when compared with stocks, options require much less parameters to understand, still one has to learn the language of options before benefitting from it.

    So if you are not willing to spend time to understand fundamentals of Options, it’s better to stay away from options.

    [color-box color=” customcolorpicker=” rounded=false dropshadow=false]Before you even dive into options, it is a good idea to first understand should you even trade options. I have prepared an ebook that has been downloaded by thousands of people all around the world. This powerful, yet easy-to-read book will provide you with key reasons “Why Should you Learn to Trade Options. Download it instantly.[/color-box]

    Buy Low, Sell High

    It’s natural. We are trained for thinking “Buy Low, Sell High”.

    That’s how, in general, investors and traders think about underlying asset. But that’s a stock trader/investor’s mind-set, not an options trader’s. Yes, it is still about “BUY LOW, SELL HIGH” or “SELL HIGH, BUY LOW”, but the way it is done in options trading is different. It’s not right or wrong, it’s just different. Believe me, when you mix “SELL TO OPEN” as first transaction with NEW “options language”, it just becomes a tough nut to crack for beginners. And BUY and HOLD doesn’t work in options simply becuase options has different character than stocks. If you don’t have proper foundation, don’t understand the basics well, there is no reason you should jump into options trading.

    So, Start it right and start it smart!

    [testimonial_slider disable_height_animation=”true” autorotate=”5000″] [testimonial name=”Anna, Singapore” quote=”As a direct result of learning under him, $7000 profit during the last three months alone . My trading skills as well as results have improved significantly.” id=”t1″] [testimonial name=”J, Spain” quote=”0% to 50% with a quite high success rate. As a direct result of OP’s strategies I have made a positive cash flow of $34,000/- within a short period of time.” id=”t2″] [testimonial name=”Luis González, USA” quote=”..16 years witnessing my capital being managed by different brokers….Option Pundit is well tuned with the market and exhibit option trading techniques far more sophisticated than my previous options brokers…” id=”t3″] [/testimonial_slider]

    Give yourself time to equip yourself better before you dive into options trading. There are plenty of books, tools, great websites and articles that can help you in providing a good understanding of options so you can “Act & Think Like an Option Trader“.

    [color-box color=” customcolorpicker=” rounded=false dropshadow=false]Find out the single biggest mistake new options traders make. Read it here.[/color-box]

    A Ticket to Get-Rich-Quick

    Options are trading instruments that provide one with good leverage. Once again, it’s not a straight forward leverage in traditional sense. Options allow you, generally speaking, 1:100 leverage as one standard option controls 100 shares. But if you are an option buyer, you can’t lose more than what you paid for. However, if you are a seller, leverage can work against you.

    A majority of new traders start options trading with the expectations of hitting home run, almost all the time. It is this get-rich-quick unrealistic expectation which then turns into get-poor-quick scenario. They think that Options are something that once they learn money will start to flow automatically and that too in big strides. No, It is just not true. Options are just another tools. Tools that allow to trade market differently vs. stocks or other instruments.

    Think about this- Even after learning the Language of Options, you still need to DEVELOP A MARKET OUTLOOK!! And it’s that outlook which generates money. It’s not options. Options are just more effective tools with much higher probability of profitting for THAT OUTLOOK.

    Making money is a process, a process that takes time to develop and mature. When you start thinking of TRADING as BUSINESS and OPTIONS as BUSINESS TOOLS, you will see success coming your way.

    [color-box color=” customcolorpicker=” rounded=false dropshadow=false] 10 Key Steps for Profitable Options Trading business. Read it here.[/color-box]

    Dull Saw, Sharpened Saw and The Third Point

    Financial markets keep on evolving. There will be newer trading instruments, newer information, new products, new industries and so on. But at the same time, the basics don’t change. The human behaviour towards money, market hasn’t changed much over the last century. Mr market has humbled many traders, regardless of their stature. There is no point in trading the markets with a huge ego based on your past laurels. While ego might work in other areas of life, it is certainly not a helpful tool when dealing with markets. The sooner ego is in check, the better are the results.

    Suppose you came upon someone in the woods working to saw down a tree. They are exhausted from working for hours. You suggest they take a break to sharpen the saw. They might reply, “I don’t have time to sharpen the saw, I’m busy sawing!” Ouch…if you don’t practice enough, you can’t make it perfect. However, spending all your time sharpening and no time sawing is just as bad as spending all your time sawing and not sharpening.  Some people may spend so much time “improving” that they never do any meaningful work.

    The Third Point: Sharpening of saw is done with a pair of files and a specialized bending-pliers called a saw set. And if you mess up the filing, you can end up with a saw that’s permanently ruined! It takes some time, care, and effort to sharpen each individual tooth of a saw, and it takes a set of carefully made tools. And you also need to know a) do you really need to sharpen the saw and b) is it the right time to sharpen the saw?

    At the start of the every trading day, start on the path of getting some real improvement in place. Start keeping a simple trading journal to document everything you do, and any thought or idea that crosses your mind.

    “STAY HUNGRY, STAY HUMBLE” is my basic requirements when dealing with markets. There is no room for “complacency”. You can’t stay the same, you also can’t ignore the new and you also can’t turn a blind eye to your toolbox.

    9 Losers, 1 Winner

    There is an old saying, and a popular one, that 90% of options traders lose money. Though I have my own reservations about this comment, but for now, let’s just accept it. Is this ratio any different from any other carreer? is that any different from another job? How many managers are there for each employee in a successful corporation? Just google to find out How many start-ups survive? 9 Losers, 1 Winner!!

    It is also very well documented that majority of the talented fund managers can’t beat a simple market ETF. In fact, there is a famous bet that Warren Buffet kicked-off in 2008 :

    “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

    So, what’s the point? It takes time and effort to take care of your money. There is still 1 winner for every 9 losers. You have to think about it. What is that 1 winner doing differently? Why is that person a winner? Are you going to spend time and efforts to be that 1 person?

    [testimonial_slider disable_height_animation=”true” autorotate=”5000″] [testimonial name=”Anna, Singapore” quote=”As a direct result of learning under him, $7000 profit during the last three months alone . My trading skills as well as results have improved significantly.” id=”t1″] [testimonial name=”J, Spain” quote=”0% to 50% with a quite high success rate. As a direct result of OP’s strategies I have made a positive cash flow of $34,000/- within a short period of time.” id=”t2″] [testimonial name=”Luis González, USA” quote=”..16 years witnessing my capital being managed by different brokers….Option Pundit is well tuned with the market and exhibit option trading techniques far more sophisticated than my previous options brokers…” id=”t3″] [/testimonial_slider]

    There you have it. Options trading is NEW, requires TIME & EFFORT to understand the OPTIONS LANGUAGE and will have its own share of success and failure. If you can’t give it what it takes, it can’t offer you much success even if it is ONE OF THE BEST TRADING INSTRUMENT for retail traders.

    It’s your turn now. What do you think? What are the pros-n-cons of Options Trading? If you were to suggest a new person, what would you tell them?

    Profitable Trading, OP

  • How Option Prices are Affected by Dividends

    Dividends usually bring smile on the faces of most investors except for some. Declaration of dividend by a company may upset a few people. Just ask an option trader holding a call option and you will know.  Dividends have an adverse effect on call option prices. I assume you have some idea about options and must be aware of the basics of options trading. Let’s understand how a dividend affects the price of an option.

    Dividends – effect on option prices

    Dividends are one of the most important factors in the Extended Black-Scholes Option Pricing Model, which affect the premium of any option, whether call or put. And obviously dividend affects the price of call and put options in different ways.

    Whenever a dividend is declared on a stock, the market discounts the dividend in the market price of the stock and hence the ex-dividend price of the stock is lower. This price adjustment in turn affects the price of the options.

    Effect on Call Options

    In case of a call option, the premium decreases with the declaration of dividend. On the ex-dividend date the market price adjusts for the cash dividend declared. This in turn results into decrease in the price of the call option attached with the stock.

    Effect on Put Options

    The opposite happens in the case of put options. With the fall in the market price of the underlying stock, the put option becomes more attractive and hence the premium of such a put option rises.

    Let’s see some illustrations to make things clear.
    Illustration (a): Option pricing without dividend.

    The Current Market Price of Apple Inc. was $409.22 as on 1st of July, 2013.. If we calculate the premiums of options of Apple Inc for the September 21st, 2013 at-the-money contracts ( i.e. strike price $410), the prices come out to be $20.7038 for Calls and $21.2683 for the Puts with the conditions as per the above illustration. In this case it has been assumed that there is no cash dividend declared.

    Now consider the situation where a future cash dividend of $3 has been declared on each share of Apple Inc.. This dividend will get discounted in the price of the shares of Apple Inc.. and the ex-dividend price will become approx $406. This fall in the price of the underlying shares of Apple Inc. in turn is reflected in the option prices as discussed above. The illustration below shows the new prices with dividends taken in purview.

    Illustration (b): Option pricing with dividend.

    As evident from the illustrations above, you can see that with the decrease of $3 in prices of shares of Apple Inc., the Call option becomes less attractive and the price drops to $19.2815 (a decrease of $1.4223).. On the other hand the put option is now better placed and its price rises to $22.7459 (an increase of $1.4776).

    Exceptions

    The effect of dividend is not of much importance in case of European Options as they can be exercised only on Expiry Date. By the time of expiry date these factors have already been adjusted in the prices. It can be observed clearly in case of American Options because of the fact that you can exercise the option before the expiration date as well. Also a naked option is more prone to the dividend effect. The effect gets neutralized in case of a covered call as the decrease in option prices is compensated by the dividend received on the stocks. Although this compensation may not be proportionally equal.

    OP’s comment– In future posts on OptionPundit I shall explain about some dividend focused option trading strategies. If you would like to stay informed, pls join our mailing list for FREE educational articles. Should you have any questions, feel free to ask us anytime-> ask@OptionPundit.com

    (This guest post was written by Mr. Patrik Fonce who is a trader and also an editor for quantshare.com)

  • Which Is the Best Broker for Options Trading?

    Evolution of Internet has revolutionized how brokering services work. Gone are the days when you needed to pay prohibitively expensive broking charges to be in-an-out of a trade and had no access to technology or analytics. If you are a self-directed investor, these days you have plenty of choices to choose from.

    Ms. Theresa W Carey of Barrons, recently published an excellent and very exhaustive review of Brokers. Without a doubt, Barron’s listing is one of the most complete and trustworthy list of brokers and I am very appreciative of this work which has been very useful over the years for my preliminary selection of online brokers. In this post, I shall share an active option trader’s perspective to choosing brokers.

    Here is the list of brokers from Barrons arranges for various categories:

    Best Brokers via Barrons Mar 2013

    For other points i.e. Trading Technology, Usability, Mobile, Range of Offerings, Research amenities, Portfolio analysis and reports, customer service and education and costs you may read the original article. The overall list has 24 top-notch brokers ranked on the above 8 broad categories. From “Usability” perspective “tradeMONSTER” was the best, in “Technology” category TradeStation was the winner but overall champion was Interactive Broker.

    From an Options Trader’s perspective, the Top 3 were 1) tradeMONSTER, 2) TD Ameritrade and 3) OptionsXpress.

    Best Broker by Needs, Barrons March 2013

    I have been using online discount brokers for the past 15 years starting with Datek which was acquired by Ameritrade. Having used all Top 4 and Trade Station, I was surprised that Tradestation didn’t show-up in the Top 5 platform for option traders. I have been a strong supporter of ThinkOrSwim (as Tom used to listen to us, the real option traders and build features that were most useful for us) as well as tradeMonster. I like both and recommend both. However, I think OptionStation (from TradeStation) also deserves equal recognition. Albeit, a trader needs to decide for himself what’s best for him.

    A platform’s need changes depending upon your trading experience, capital size and style of trading. Assuming usability, comprehensive charts, risk/rewards analytics, research reports, good scanners and reliable data feed as basic “points of entry (PoE)” for a good broker; here are 5 key “points of differences (PoD)” that differentiate an excellent broker from a good broker (More later).

    1. As simple as it may sound, “Mid-Price” is a very handy and important tool for an option trader. Even today, I rely on it extensively to place and modify my orders. If a trading platform doesn’t offer this feature, I need to think twice before joining them. Some brokers, even today, don’t offer “mid price” tool. Even if your broker does offer the mid price, check out the mid price for credit spreads if it is correct.
    2. Another very important feature that I suggest to review before joining, how many clicks you need to “place” or to “modify” your order (price, quantity or both). For example, if I am trading an Iron Condor which consists of 4 options leg and I had to fill details for all 4 manually and then keep revising the order with the price & time, I will simply keep on doing this while missing out potential opportunities. Does your platform fill at least the months and underlying automatically? If it doesn’t, It will be a nightmare, as one might have to fill underlying, month, strikes and then quantity and then prices (and if it doesn’t have mid, then you need to have a calculator handy). You might have to either get a fill at bad prices or you will be frustrated. At times, time is of essence and I don’t want to be stuck when I need simplicity the most.
    3. Chart trading comes handy for visual traders. For instance, as an active trader, I might simply draw points on the charts where I want to get in and get out.
    4. Can I backtest my strategies? Subscribing to the software that allows backtesting can cost huge sums. Ouch! There are only a few platforms that allow you to back test your strategies. Many a times, traders underestimate the power of back-testing. However, as a trader evolves and start to systemize his or her trading, this feature alone can save and add $$ to the bottom-line.
    5. How does a broker’s platform arrange positions for buying power calculations? Don’t under estimate this. As an option trader, I trade Iron Condor, Butterflies, Calendars, ratio spreads, back spreads, diagonals, straddles, strangles and many of my own proprietary combinations. I may have multiple strategies for the same underlying. If your broker’s software auto arranges those in funny ways such that your buying power reduced dramatically or worse negative, you can’t trade. You will then have to call their customer service to place orders!! I have had experiences when I had more than enough buying power but my broker’s software arranges them in such a way that I couldn’t trade. I had to call the customer service and it took them a lot of time before they could even understand my positions. In the meanwhile, markets had already moved. They told me they know there is a “bug” in their system (for months and still no resolution to this). This can be a frustrating experience for no fault of traders.

    Bottom-line, I suggest you read Barron’s excellent review for various details and add a trader’s perspective as listed in 5 points above. When you combine the two, I hope, you might be able to find best solution for your trading need. If you need my help, please feel free to write to me. I shall reply to you within 48hrs.

    Please feel free to distribute this article (without changing contents) to your trading buddies and friends you care about. You might save them lot of trouble, frustration and money in future.

    Profitable Trading, OP

  • OP Income Newsletter Mar 2013 +15.3%

    Aiming to generate twice the SPX returns in 2013.

    OPNewsletter is very much on track to deliver my personal aim i.e. 2x the SPX returns by the end of 2013.  Jan 2013 was a solid +15.5%, Feb was +2.3% and March was +15.3% on max capital utilization of 36.3% thus effectively yielding +5.58% on the overall portfolio capital. This is 10th consecutive positive month; in the overall 65 months of consistency of solid gains regardless of bear, bull or sideways markets.

    (If you are not an OPNewsletter member , pls click here for a RISK FREE sign-up).

    For the OP Income Newsletter, Mar 2013 portfolios delivered +15.5% on maximum of 36.3% capital employed based upon OP’s dynamic capital allocation in line with risk/reward. If however, one assumes a 10%/ fixed per trade capital allocation, the results will be double of this.  There are several methods on how you can can allocate capital. Some are fixed, while other are dynamic and how you allocate can alter the portfolio performance. There is nothing wrong or right about it, it is your own preference that you might be comfortable with. Let me show you how DIFFERENT CAPITAL levels for the SAME trades, for the SAME RETURNS will alter the final profit & loss-

    The table attached has two scenarios- 1) OPN’s DYNAMIC allocation (real trades for the month of Mar 2013) and 2) assuming a FIXED 10% per trade allocation. The same trades will deliver 5.58% for overall portfolio while scenario 2 will consider those gains as 10.3%.

    So which one is better? It depends. It depends on your comfort level with regards to the risk you are assuming in that trade.

    Another key point to note is the investment level for the same trade.

    For example- Say you are opening a RUT Iron Condor, do you assume investment level as =Margin-credit received? or something different. As naive as it may sound, you may find many folks assume no margin as the trade is being done for a credit. (Don’t confuse this margin with typical margins offered by broker e.g. 2x of your capital for trading equities. This margin is backed by the cash in your trading account). It can’t be farther than truth; one needs to invest money to initiate that credit trade.

    How about assuming investment for debit spreads? some assumes there is no margin as you’re investment is only what you are paying to purchase a spread. While true in some cases, not in all. It can be deceptive on surface. You may want to read my post on how to calculate margin for VIX calendar spread. Thus, incorrect margin assumption can also alter the performance. Some don’t assume any margin on $VIX calendar spread at all.

    Think of it for a minute-

    OPN VIX Calendar in March 2013 was opened for $72 debit and was closed for $110 credit. Thus gains were $38.  One way to report performance is that gains are +52.8%!!! and another as it is in OPN i.e. +8.33%.

    The difference is due to margin assumption. +53% assumes no margin (only debit), while OPN assumes $456 as cost to open that calendar.

    So how does OP Income Newsletter calculate its performance?

    OP Income newsletter calculates results based on final overall returns (i.e. for all 6 trades) and then divide that with the maximum investment used throughout the month even if that max investment was for 1 day.

    It uses median REAL fills, as shared by REAL members, vs theoretical fills to calculate returns/trade.

    Margins are calculated based on the maximum investment one has to make to open the trade. 

    OPN results, does not include P&L from OPNExtra! which also has a solid track record.

    Thus, the point is, there is no right and wrong with the assumptions you choose.  While individual performance may differ based on the fills they get, what really counts is the $$ value that is delivered to your portfolio.

    Be realistic, allocate capital efficiently and manage risk well. In the long run, I believe you will be fine.

    (If you are not an OPNewsletter member , pls click here for a RISK FREE sign-up).

    We are primarily trading VOLATILITY and NON-DIRECTIONAL income trading strategies. The key objective is to preserve capital while gradually building gains as oppose to trading in hopes-n-dreams and lose capital. Subscription are currently open and there is no wait listing fee. The objective is still the same as it was 65 months ago i.e. 5-7% monthly gains on invested capital. OP Income Newsletter is NOT a GET-RICH-QUICK-NEWSLETTER. As proven time and again, the market neutral and volatility strategies that we trade are scalable and diversified.

    Here is a quick feedback from one of the EX-OPN member who has now started his own business , you may kindly read more here.

    I would be more than happy to share my thoughts with you about the newsletter service you provide to members.

    First off, let me begin by saying that your level of commitment to your subscribers is top shelf quality, and greatly appreciated. I have enrolled in a couple of other “advisory-type” services in the past, and could never duplicate the promised results that were advertised. Not so is the case with your service. Once a recommendation is posted, your timely adjustments certainly reflect what is going on in the market real time, and the attention you pay to detailed risk management is HUGE. It is very apparent you are trading what you are recommending, and the focus is living to trade another day. I can honestly say I did not expect this type of performance when I initially enrolled, but am quite elated and content with the service thus far.

    I would highly recommend your service to any option trader at any skill level. The answers you provide to your members are great in that you seem to realize a newbie does not need complex discussions, and the very advanced trader does expect more elaboration than “do this, or do that”. I also believe that your advertised results are accurate and repeatable by any member willing to spend the time required to learn this craft. I could highly recommend this service and would be more than willing to elaborate further if requested.

    Thank you for this opportunity to share my experiences, and keep up the great work”

    Warmest regards,
    Kevin Sass
    Gilbert, AZ, USA
    Trading Experience: Options Trading exclusively since Feb 2007

    Just to reinforce, earning trades are covered under OPNExtra! which is FREE for the OPN members and is not available for others.

    Value Delivered by OptionPundit Income Newsletter

    Should you have any feedback, suggestions, I shall appreciate those in the comments section. Should you have other ideas on how best to calculate performance, you are most welcome to share. Let’s have that dialogue as having a true transparent performance is key to bring trust in this business which is clouded by those who think you can be millionaires, tomorrow, by trading options. It takes time to sharpen the saw and learn the trading business.

    If you are still not an OPNewsletter member, this probably will be one of the most interesting years to join. For those who may be interested in following me on Twitter, you can find @OptionPundit at Twitter.com/OptionPundit;

    Aiming to generate twice the SPX returns in 2013

    OP

  • How To Calculate VIX Options Calendar Spreads Margin Requirement

    The Volatility Index (VIX), also widely known as “The Fear Index” has been gaining lot of popularity especially after the recent financial crisis. These days almost every major asset class has its corresponding VIX, and in fact several countries have introduced VIX equivalent for their leading market indices. After several months of trading it personally and refining selection criteria, I introduced VIX calendar spreads for OP Income Newsletter in 2009-10. Now this is almost one of the most regular income trade (assuming my selection criteria is met). We trade both VIX Cash Index as well as VIX futures and past performance trading record is absolutely fantastic.

    (If you are not an OPNewsletter member , pls click here for a RISK FREE sign-up).

    Trading VIX calendars is one of the most interesting play in the option’s world. And one needs to be careful before trading it as your risk may not the similar as in implied via regular calendar spread. You may lose more than the debit you pay for. And the key reason is that VIX options are priced based on VIX futures, not VIX cash index.

    Equity long calendar spreads don’t require margin. Your cost is the debit you pay. However, VIX calendar spreads requires margins. One of the key things that I get asked time and time again about VIX calendars is how to calculate margin requirement for VIX calendar spreads and thus the idea behind this post.

    In order to test margins I used ThinkorSwim to check their margin requirements. I used mid prices as of March 26th close. So here is how April/May calendar will look like-

    • Sell to Open VIX April 16 Call and  Buy to Open VIX May 16 Call
    • Total Buying Power Effect : $432.50 including $105 debit +Commissions
    • Thus April/May cost: $432.50
    • May/June costs $502.50
    • Jun/Jul is costs $562.50
    • Jul/Aug costs $600 and
    • Aug/ Sept costs $645 including $45 debit;

    Thus as you can see, the margin requirement change as you move from adjacent month to next and so on. IB shows $150 as margin requirement in pre-trade screen but actually the margin is shown once you confirm the trade. Here is what IB says about the VIX margin requirements –

    Specific options with commodity-like behavior, such as VIX Index Options, have special spread rules and, consequently, may be required to meet higher margin requirements than a straightforward US equity option. Clients are urged to use the paper trading account to simulate an options spread in order to check the current margin on such spread.

    There you go, “commodity like behavior”. Though pre-order screen of IB shows margin requirement as $150, you should check it once you are in the trade or do so via paper trading on IB software. I think it is inline with other brokers and as per exchange policy.

    Thereafter I referred to CBOE website to see if I can find something, here is what CBOE states about VIX–

    – Purchases of puts or calls with 9 months or less until expiration must be paid for in full.
    – Writers of uncovered puts or calls must deposit / maintain 100% of the option proceeds* plus 15% of the aggregate contract value (current index level x $100) minus the amount by which the option is out-of-the-money, if any, subject to a minimum for calls of option proceeds* plus 10% of the aggregate contract value and a minimum for puts of option proceeds* plus 10% of the aggregate exercise price amount. (*For calculating maintenance margin, use option current market value instead of option proceeds.)
    – Additional margin may be required pursuant to Exchange Rule 12.10.

    Or to put this into a formula-

    Index Options: Call Price + Maximum ((15% * Underlying Price – Out of the Money Amount),
    (10% * Underlying Price))

    Above explanation is for writing naked or uncovered. But one may argue, we have a long same strike option so I am covered like in equity options. This is where things get more interesting.

    So here is my hypothesis about the VIX options, In case of VIX, most brokers’ treats short side of the calendar as a short call. And long position that you use for covering the risk, is considered as a long position. Thus usually the margin requirement will be Margin on Short side+ Cost of Long Side option.

    (If you are not an OPNewsletter member , pls click here for a RISK FREE sign-up).

    Another key thing to note, the margin requirement will change according to the price change in VIX. Let’s test the hypothesis (Prices as of March 26th close)-

    • Margin required for shorting April 16 Naked call- $255.50 (as per ThinkorSwim)
    • Option premium for April 16 Call- $72
    • The asking price for Long May 16 call is $177
    • Thus total cost of the spread for 1 Long April/May calendar is $255.50+$177= $432.50)

    Is there a straight answer for you to calculate the margins? No, I haven’t found any. But the above does provide a reasonable idea on what kind of margins are required. For OP Income Newsletter, when I trade VIX calendars, I use roughly $500 as margin requirement per calendar.

    So here are the key take ways-

    1. Margins on VIX calendars are = Roughly $250 + Price of long Legged call, it’s NOT just the debit you pay for.
    2. Higher-up the expiration cycle, higher the cost of long leg and thus higher cost of calendar spread.
    3. The margin requirement will change depending upon VIX levels. It is never constant.
    4. You can lose more in VIX calendar spread than the debit you paid for. ( I shall explain this in another post).

    Hopefully, this clears some doubts on how VIX calendar margins are calculated. You may want to check with your respective brokers on how VIX margins are being calculated. If you have feedback or corrections about the post above, I shall be more than happy to correct and update.

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    Profitable Trading, OP