Geldpress

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.

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!

This site discussed a play on DNDN just a few days ago, with this article.  Implied volatility had spiked in DNDN due to the announcement of an April 28th conference with the AUA (American Urological Association) that DNDN was invited to.  The conference is not the FDA, and had no capacity to approve or deny Dendreon’s Provenge drug.  But nonetheless, the spike in volatility provided ample opportunity to sell some premium.  With my own account, I took the conservative approach with a calendar collar (Buying the shares and the April 5 PUT’s, and selling the May 5 Calls).  I also announced a more aggressive play of just buying the shares and selling the May 5 Calls or May 7.50 Calls (without the added PUT protection).  Take a look at the chart of DNDN – before and after our entry into the DNDN calendar.

If you played along with the DNDN play, then regardless of which play you did, you have already collected over 90% of the profit potential well ahead of the May option expiration.  This is due to the delta effect.  Prior to the GAP UP, the May 7.50 strike options were out of the money.  After the gap, those same options are now deep in the money.  The more in the money the option is, the more it behaves like a stock,which means that most that time premium sold from the original covered has already been collected.  Here is a recent snapshot of the option chain data:

• DNDN last traded at $17.20
• May 7.50 strike call is about 9.85
• Adding 7.50 (strike) to 9.85 option price comes to $17.35, which is just 15 cents higher than DNDN shares.

If you stay in this particular trade through May expiration you will only collect another $15 per covered call contract, but you risk making it through potentially damaging conference news on April 28th.  Rather than risk everything for a few dollars more, covered call players on DNDN have the opportunity to close the entire position on the delta effect.

To close the position, simply buy back the originally covered call you sold (BUY TO CLOSE), and then *IMMEDIATELY* sell the Dendreon shares.

Disclaimer: This post is informational only, and not advice of any kind.   Trade at your own risk!

Also see:

• Time for cover – the covered call
• Covered Calls – Scottrade, Tradeking, Fidelity
• Covered Call Writers Love High Volatility
• The VIX index and covered calls
• Covered calls – removing the covers and going naked
• Dendreon Calendar Collar Or Covered Call Looking Interesting
• Portfolio Protection And Adjustments With Stock Option Collars

Goldman Sachs is now trading again near $115, where Warren Buffett purchased the bulk of his shares.  I don’t follow Buffet’s trades, but I do recognize that his purchase price acts as a good support level.  Goldman Sachs is still mostly a big black whole of finance, and I would never risk my money on an unhedged position in Goldman.  But for a short term trade, I do like, and just initiated an option collar on Goldman Sachs.

• Purchased 100 shares of GS (around the 115 mark)
• Sold a May 125 covered PUT for around $6.50
• Bought a May 115 PUT for around $6.50

Implementing the collar for May was essentially free, since I collected the covered call premium to pay for the PUT protection.  Goldman Sachs earnings are scheduled (according to this Yahoo Link)  to be released on APril 14th, just a few days ahead of April options expiration.  For that reason, I opted for the May collar, which gives me more time to adjust the collar (depending on how it looks after earnings) if need be.  With no adjustment, my profit is capped beyond the 125 level (about $1,000 max profit), which is the upper end of the collar, and my losses are capped below the 115 level.

Goldman Sachs has recovered significantly off its low of $47, and in the short term they will probably endure more financial pain.  But two of their competitors have sustained near fatal blows – Bear Stearns and Lehman Brothers.  I say “near fatal” because those organizations have been partly absorbed into other defunct organizations.  In the last month, Goldman has displayed an upward trend of higher lows and higher highs.  The chart could easily be null and void as far as an indicator of whats to come after earnings.  But based on the recent insanity in the markets (investors buying financial companies again), I like the risk/reward of this trade and just executed it for my own account earlier today.

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

For more insights on option collars:

• Portfolio Protection And Adjustments With Stock Option Collars
• Model A Stock Option Collar With Op-Eval Pro Software
• Married Puts, Collars, And Hybrid Hedging
• Bring Your Collar Into These Volatile Markets

For a great book on adjusting option positions:

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

Covered calls are great for reducing  risk in your portfolio, as well as potentially enhancing your returns.  But the amount of protection provided by a covered call is often not enough for today’s insanely volatile markets.  When you need more protection than the covered call will offer you, it’s time to consider the stock option collar.

Where a covered call will LIMIT only your GAIN on an investment, an option collar will LIMIT BOTH YOUR GAIN AND YOUR LOSS.  A covered call is a 2 legged position – shares of an underlying stock in 100 share increments, and the SALE of a CALL OPTION against those shares.   An option collar starts off as a covered call, but adds the PURCHASE of a PUT OPTION for added protection on the downside.

Consider the example below in the geldpress option calculator, which can be downloaded here.  The top section entries (top arrow) is where the option collar simulation starts, with the following criteria shown in the example:

• 100 stock price
• 40 days until option expiration
• Selling a 105 strike covered CALL
• Buying a 95 strike PUT option
• Assumed 1% risk free rate of return and a 45% volatility on the underlying (normal in today’s market)

Notice that the effective cost of implementing an option collar is almost ZERO.  The cost of the PUT option ($359) is essentially financed by SELLING a higher strike covered call ($395).  At expiration, the gains on the stock are capped beyond $105 (the covered CALL strike).  And the losses are capped below $95 (the PUT strike).

The simulation of all three legs (stock, covered call and put) of the option collar are shown above, assuming a stock price drop from $100 to $90, and time to expiration going from 40 days all the way to expiration (left to right).

With the collar in place and 20 days before expiration, and a $10 price drop, here is what happens:

• The loss on the stock position is $1,000 (100 – 90)
• However, the protective PUT gains in value by $326 (685 – 359), And…
• The covered call decreases in value by $362 (395 – 33), But…
• A decrease in a SOLD COVERED CALL is an INCREASE in value to the SELLER (you).
• Despite the $1,000 stock loss, the protective collar limited your loss to only $312

And the real beauty of the option collar is the ability to adjust your position by doing one or more of the following, depending on your trading style:

• Removing the collar and going naked
• Removing a portion of the collar (selling the put, *OR* buying back the covered call)
• Resetting the collar to new strike prices
• Moving the expiration of the option collar legs further out in time

For other ideas on Options Adjustment Techniques, BUY THE FOLLOWING BOOK:

Feel free to download and modify the tool to your liking, but remember, use at your own risk. There are NO guarantees.

Also check out:

• Time for cover – the covered call
• Covered calls – removing the covers and going naked
• Bring Your Collar Into These Volatile Markets
• Married Puts, Collars, And Hybrid Hedging
• Model A Stock Option Collar With Op-Eval Pro Software

For a detailed guide on building OPTION PRICING Applications in Excel, BUY THIS BOOK.

The new stock options book by James Bittman, Trading Options as a Professional, also includes a free copy of the Op-Eval Pro software.  The free software is not as full featured as the many fee based options software packages, but it will do the trick.   The software has 6 main functions for modeling stock option price behavior over time – single option analysis, spread option analysis, Graph view, Table view, portfolio view and distribution view.  The images below are snapshots from the portfolio view.

First, if you are not familiar with stock option collars, go review the following:

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

The first image below is the initial setup of the collar in op-eval pro software, with the following assumptions:

• Initial Greeks:  Risk free rate is 1% and volatility is 45%
• Purchase 100 shares of stock at $100 per share:  $10,000 total
• Purchase a 95 strike PUT 40 days prior to expiration:  Initial purchase price is $359
• Sell a 105 strike CALL 40 days prior to expiration:  Initial premium collection is $395

The second screen below was created in the software by advancing time forward 20 days.  Notice a few things that this free software will show you:

1. The new prices of the PUT and the CALL have been adjusted on the left hand of the screen, based on the new time to expiration:  only 20 days.  The new prices shown are based on an unchanged $100 stock price, but with only 20 days until expiration.
2. The graph on the right side added an extra line.  The original gray line models the profit/loss of the combination of all three positions (stock, put, call) on the initial purchase date, with 40 days left to expiration.
3. The second orange line models the combination after 20 days, with only 20 days left to expiration.
4. As you can see from the orange line, a stock option collar limits both your maximum gain and maximum loss.  At 20 days until expiration, the combined position has a maximum loss of about $450 near an $80 stock price.  The maximum gain is also about $450 at about the $120 stock price.  Note: At expiration, the maximum gain occurs at or above the 105 CALL strike price, and the maximum loss occurs at or below the 95 PUT strike price.  The software allows you to move forward or backward and time from the initial 40 days all the way down to zero days (expiration day), and view the potential profit/loss at each day.

Software Limitations – The software is great for modeling simple positions or combinations through time.  But the profit/loss graphs would be much better if they could be broken down into the various components – stock itself, and each option.  The real power of options comes from the ability to monitor and adjust your options as time goes by.   As an example, consider the possibility that the underlying stock in the example above goes from $100 to $80 in only 5 days.  The stock loses values, but the PUT option and the Covered Call both GAIN MONEY.   At this point, the experienced option trader would analyze the situation and possibly make an adjustment.  One possible adjustment would be to take profits on both the PUT option and the COVERED CALL.  If a quick share price recovery is expected, then you could feasibly wait for the recovery, and then RE-APPLY the COLLAR.   Or, if a recovery in share price is not expected, a new collar could be placed near the new $80 strike price (after taking profits on the first collar components).  These types of scenarios would be very difficult, if not impossible, to model in the Op-Eval Pro software.

Despite the limitations, the Op-Eval Pro software is decent and functional, and for the price (included with the book), you can’t beat it.  It is probably adequate for beginner and intermediate option traders, especially when combined with James Bittman’s book Trading Options as a Professional.  The book is great for option traders at all levels, from beginner to advanced.  It is one of the best organized books I have seen on stock options.  It goes into great and well written detail on the nuts to the bolts of the option market – the fundamentals, the greeks, synthetic relationships, arbitrage, volatility, a few spread systems and strategies, greek neutral trading (Brilliant write-up on this topic), and position risk and money management.

Click below to purchase James Bittman’s new book on options:

Trading Options as a Professional: Techniques for Market Makers and Experienced Traders by James Bittman

For a detailed view on how to better monitor and adjust option positions, then buy the book below with it:

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

Uncertainty remains, the markets are lower and volatility is increasing with this week’s options expiration approaching.  There are several interesting option terms that are often discussed during options expiration week.

Maximum Pain – This is the theory that secuirities will close on expiration day at the strike price that causes the most amount of pain to both call buyers and put buyers.  Surprisingly enough, the point of maximum pain for options buyers is often correlated to the point at which an underlying security will close the option expiration trading day.  For this reason, some traders specifically analyze and set up new option trades around that magical point called maximum pain.  There are several algorithms for computing the maximum pain strike price, but the general idea is to find the highest open interest among the various strikes of calls and puts.  Here is today’s view of the SPY ETF (Models S&P 500) option chain for February.

From the image above, the CALL strike with the highest open interest is at 83.  The PUT strike with the highest open interest is 80.  The highest combined total open interest for both CALL’s and PUT’s is at the 80 strike. (154,591 + 43,277).  By some maximum pain algorithms, the S&P is likely to close on Friday at 800.

Pin Risk – This is the theory that says securities will sometimes close option expiration days very close to an available strike price rather than at some point in between.  On options expiration days, many option traders must face the decision on whether to ROLL their options to subsequent months.  Option sellers (i.e. covered call writers or calendar spread players) face the decision of whether to let out of the money options expire worthless, or buy them back or roll them if they risk closing in the money.    As an example, consider Apple (symbol AAPL) which exhibited an intraday trading range today from 94.28 to 97.04, and closed at 94.53.  The 95 Strike CALL options went from being out of the money to $2.04 in the money, and closed out of the money.  If this were expiration Friday, many option players would have to decide whether to roll options or take a chance that they may close unexpectedly in the money, or even pin near or exactly to a specific strike price.

A hybrid collar option play on Bucyrus was mentioned on Geldpress at this link last week.  The idea was to put a collar around Bucyrus and protect against a potential decline in February earnings.  The Bucyrus collar mentioned was the following:

• Purchase shares in Bucyrus
• Sell March covered CALLS
• Buy February PUTS, for much cheaper than the March covered call premiums.

And the idea was to WAIT on buying the February Puts because of a perceived and imminent decrease in implied volatility.  That’s the “hybrid” portion of the collar – timing the individual components of the option play.

Well, as of today, the protective PUTS on Bucyrus are significantly cheaper than they were after the play was first mentioned.   Take a look at the February 15 PUTS on Bucyrus, which can be had for just $50-$55 (previously $80-$120) per contract as of today.

Disclaimer: Trade at your own risk!