In last week’s article, we learned about "writing" or selling put options.
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A short put strategy offers limited profit potential and unlimited risk.
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Selling a call option, or "writing" an option, can be an extremely risky business.
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Every astute trader and investor knows that before entering any trade, they must first assess their risk. In other words, they must ask themselves, how much can I lose if I am wrong?
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Buying a put option is a welcome alternative to short selling stock.
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Call options are an attractive alternative to buying stock.
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Option pricing is a complex process. There are seven major components that affect the premium of an option.
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Most traders, who begin to look at the wonders of options as a trading instrument, soon learn about this astonishing phenomenon called time decay.
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A covered call trade combines a long stock position with the sale of call options against it.
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Volatility to the option trader is like weather to a race car driver. Race car drivers understand how a race car handles in all weather conditions.
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Uncertainty in the markets seems to be commonplace these days. Investors are not only looking to grow and get a good return on what they have, but they are also anxious to protect it as well.
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I was first attracted to the idea of trading options because of the leverage they offered. I heard that instead of buying the share, I could purchase an option to buy the same share for just a fraction of the cost and still make the same amount of money as if I had owned the share, significantly increasing my return.
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Exchange Traded Options (ETO’s) are one of the most profitable tools available to traders today. They offer traders the ability to leverage positions, manage risk and enhance returns on existing share portfolios.
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Since all markets have the potential to fluctuate beyond their normal trend, it is essential to learn how to use strategies that limit your losses to a manageable amount. There are a variety of options strategies that can be employed to hedge risk and leverage capital. Each strategy has an optimal set of circumstances that will trigger its application in a particular market. Vertical options spreads are basic limited risk strategies and that’s why we tend to introduce them first.
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A bull call spread is a debit spread created by purchasing a lower strike call and selling a higher strike call with the same expiration dates.
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A bull put spread is created by purchasing a lower strike put and selling a higher strike put with the same expiration dates.
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A bear call spread is a credit spread created by purchasing a higher strike call and selling a lower strike call with the same expiration dates. This strategy is best implemented in a high volatility, bearish market and offers both limited profit potential and limited downside risk. Since this is a credit spread, it is best to use options with less than 30 to 45 days till expiration. A bear call spread makes the maximum profit when the short call expires worthless. Therefore, it’s best to choose a short strike price that the underlying stock has a high probability of falling below.
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Investors often experience a progression from the stock market to the world of options trading. In addition, as investors become savvier, the appeal of options increases, but the perceived complexity of these instruments diminishes. Sooner or later, traders realize that options hold various advantages over stocks—their ability to structure different types of risk-rewards, the ability to take relatively small amounts of capital to control a much large amount of capital (a.k.a. leverage), and the ability to trade for profits regardless of market direction. However, although many stock market investors begin to appreciate the flexibility and advantages of options, many also take along with them a bias regarding the stock market. Specifically, there is a tendency for traders to think in terms of market direction: i.e. will this stock or market move higher or lower? But often times, a stock or index will move sideways for a prolonged period of time. In that case, strategies that depend on direction will not yield optimal results and the better approach will require some horizontal thinking.
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Have you ever heard the expression that options are “wasting assets�? Since options suffer from what is known as time decay, with each passing day, the options contract will lose value. Therefore, if a strategist buys a put or call and holds it in their account, even if the underlying stock or index makes no price movement at all, the portfolio will lose value. As a result, options strategists must carefully examine how time is effecting their options positions. This article explains how.
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The CBOE put-to-call ratio is among the more widely watched barometers of market sentiment. The ratio measures the daily trading of puts verses calls on the first and largest US options exchange, Chicago Board Options Exchange [CBOE]. Using the ratio requires a bit of contrarian thinking and a general belief that the crowd (in this case, options traders) is often wrong regarding the direction of the market. In addition, in order to get the most use out of the ratio, it is sometimes helpful to break the ratio down into smaller pieces and focus in on the trading of stock, rather than index, options. Let us see how this is done.
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Successful trading is part science and part art. If you have found a mechanical trading system that works and you are really disciplined, you can simply apply the rules and let the mathematics work. However, if you are like most of us, you will get greedy, get scared, change your mind, decide to tweak the system, etc. In addition, the market will go against even the best of trading systems. This is where most of us get into trouble. When one recognizes that a trade is not working, even following our system, we will want to repair it.
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The stock market has shown much volatility in the past three months, with the major market indices reaching new highs and then falling back down. The reason for this bullishness has been an improvement in economic data and much stronger earnings in the third quarter. However, expectations have become so high that it has been difficult for stocks to reach new highs despite the positive news. In fact, there is a wide range of forecasts for the stock market, with analysts expecting everything from the Dow ($INDU) to reach 11,000 - to a severe drop for the indices. However, another possibility is that the major market indices will consolidate some after such a huge run up in price this year. Thus, we have decided to look at a neutral trading strategy called a butterfly.
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We have been following a mock trade using a butterfly strategy on the Nasdaq 100 Trust (QQQ) this past month and so far it has worked out well. In fact, Wednesday’s trading left the Qs at 34.21, which is just 21-cents above our max profit point. The Naz has performed like we expected, which saw some profit taking while staying in a trading range. Remember, a butterfly is a strategy that benefits from sideways trading in the underlying security. In our case, we entered a slightly bearish butterfly, choosing to use slightly OTM strikes for the body.
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Recently I have had some requests to cover a calendar spread strategy using LEAPS. As a result, we are going to discuss this strategy and enter a mock trade. However, because this is such a long-term strategy, we will only update it when needed instead of our usual weekly instalments. Nonetheless, this strategy is a great way to make profits without needing to watch the stock market on an hourly basis.
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We’ve started a new article series based on long-term calendar spreads. Basically, we are looking at the advantages and disadvantages of using LEAPS (Long Term Equity Anticipation Securities) and selling options against these LEAPS to pay down the cost of the long-term option.
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During the past few months, we have been tracking a long-term diagonal spread on the Nasdaq 100 Trust (QQQ). We are still following this trade, but as it is long term, we have only updated occasionally, normally right before option expiration. However, since we needed to sell a new option for December, we have updated the trade.
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At the Annual Trader’s Conference in 2003 we saw a great presentation from Mike Wade on trading Options with SITM Techniques.
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Following on from last week’s article, this week’s topic is spreads. I am confident in saying that the majority of option traders begin using straight long puts and calls.
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Some time ago, I received an e-mail from a reader complaining that he was not making huge sums of money trading options.
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Beginning and intermediate traders constantly request that I describe the very basic and first step decisions that take place when selecting from the variety of options strategies available.
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As a rule, Australian Exchange Traded Options control 1,000 shares, while US Options control 100 Shares. An example would be $12.00 BHP Call expiring March ’04 on the ASX, which controls 1,000 Shares. If this Option is trading at $0.59 per share, then each contract will be worth $590.
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The great thing about Options is they provide such a flexible trading tool and can be applied to effectively every market condition, except it being closed of course. Then again there is time decay! Their flexibility can be their undoing in some Trader’s eyes due to the complexity that can be involved with having so many variables to manage. The main thing is to start with the basics and build from there.
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“The market does what it does to fool the majority of people the majority of the time�. No doubt this quote or concept will be familiar to many of our readers. While there will be plenty of market participants that have a clear view (right or wrong) as to where the markets as a whole are heading, some may have a foot in both the bull and bear camps currently.
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With all the talk of a potential retracement in the market, those readers with a medium term view on their trading or investments may be looking to cash in their profits.
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You may or may not be surprised to read that the majority of players in the option game have a limited understanding of volatility and what it means to option premiums.
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The compelling attraction of options for most traders has to be the leverage and flexibility. It is this flexibility element that I want to touch on this week. As it is theoretically impossible to develop a trading strategy that is right 100% of the time, there will be times when markets move against us.
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You don’t have to travel far into the option world to hear statistics like “70% of all options expire worthless” bounced around. Does this mean every option that expires worthless is a losing position? Of course not! Having said that, we can use this statistic to our advantage.

Now we all know that selling uncovered options can be very dangerous, especially for beginners. The argument for using naked option strategies is that when using options close to expiry, the premium received coupled with time decay will more than cover for any large movements against the position. While this is true, it is not a trading method for the faint hearted.

Speaking to quite a number of option traders every week gives a good feel for what topics are of interest or importance. One thing I notice with those new to trading options, and some not so new, is that many don’t leave enough time to expiry when opening positions.
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What makes directional option trading strategies a challenging art is not only the fact that the direction of a market’s trend has to be established correctly, the best option or combination of options needs to be found based on expiry date and strike price.
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Most of us sell time in some way, whether it be through our employment or own business. In option trading, strategies that involve profiting in part or completely from selling options are also known as selling time.
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Last week we discussed the pros and cons of covered call writing and the best circumstances to apply the strategy. This week I want to touch more on a topic I have mentioned briefly in previous editions.
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A strategy not widely used in the Australian market is the credit spread. Credit spreads involve the sale of an option and purchase of another option of lesser value to cover it. To construct a bullish credit spread we need to sell a put and buy a put at a lower strike to cover it.
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Many option traders are involved in the market with little or no interest in exercising the options they are trading and/or buying and selling the underlying stock.
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The last few weeks have definitely been eventful with consecutive days of new highs on the SPI 200.
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Following on from last week’s article on XJO options, let’s have a look at some real trades.
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I want to take this opportunity to illustrate the leverage that can be gained from a basic option trade. We have seen renewed excitement in the last week with another all-time high on the SPI 200.
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It is no secret that the majority of options expire worthless and that many successful traders use this fact to their advantage in many of their trades.
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Most of us will agree that having predetermined exit levels for taking profit and minimizing losses is an extremely important part of any trading system.
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The electronic age we live in has caused a massive increase in the ease by which the average investor can get in and out of the market. Many people these days have access to the Internet during the day at work in order to follow their local markets and at home in the evening to follow markets abroad.
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We have covered the idea of portfolio insurance and the pros and cons of strategies like Collars in previous articles. As a good friend recently applied a slight variation of the Collar to one of his existing share trades and in light of the current market conditions, I thought it worth re-visiting them.
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They say repetition is the mother of skill. Well in a slightly difference vein, I want to revisit option exercise and assignment as it seems to be a topic that is often the source of many questions for those starting out in this game.
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Many new students often ask about the effective use of trading spreads over simply buying puts or calls. The argument being, why would you ever want to limit your profit and increase my brokerage? This is a fair point.
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A diversified approach is important in any investment strategy. There are varying levels of diversity from Macro to Micro levels.
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A GAP is a term used to describe when a stock opens at a higher price than it closed. The word GAP refers to the gap that is left in the daily chart, the empty space from yesterdays close to today''s open.
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Using multiple indicators to pick or confirm trades has been proven to be successful in uncertain markets.
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Let''s say its two weeks before the election and we''re not sure which party is going to be elected, but at the same time you''re thinking that if Mr Howard is re-elected Macquarie Bank will be very strong and break the double top that has formed.
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As you may know, I have written a number of articles on GAPS recently. As there are often many ways to interpret and trade the same data, so I thought it would be of value to offer a slightly different perspective.
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As uncertainty in the marketplace increases, the price for options usually increases as well.
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Many would be familiar with the calendar spread – a strategy designed to profit from sideways trending and range-bound markets.
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On the 28th of October a strangle on eBay could have been entered by purchasing a 37.50 put and 40 call for a debit of $410.
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Quite often the simplest of technical analysis techniques are pushed to the back of our minds to make way for the more complex methods.
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OneSteel (OST) has been one of the strong performers during the recent commodities bull run.
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In Trading Tutors Newsletter #133 I wrote about an options strategy called the strangle.
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In Trading Tutors Issue #135 I wrote about how the use of the most basic technical indicators
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Two weeks ago in the Trading Tutors Newsletter #143 I wrote an article on how to combine the use of the Fibonacci retracement tool and simple trend lines to identify bullish set-ups.
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In options trading there are four variables, termed the ‘Greeks’. They consist of delta, gamma, theta and vega.
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In Trading Tutors Issue #147 3 March 2006 I introduced the Greeks to you.
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Options are one of the more complex derivatives available to traders. There are several variables that form the pricing of an option. It is important that option traders understand each of the main variables.
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Traders can forecast that stocks will move up, down or sideways. By trading options, money can be made when the price of the underlying stock or asset moves in any forecast direction.
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TTN issue #154 I explained the various components that go into the pricing of an option using the Black-Scholes Options Pricing Model.
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The past week and a half has seen markets around the world retrace from their recent highs. Many markets, including the Australian All Ordinaries (XAO) have passed through the first level of support without hesitation. Will this retracement continue, becoming the start of a bear market?
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There are two types of options - calls and puts. These can be bought and sold by traders. In this article I am going to go back to basics and explain how a call works using an analogy far from the financial markets.
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In Trading Tutors Newsletter #159 I used an analogy away from the markets to explain the concept of a call option. Based on this it is quite appropriate to write about a current long setup where trading a straight call offers an attractive ‘reward to risk’ ratio.
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A basic calendar spread is buying a long term option and selling a shorter term option both using the same strike prices.
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The next two articles will focus on a very important and often misunderstood concept by the novice in the world of options trading.
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Part 2 of this series will focus on the converse being Volatility Crush and how this impacts an option’s premium.
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Last week I returned from holidays where I explored Central and Eastern Europe. Whilst away I discovered two areas synonymous to trading which I will share with you.
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When trading options using software, it is very important to understand the “picture� and how the risk graph was created.
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On average, September is the worst performing month of the year in the share markets. Investors and traders exposed to downside movements may want to consider taking out ‘insurance’ on their portfolio with long put options.
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Sound risk management is paramount to being a successful trader. The best way to ensure this is being practiced is through the construction of a trading plan before the trade is entered.
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Ever wondered why a stock chart suddenly jumps up and then trades sideways? Ever tried to place a sideways options strategy on this type of chart and found the trade made no money?
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How about a strategy that allows you to make money when your forecast in direction is incorrect? The ratio backspread is an options strategy that allows this to occur.
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Have you ever been in the situation where you owned shares in a company and saw a nice profit turn into a loss? Have you been worried about the share market falling?
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The Volatility Index (VIX) on the Chicago Board of Options Exchange (CBOE) is commonly known as the ‘fear gauge’ for the US stock market.
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Have you ever seen a stock moving sideways for what seems like an eternity? Can you set up a long term trade that can take advantage of this type of movement?
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Have you ever noticed that some stocks consistently make substantial moves upon earnings announcements? If you have a stake in a company characterized by this, the earnings period can be a time of increased anxiety.
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I know we’ve all felt like strangling a stock at some stage, but this article is referring to the options trade! Have you ever watched a company for a period of time and noticed certain patterns repeating in behaviour?
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Ever gazed at an options chain and wondered, "Which one should I choose?" There are literally dozens and dozens of options available for most optionable stocks.
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Starting out a new year is an opportunity to reflect on the trading year gone by. It is a time to sit back and think about what things have been working well and what things could have been done better.
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The percent to double figure is very important as it informs the trader how far a stock would have to move for their option to double in value.
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It is a well known fact that options can be used to control risk and reduce the overall cost basis when compared to owning stock.
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A commonly traded strategy of newbies to the options world is the vertical debit spread.
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There have been a lot of questions lately from students on how to analyse the risk of a trade.
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For US options traders 2007 is going to be a great year! Why? Recent law changes to margin by the Securities and Exchange Commission is going to revolutionize the flexibility that options offer.
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Those who are new to options trading generally find the concept of Implied Volatility (IV) a little difficult to grasp.
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BHP is a stock that has had a wonderful run of late. Wouldn’t it be nice to lock in the gains of the current upward move while removing the downside risk associated with volatility?
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In last week’s TTN Oscar Lee wrote an article that explained how upside gains can be locked in through purchasing a put option.
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In options trading there are four variables, termed the ‘Greeks’. They consist of Delta, Gamma, Theta and Vega.
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The dramatic falls in the past few weeks in global stock markets has caused option implied volatility (IV) to increase.
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Rupert Murdoch’s News Corp is the world’s largest media empire. The ticker symbol on both the ASX and NYSE is NWS. In this article I am going to focus on the ASX price action, provide some basic technical analysis and use options to take advantage of a move should it eventuate.
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Apple Inc (AAPL on the US NASDAQ) is a very popular stock with a well known brand name.
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Autodesk Inc. is a software development company that is listed on the Nasdaq Stock Exchange under the ticker symbol ADSK.
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After presenting the first of the Safety in the Market Module – One Day Profitsource Workshops in Melbourne recently, it has become apparent that some of our SITM students incorporate other technical methods to view charts.
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The DOW had recorded its twenty-first record day for the year by Wednesday night.
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In my article titled “Is The Apple Green?” at the end of March this year, I wrote about the potential upside in Apple Inc (AAPL:NASD).
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In the past two Trading Tactics newsletters, I have written about a strangle on News Corp (NWS on ASX) and a calendar spread on Autodesk (ADSK on NASD).
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Is the resource boom over in the Australian market? The press is full of stories saying strong Chinese demand for raw materials will drive the prices of commodities up forever!
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A true trader never stops learning and understands that market wisdom comes from many voices.
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Welcome to the second part of my series of articles on the Credit spread.
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