Geldpress

Anadarko Petroleum witnessed some massive volume in the June 45 strike calls yesterday.  Even today, there is significant volume in the same June 45 strike calls.  I just initiated my own play on Anadarko, but using the strategy discussed at the following link:

• Option Strategy – Finance Calls By Selling Puts

Here is a static snapshot of the June option chain for Anadarko.

I initiated the following play this morning:

• Bought the June 45 strike call
• Financed most of the cost of it by selling the June 44 strike put
• Note:  Other options are to sell the 45 or 46 strike puts if you are more bullish.

I executed this trade in my OptionsXpress account.  They only charge a single commission for up to 10 options of a spread contract.  Virtually every other broker would have charged 2 commissions for this order; optionsexpress only charged 1.

My margin balance requirement for the trade is $4,400 for the naked put sale.  I’m fine with having the shares put to me if Anadarko drops because I need some more oil and energy in my portfolio anyway.  And if Anadarko does go up significantly, then I will cash out my call option for a profit and look for another energy play later.

Disclaimer: This is *NOT* advice.  Trade at your own risk!

Let’s say you are bullish on a $45 stock in the short term.  What are your options?  You could buy 100 shares outright for $4,500.  You could sell a covered call against the stock to reduce your cost basis.  But the covered call reduces your potential profit, and if your bullish sentiment is correct, do you really want to reduce your potential profit?

Another option is to buy at the money (ATM) front month calls on the stock.  Even if you paid $2 for a front month call option, the most you risk would be that $200 premium per contract.  And your maximum gain is completely untapped.  If the stock goes to $55, then your ATM 45 strike calls become worth at least $10 each, for a 500% return.  Of course if the stock stays at or below $45 into expiration, you also risk losing 100% of your money.  But if you have a chance to lose 100% of your money, losing 100% of $200 is better than losing 100% of $4,500.  And that is the power of options!

What if you really liked the stock at $45, and were happy to own it at that price eventually, but wanted an inexpensive method to gamble on a potential explosive upside.  This is possible, and you can finance part or all of the purchase of your call options by selling naked puts against them.  With this method, and depending on the strike prices chosen, it’s even possible to get free call options.  Nothing is completely free of course, and every strategy has an associated risk with it.  Here is an example scenario.

• Assumption: Stock trades at $45, 45 strike call trades for $2, and 44 strike put trades for $1.50
• Buy (1) 45 strike call for $200 total
• Sell (1) 44 strike put for $150
• Total cost of the trade is $200 – $150 = $50

What are some possible outcomes? – If the stock goes to $50 at expiration, then your 45 strike call is worth $500 and the 44 strike put expires worthless.  Your profit is the $500 value of the call minus the $50 to put on the trade, or $450 total profit.

If the stock drops to $40 at expiration, the 45 strike call expires worthless.  By selling the 44 strike naked put, you are forced to buy the shares for $44 each, or $4,400 total for 100 shares.  At that moment in time, since the shares are only worth $40, then you have a paper loss of $4,400 – $4,000 – $50 = $450.  But the original assumption was that you were happy to own the shares anyway at the original price of $45, but wanted to take a short term “gamble” on potential upside first.

By using this strategy, there is an important consideration to keep in mind.  Your broker will almost definitely require naked put sellers to maintain cash in their account to cover the full potential loss.  By selling (1) contract of a 44 strike put, your broker will likely require you to keep $4,400 cash in your account (referred to as your margin requirement balance) just in case.

Also from Geldpress:

• Total Bailout Cost Now $12.8 Trillion
• Warren Buffett And Hank Paulson – Negotiator And Thief
• Best Book For Understanding Option Greeks
• Option Collar Length – Front Month Or Leaps
• Option Bible On Diagonal Calendar Call Spreads
• Triple Leveraged ETF’s And Counterparty Risk

David Tice, the chief bear market strategist for Federated Investments (manager of Prudent Bear Fund), shares his bearish opinion in the video below. For those that have no time to view the 8 minute video, the summary of the prediction is for the S&P to hit 400.

For more information on the diagonal calendar call spread, check out this article:

• Option Bible On Diagonal Calendar Call Spreads

Calendar spreads involve buying and selling options on the same underlying security over two different months.   Some people refer to calendar spreads as covered calls on steroids.  When the strike prices of both options are the same, it is a calendar spread.  When the strike prices are different, it’s commonly referred to as a diagonal calendar spread.  Here is the option chain on US Bank showing calls for June and January.

The option play I recently executed was the following:

• Buy CALL options in the January 2010 LEAP for US Bank at the 17.50 strike
• Sell CALL options for June at the 19 strike. (The 20 strikes also look appealing for more bullish traders)
• The approximate cost is about $310 per spread contract ($440 for Jan 17.50 minus $130 for June 19)

In order to execute this trade, Level 3 (option spreads) options trading is required.  The delta on the 17.50 strike options will be higher than the delta of the 19 strike options.  A higher delta means that if the shares in US Bank explode higher, the LEAP options should gain more value than the June 19 options lose in value.  On the other hand, if the shares in US Bank drop significantly prior to June, then the loss on the spread is significantly less than the loss on the LEAP’s outright.  By spreading the options, the potential gain is reduced, but the potential loss is reduced along with it.  If we are indeed in a tight trading pattern, then it may be possible to continuously ROLL the front month options forward as option expiration approaches, and collect premium month after month after month.

Calendar spreads, whether normal or diagonal, can be adjusted like any other options positions or spreads.   Possible adjustments are some of the following.

• On an aggressibe stock price dip that is perceived to be temporary, it’s possible to buy back the front month calls (BUY TO CLOSE) for a profit, and let the LEAP’s run naked.
• On an aggressive stock price rally that is perceived to be long lasting, it’s also possible to buy back the front month calls (BUY TO CLOSE) for a loss, and let the LEAP’s run naked.
• At or near June expiration, it’s possible to ROLL the front month options forward and collect additional premium.  Rolling would involve buying to close the existing option and selling to open the next month in the cycle (July).
• The LEAP option can also be adjusted by ROLLing the option UP or DOWN after a big price swing.  Rolling down an option will increase the delta.  Rolling up an option allows the trader to collect some of the premium, and reduce the delta to the preferred target range of delta.  It’s all based on personal preference and your own trading style.

Disclaimer: No accuracy guarantees of anything on this site.  Trade at your own risk.  The above information is *NOT* advise of any kind.

The Geldpress trading team is still mildly bearish on the market in the short term.  But we are carefully watching the price action of several fundamentally sound companies for a potential entry in the next few weeks.  The watch list, in no particular order, includes:

• HAIN, CPB, HES, RBA, CMS, ABT, MKC
• BMY, FISV, PCP, CAM, HRS, SII
• RIG, FLR, JEC, SGP, EMR, AMZN, ABC
• MCK, SGR, CVS, CL

As always, trade at your own risk, do your own research, and practice money management!

Disclosure: Currently long BMY

For most professional options traders, using just a few option strategies over and over again will suffice.  It’s just not really necessary to understand the hundreds of possible option strategies and spreads to be successful.  But for those that want to study all the combinations, The Bible of Options Strategies is a book worth picking up.

The nice thing about this book is the consistency.  Every strategy is attacked with the same explanation headings, including:

• A description of the stragegy, and a risk profile graph
• The exact steps to entering and exiting the option strategy
• Context information on outlook, rationale, time decay effects, time period selection, and stock and option selection
• Risk profile and information on the greeks (delta, gamma, theta, vega and rho)
• Loss mitigation and adjustment information
• Example trade

From the Bible:

The Diagonal Call is a variation of a Covered Call where you substitute the long stock with a long-term deep in the money long call option instead.  This has the effect of reducing the investment, thereby increasing the yield…

Let’s say we’re looking to do a Diagonal Call on a $25.00 stock.  The two-year $20.00 call is say, $7.50, and we’ll sell next month’s $27.50 call for $.75, giving us an initial cash yield of 10%.  If the share rises to $40.00, within the next month, our long call will be worth at least $22.00 ($20.00 intrinsic value alone).  We’ll have to buy the stock for $40.00 and sell it at $20.00 (making a $20.00 loss), but we’ll retain the $.75 from selling the short-term OTM option.  Total position is still profitable by around $2.75…

Because we’re buying deep ITM calls, the long option will have a higher delta and will move more in step (dollar for dollar) with the stock as it rises.  This means that the stock rising explosively won’t damage our position, unlike with the Calendar Call.

To purchase the book for yourself, just click the book below:

The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies by Guy Cohen

Volatility, as measured by the VIX Index, has finally winded down from the absurd 89.53 high it hit this past November.  It’s current reading (33.12 at last glance) is still high by historical measures, but at these levels and lower, it becomes less expensive to hedge a portfolio with index puts.

For another look at volatility and the VIX index, check out this Geldpress article about high volatility.

There are several ways to hedge positions in a portfolio, including:

• Covered calls
• Stock Option Collars
• Married Puts on Equities

Those hedges protect a single position, but for general protection for an entire portfolio, an index put is the method to use.  The idea is simple, and involves just a few decisions:

• Which index to use for protection – The choices are many, including the S&P, Dow Jones, Nasdaq or even some of the sector indexes (healthcare, energy, etc).  The general rule is to use the index that most closely matches your own portfolio.   Since I keep my own portfolio’s pretty diversified, my personal preference is to use the S&P 500 as an index put hedge.
• Which strike price to use for protection – The general guideline for index put protection is to use at the money or slightly out of the money options for general portfolio hedging.  More experienced traders will sometimes use out of the money options for index portfolio hedging.  My personal preference is to stay at or near the money for hedging and use out of the money options for speculative gambles.
• Which expiration month – There is wide debate on this topic, but in general, the answer to this question should match your own trading style.  If you are an aggressive day trader, then front month index put options are probably your best tool for portfolio heding.  If you are a more hands off long term trader, then long term index put options (LEAPs) are the method for you.  My personal style is somewhere in the middle, and I start off with index puts 3-4 months out, and then roll them out when there is only 1 month remaining.
• How much protection – Forget the theory.  Recognize that index put hedging is expensive, and may cost you several percentage points from your yearly performance.  But it may also let you sleep better at night, and allow you to survive repeat performances of the market behavior similar to that of the last year.  As a general rule, I will spend 5-10% of my portfolio value on index puts.  If that 5-10% buys 5 contracts 3 months out, then that is the baseline.  From that starting point, make your own adjustments based on your daily or weekly portfolio performance.  If the overall market drops 2.5% in  a day, but your account only dropped .5%, then ask yourself if you are satisfied with the protection.  If you are satisified, then you have the right amount of protection.  If you are not, then add some additional puts to your baseline.  If you r account does not increase enough with an overall rally, then perhaps you have to much downside protection.  Also recognize that index puts need occasional adjustments, like any other option contracts.  For more information on index puts or option adjustments, check out one of the following books.

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey Cohen

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour

Disclaimer: Trade at your own risk.

Trend Trading for a Living, by Thomas Carr is overall a concise but well written book on technical analysis and trading.  It starts off like a late night infomercial con artist sales pitch, but then surprisingly it gets better fast.  Here is an excerpt from the infomercial-like first chapter:

Trend trading is the ideal home-based business.  There is no inventory in warehouses, nothing to ship, no bothersome customers, no cold calling, no gimmicky marketing….  There is no Wal-Mart down the road to undercut your prices.  There are no franchise fees, no staff to employ, no lawyers to keep on retainer….Compared to most other home businesses…trend trading has as low a set of barriers to entry as any business could possibly have.  Profit margins run well over 90 percent.  It’s hard to beat that!

What the author fails to state is that most people who attempt to make a living through trading will fail in their attempts.  The author also fails to recognize that trading is nothing more than a market sum game, and that in order to beat the market, somebody else must be losing their shirts to hand you those free piles of cash.

I was almost ready to give up on the book after the first chapter, but as stated, it does get better fast.  There are many technical analysis books that are immensely more detailed than Trend Trading for a Living.  But where this book shines is in capturing only the most important topics in a concise and well written text.  Part 1 of the book starts off with the infomercial, but moves quickly into the most important technical indicators in chapter 2 – simple moving averages, MACD, Stochastics, On Balance Volume, relative strength index and commodity channel index.  There is also a brief piece on hermeneutics (the author’s doctoral dissertation subject), “the study of how the mind understand and applies the content of written texts”.  The moral of the story is to ignore the news, ignore your personal bias, ignore Jim Cramer, ignore CNBC, and just watch the charts.

Part 2 of the book goes more into the trend trading basics, setting up watch lists, determining market direction, and a good test to practice your own chart reading skills.  Part 3 of the book talks more on how to select stocks to trend.  And the best part in this section is the detailed screening list for each of the technical trend patterns discussed.  For a good “Pullback” criteria list of stocks, search the stockcharts.com screening tool for the following:

• 60 day simple moving average of volume for today is greater than 500,000
• 60 day simple moving average of close for today is greater than 15
• The chart has a bullish engulfing pattern for today
• 20 day simple moving average of close for today is greater than the 50 day simple moving average for today
• Daily close for today is less than daily close for five days ago times 1.15

Part 4 of the book provides a good summary of trend trading with stock options, and part 5 of the book unfortunately to much like the infomercial in chapter 1.  Luckily, part 5 is also short enough to be ignored completely, and there is enough worthwhile meat in the book between the first and last chapters to warrant a purchase.

Trend Trading for a Living: Learn the Skills and Gain the Confidence to Trade for a Living by Thomas K. Carr

Nearly everyone says the same thing about out of the money options – they are to dangerous and only highly experienced option traders should participate in them.  But the reality is that any stock option strategy can be dangerous at times.  The trick with out of the money options is to understand the risks and rewards, understand WHY you are buying them, utilize effective cash management, and have a planned exit strategy – BEFORE YOU BUY.

Activision(symbol: ATVI) is one name that I like for a small out of the money directional  call option play.  Check out a morning snapshot from the option chain for May and June below.  Activision is scheduled to release earnings today, after the market closes.

From the chain above, take notice what is going on:

• Implied volatility in the May options is very high- about 82 near the money
• Implied volatility in the June options is also high, but not as quite – about 57 near the money
• Open interest in the CALL options is nearly 10:1 of that of the PUT options
• There were over 1600 contracts of the May 10 strike calls traded today (in the money)
• Even the out of the money May 11 and May 12 options saw volume today (693 and 202)
• Implied volatility will almost certainly drop to the 30-40 range matching the overall market after the earnings announcement later today.

Many people like the May 10 strike calls on Activision.  But if Activision drops below 10 after earnings, those options will expire worthless.  I personally like the June 11 strike (70-80 cents) or the June 12 strike options in Activision for 35-40 cents each.   Even if Activision falls to $10 after earnings, those out of the money options could still have some value left.  These out of the money option plays are risky, but for a small bet, they could prove very rewarding if Activision spikes to $12 or higher in the days following the earnings announcement.  The trick with out of the money options – or any options for that matter – is to understand the risk reward profile before placing the bet.

Disclosure: Author is long the June 11 and 12 strike calls in Activision.  (small bet!)

Disclaimer: Trade at your own risk!

May 8th Update: Activision reported good earnings yesterday as expected, and the stock closed at $11.81 on Friday.

Here is the June option chain below, as of the close on Friday.

Notice how the out of the money (they were out of the money before earnings) June 11 and June 12 strike options on Activision jumped up after earnings.  Volatility also took a dive from the 55-56 level to the 47-55 level near the money.  Here are the 1 day performance results from the June 10,11 and 12 strike call options:

• June 10 were 1.35 before earnings and about 2.00 after (48% return)
• June 11 were about .75 before earnigns and about 1.25 after (66% return)
• June 12 were about .40 before earnings and about .70 after  (75% return)

Also notice that June 12 strike options (out of the money prior to earnings) went up the most, even with Activision still trading under the critical $12 strike level.  Activision closed Friday’s session at $11.81.

To sum it up, out of the money options are risky plays, but they can yield healthy returns.  The trick is to understand your risk reward ahead of making any option plays.

An option collar is a combination option strategy that involves 3 distinct legs:

• Long shares of stock
• Short a call (usually out of the money)
• Long a protective put (usually at the money or out of the money)

For more info on stock option collars, check out:

• Bring Your Collar Into These Volatile Markets
• Married Puts, Collars, And Hybrid Hedging
• Portfolio Protection And Adjustments With Stock Option Collars

The strike prices of the covered call portion and protective put portions of the collar are a matter of personal preference and individual risk tolerance.  For greater downside protection, an at the money protective put would be purchased, but this comes at a higher cost than the out of the money protective put.  The covered call strike price is also subjective; the higher the strike, the greater the potential reward.  But since the protective put is partially financed by the selling of the covered call, a lower strike covered call would have the benefit of covering a larger perecentage of the purchase price of the protective put.

What about the option collar duration.  Many stock option books present the case of stock option collars as a longer term hands off investments involving long term LEAP options (January expiration 1 or 2 years out).   But there are also advantages to using shorter term options as part of a collar trade.  If a stock moves up quickly toward the strike price of the covered call then a shorter duration collar would realize the maximum profit faster than a longer term collar.  As a demonstration, consider the following example:  (download support file here)

• Purchase 100 shares of stock at a price of $100 each – $10,000 total
• Purchase 1 protective put at a 90 strike
• Sell 1 covered call at a 110 strike
• Compare a 30 day duration with a 60 day duration option collar

The three sections of the images above are:

• TOP – Initial assumptions of the collar
• MIDDLE – calculations using a 30 day collar, with maximum profit realized after 30 days.
• BOTTOM – calculations using a 60 day collar, with 30 days left before expiration of collar legs.

With a 30 day collar, the maximum profit of $1,027 can be reached after 30 days (collar expiration) when the stock price reaches the strike price of the covered call.

However, 30 days after initiating a 60 day collar, the same stock price movement up towards the covered call strike yields a lower profit of only $591.  This lowered profit is mainly due to the loss in the covered call from having another 30 days left until expiration.

The disadvantage to a shorter term option collar is the limited time horizon to make adjustments in the event of a sharp decline in share prices.   For this reason, I personally prefer to have shorter term collars extended at least 30 days past earnings releases.  If the shares decline sharply after earnings, profits in the protective put and covered call can partially offset the loss from the share price decline.   And shorter term collars can always be rolled out for more time and adjusted with new strikes on both sides of the new stock price.

When deciding on the length of your own option collars, you should consider the following:

• What is your upward price target and how quickly do you expect it to get there
• Whether you want a long term hands off trading vehicle, or a more active adjustment vehicle

Disclaimer:  Options can be dangerous.  Trade at your own risk!