Archive for the 'calls and puts' Category
A couple of posts back I pointed out how critical it was that if we are to learn how to trade options profitably, then we must “manage by the numbers” and trade as a business. I also introduced you to the Greeks, which I went on to explain are the numbers you need to know in order to manage your portfolio of trades profitably.
Delta you may recall measures the change which occurs in an option’s value and Gamma measures the change of an option’s Delta.
Today we move on to explore another of the Greeks, Theta and in my next post we will wrap up the Greeks with a look at all important Vega and also touch briefly on Ro.
I have just set up new positions for the month of April, and so I will explain these in the light of two of these new positions I have on the IWM index.
As time approaches expiration, the option you have acquired is losing value on a daily basis. Theta is a measurement of that loss in value. The types of positions which we will be looking to put on with the Trading Pro (previously OptionSphere) program are all Theta positive positions. With an option losing value more quickly as it approaches expiration we see this reflected as an increase in the size of Theta. The nearer we get to expiration the greater the increase in size of Theta.
So .. back to the IWM position which I put on a couple of days back. This shows a Delta of -1.49 and a Gamma of -7.11 (both pretty neutral positions) and a Theta of 4.46. So, provided the price remains within a certain range this means that I should be collecting on average $4.46 for every single day I am holding this position through to expiration. The reality is though that price is usually constantly changing and so Theta and the other variables will change along with it. The higher we find Theta then the better it is for us, because that is how we make money when we are trading options.
Now, it goes without saying that you don’t want to find yourself in the position where you have negative Theta. For example, if the above was -$4.46 then this is the amount of money on average I would be losing each day and this loss would become even greater the closer I got to the strike price of the option I’m buying.
Now, in the case of the IWM position I had put on two positions using a double calendar spread. I had purchased a 45 call and a 39 put in the the month of May with the sale of the same in the front month of April. So, in making my selection, to ensure that I did not find myself in a loss situation I had to be absolutely correct with regards both timing and direction. Now, as I say .. almost certainly the price is going to bounce around a bit and I may well find myself having to adjust my positions. But that is no big deal .. and after all .. it’s all part of the art and science of knowing how to trade options with confidence.
Well .. you could be forgiven for wondering about the unusual title for this blog post. But you may recall in the last post I warned of the dangers of selling an option whether a call or a put, unprotected. The term for that is naked. Hence me varying the usual title of ‘how to trade options …”
For example, lets say I make the rather foolish ploy of selling a call option, assuming I am allowed to do this. The reality is that short of exceptional circumstances, I would not be permitted to do so. But .. as a theoretical example… Yes .. the potential exists to make a very good profit if the price goes down (remember I sell a call option in the expectation that the share price will drop below the strike price) but in the event of it swinging the other way .. I stand to incur literally unlimited loss .. why would I dare want to go there? Same thing applies on the puts side when the price moves in the opposite direction.
The secret is to hedge your ‘bets’. And that is done by placing ‘covered’ positions known as spreads. Remember that the share price cannot be in two places at the same time. So, if the intention is to sell a call option, such as was the case with the May 120 call illustrated in my last post, you would protect this with the purchase of another call at a slightly higher strike price (say a May 125 call). You sell the May 120 call on the basis that you expect the share price to go down but you purchase the May 125 call to ‘hedge your bet’ just in case the share price goes up. Because the share price cannot be in both places at once you will always be in profit on one side of the transaction. Yes, overall you may sustain a loss, but it will be much less than if you had sold the option contract naked. And .. the potential still exists to make a very healthy profit. Exactly the same thing applies on the puts side.
With the OptionSphere course we place spreads for both calls and puts, thus ensuring the best possible starting point for setting up our positions. Remembering thought the two inviolate rules of the market place that options and their underlying shares go up and go down and that they expire, the chances are that at least with some of our spreads we will need to make adjustments .. to bring our positions back into line. More about that shortly.
These vertical spreads form the basis for how we go about trading as a business. Specifically, although not exclusively, our focus will be on the sale of Iron Condors (two vertical spreads – one with calls, the other with puts) and the purchase of Double Calendar spreads (the purchase of a call and put in the ‘front’ month together with the sale of same in a subsequent month). Other types of spreads occasionally used .. Single Vertical Spreads (more often than not with adjustments) and Straddles with Protected Wings. It is not important that you try and remember these terms right now though, just know that with whichever spread chosen there is a strategy in mind.
This multidimensional and multidirectional approach to options trading, ensures that we trade with minimal risk at all times, that we know the extent of that risk before we go ahead and put the position on, and it ensures that we learn how to trade options with confidence. Next post? An introduction to the Greeks!
Wow . . second time round. The last post I put up with this title mysteriously ‘disappeared’. I am mystified! This may be a little thinner on content, but I promise you that you will be none the worse for it. You will see that as this blog unfolds I will have plenty more to share with you on how to trade options as a business.
But first off .. just what is an option? Essentially it is a contract which gives the purchaser the right (but not the obligation) to acquire shares at a given price (known as the strike price) any time up until the expiry date of the option. For the most part, traders do not bother to exercise this right, preferring instead to gain greater leverage on any movement in the share price, by trading the option contract itself.
Integral to options trading are two terms which we need to get to grips with. Calls and puts.
Lets take some examples to better explain the nature of calls and puts. I buy say a March 125 call (strike price $125) which expires in the 3rd week of March. The current price of the underlying shares is $124.25. I do this because I believe the shares will go up.
If they go up to say 135, then that 125 call has just become that much more valuable. I can sell it and pocket the premium – or I can go in and buy the shares at 125 and immediately flick them off for 135, pocketing the profit. But note .. any profit I receive is of course reduced by the price I paid for the call.
If the price goes down .. I will have a loss.
If I sell say a May 120 call, then I am immediately credited with the premium which I get to keep if the shares go down below 120, before expiry date. In other words I am selling these on the basis I expect the share price to go down. The premium is ‘credited’ to me and that will always be the maximum profit I can receive on that trade.
If the shares go up, I can have an unlimited loss. Do not be concerned on reading that, because in practice you will never sell an option without protecting yourself .. in the same way that you might hedge a bet at the races. More about that in the next post I put up.
Now, lets look at the scenario where I buy a March 85 put, also expiring in the 3rd week of March. The current price is $87.62. I do this because I believe the shares will go down. If they go down to below 85 .. the contract has now become that much more valuable and I can make an unlimited max profit . Wow! Whoopee, I hear you say! But as with the call, any profit I make has to be reduced by the price I paid for the put.
If the shares on the other hand go up, I incur a loss.
Should I sell a Mar 90 put, let’s say current share price is $86.55, I do this because I believe the shares will go up in value. Should the shares go up beyond $90 I make a profit, (the premium credited to me) and if they go down bear an unlimited loss. But as I said before .. don’t freak out on reading that. Easily remedied!
Next up I will explain how to trade options as a business by placing on spreads rather than individual positions and the reasons we do this, cover some of the types of spreads we are using with this program and why you must never sell an option unprotected, or “naked”. I will also update you on how my own positions are holding up.