Hedging Options » Options Trading Strategies

The Effects of Volatility on the Time Spread When Trading Options

admin — Sat, 09 Jan 2010 18:57:15 +0000

When purchasing a time spread, the investor should pay attention not only to the movement of the stock price but especially to the movement of volatility.
Volatility plays a very large roll in the price of a time spread and, as we have stated, the time spread is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.
Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads. Let’s start with option volatility.
An option’s volatility component is measured by a term called vega. Vega, one of the components of the pricing model, measures how much an option’s price will change with a one point (or tick) change in implied volatility. Based on present data, the pricing model assigns the vega for each option at different strikes, different months and different prices of the stock.
Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick). Remember, vega is given in dollars per one tick volatility change.
As we continue to discuss vega, keep these facts in mind
1. Vega measures how much an option price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at the money options.
4. Vega is a strike-based number – it applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.
It is important to note that an option’s volatility sensitivity increases with more time to expiration. That is, further out-month options have higher vegas than the vegas of the near term options. The further out you go over time, the higher the vegas become.
Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that vega values increase as you move out over future months.
The at-the-money strike in any month will have the highest vega. As you move away from the at-the-money strike, in either direction, the vega values decrease and continue to decrease the further away you get from the at-the-money strike.
Remember, vega (an option’s volatility component value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike. The chart below shows vega values for QCOM options.
As you look at the chart observe the important elements: the stock price is constant at 68.5; volatility is constant at 40; time progresses from June to January; and finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time. Also notice how the value decreases as you move away from the at-the-money strike.
Another important fact about vega is that it is a strike-based number. That means that the vega number does not differentiate between put and call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. So, the vega number of a call and its corresponding put are identical.

Options Seller Risk/Reward

admin — Fri, 08 Jan 2010 20:25:24 +0000

The seller of a time spread buys the nearer month option and sells the outer-month option in a one to one ratio.
In order to profit from the sale of the time spread, the seller is looking basically for two things.
First is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.
Second, the stock can move. As stated before, a time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. So, as long as the stock moves in either direction away from the strike, the seller’s position could be profitable provided that time decay does not outperform the stock movement.
Time, unfortunately, never works in favor of the time-spread seller. The passage of time hurts the seller because the nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value. That obviously produces a loss for the time spread seller. Time can neither be stopped nor turned back. It only moves forward which always hurts the time spread seller.
Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long) due to the out month option’s higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.
The seller, in theory, has an unlimited loss potential. For the seller, the maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out- month call. As we know, the out month call will be more sensitive to movements in implied volatility due to a higher vega or volatility sensitivity component. If implied volatility increases then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.
The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, he/she will be left short a naked or un-hedged option and a loss on the position. If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured. As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.
Once the long option expires and the seller is left short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem. While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they probably will not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

How to Trade Options â Diversified Trading Stock Options but Still Suffering Concentration Risk

admin — Sat, 19 Dec 2009 20:27:01 +0000

Applying a more complete definition of diversification can help retail option traders diversify their portfolio profitably, beyond equities.A buddy started online options trading from home, in the last 6 months. He was trading a mix of Verticals, Calendars and Iron Condors using highly liquid Indexes but was failing to get consistent profits.Â Naturally, I asked, âWhich Indexes?âHe answered, âDJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP.Â Iâve incorporated broad-based Indexing across large, mid and small-cap stocks to remove single stock exposure.Â Having learnt how to trade options with Verticals, Calendars and Iron Condors, Iâm spreading across these various Indexes. Iâm being careful with money management, 2%-5% per trade, Iâve diversified risk, yes?âNo. He has partially diversified a portion within his portfolio; but, is still suffering concentration risk.Â All he has really done is allocate capital across multiple products, using various option spread types; yet, all his trading capital is stuck in equities.In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes.Â Bear in mind the MNX and the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index.Â Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP – both the SPY and the XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled.Â Duplication is not diversification.Â Even if you allocated capital to the smaller versions of the Dow: DJX, the European style cash settled version of the DIA which is the American style stock settled version.Â Moreover, if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and away from large-caps, you just sunk more of your trading capital into equities.Â Again, you cannot achieve diversification by adding more capital in the same asset class.Â That is concentration risk in stocks. Do not confuse asset category (market capitalization) with asset class.Why bother diversifying across Asset Classes? To answer this question, Iâll use an example of a well known traded stock:Â Apple (AAPL).Â You wonât need to understand Fundamental Analysis to follow the reasoning.Summarizing a financial extract from its Annual Report, Apple has almost ~30% of its Net Sales distributed across: UK, France, Germany, Spain & Ireland and Japan.Â Appleâs customers in Europe are paying in EUR/GBP and customers in Japan will be paying in JPY.Â Even though you are trading Apple directly as a US parented firm listed in the US and the currency of the parent is USD denominated, the company has currency exposure to the EUR/GBP and JPY arising from operating sales entities in those jurisdictions.Â So, you are already exposed to currency and geographic risks by choosing Apple as a product to trade, even though you are constructing an option trade on the stock.So, it makes sense, rather than have these exposures wrapped inside the stock, where you are subordinating non-equity risks to the stock, to deliberately surface the risks in Geography, Commodities and Currencies.Â Then, isolate these elements and trade them directly using optionable Geographic ETFs, Commodity ETFs and Currency ETFs.Is there an example of a consistently profitable and diversified portfolio to see the merits of trading options beyond equities? Yes.Â Follow the link below, entitled âConsistent Resultsâ to learn how to trade options using a multi-asset class set up.Â Notice how the profits step up gradually, from the mid hundreds to the higher hundreds; then, from the higher hundreds into the thousands.Â While, the losses are contained within the mid to lower hundreds.Â Diversification to trade options in non-stock asset classes using Geographic ETFs, Commodity ETFs and Currency ETFs, deliberately dilutes the concentration risk in the portfolioâs P/L.If you are puzzled, yet intrigued, you may well ask, âI donât need to Beta-weight the Deltas of my option positions; then, hedge using Futures?Â Do I need to adjust my existing positions by embedding single options; or, morph the original spread into a hybrid option strategy?âNo, is the answer to both questions. Just as it would not make sense within stocks to say Beta-weight a company like GE to the SMH (Semiconductors Holdrs), there is even less sense to Beta-weight a broad-based Index like the SPY to an Emerging Market ETF, Commodity ETF or Currency ETF.Â Diversification is designed to break the commonality in correlation between the asset price movements of products, in the retail traderâs portfolio structured for online options trading.Â Adjustments fail to provide the consistency in laddering up the profits as seen in the portfolio, because an adjusted trade often fails to restore, let alone improve the original profile of the tradeâs volatility and probability that was bought or sold.How is this possible? Volatility can be added to/reduced from the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or, ALL at the same rate. It is the volatility level across various asset classes that is targeted for diversification.To conclude, hereâs the point to reflect on.Â While diversification alone does not guarantee a profitable portfolio, do you think you are diversified trading stock options but still suffering concentration risk? Think deeper.

Options Trading Strategies â Intermarket Analysis in Brief for Retail Asset Allocation

admin — Tue, 15 Dec 2009 18:55:22 +0000

If you are trading a mix of Verticals, Calendars and Iron Condors across highly liquid indexes like the DJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP, is your trading risk adequately diversified? No.In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes.Â Bear in mind the MNX and the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index.Â Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP – both the SPY and the XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled.Â Duplication is not diversification.Â Even if you allocated capital to the smaller versions of the Dow: DJX, the European style cash settled version of the DIA which is the American style stock settled version.Â Moreover, if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and away from large-caps, you just sunk more of your trading capital into equities.Â Again, you cannot achieve diversification by adding more capital in the same asset class.Â You need to learn how to trade options without concentration risk in stocks.Â Do not confuse asset category (market capitalization) with asset class.This is where there is a need to understand Intermarket relationships.Â Intermarket analysis requires the simultaneous analysis of 4 main Asset Classes: Currencies (U.S. Dollar remains most liquid of all major traded currencies), Commodities, Bonds and Stocks.Â Synchronizing the rotation of asset allocation within your own portfolio lies in getting a grip on how these four markets interrelate with each other.Hereâs the synopsis of the relationships.Â Commodities lead bonds, bonds lead stocks and stocks lead commodities.Â The cycle holds true at least in a normal inflationary/disinflationary environment.Â Other than itself, Commodities affects 2 markets (Bonds and Stocks); effectively, impacting 3 out of the 4 Intermarket relationships.Â Even if you do not trade Commodity ETFs as part of your portfolio, you need to track Commodities as a leading economic cycle indicator.Â The futures/Mini Futures that you see on news headlines/trading screens are relevant only as daily gauges for stock market behaviour.Â They are not a cycle indicator across Asset Classes.So, you may already understand the criteria to define a “normal” economic cycle for the Directional Relationships to behave “ideally” (see below); BUT, how do you determine which Asset Class is driving the cycle? In other words, at a given point in the Intermarket cycle, how do you determine which Asset Class has the DOMINANT Relative Strength to trade? Follow the link below for a video-based course, to learn how Relative Strength – a rotational algorithmic measure is used to replace conventional Fundamental Analysis, as an asset allocation technique.Moving on, hereâs the Business Cycle in brief.Â Bonds lead stocks, to trend in the same direction â except during deflation when bonds rise and stocks fall.Â On average bonds are 18 months ahead of stocks in rising to their peak or falling to their bottoms; thereafter, stocks follow in the same direction.Â If bonds have not broken down yet, this extends the gains in the stock market, acting as support for prevailing stock market levels.Â The real risk begins to build 5-7 months after the bond market peaks or bottoms, thereafter the next 6 months stocks accelerate in the direction bonds have set.Typically, commodities and bonds have an inverse relationship: as commodities rise, bonds falls but as commodities fall, bonds rise. Inflationary expectations affect bond prices. US Dollar movements which is tied into Monetary Policy changes affects commodity prices.Â Commodities lead bonds 12â18 months in advance (it takes this long for Monetary Policy to come into effect) and 24â27 months before the economy fully absorbs the policy changes.Now, the relationship between commodities and stocks. Stocks tend to lead commodities. Commodities are a hedge against inflation, with price inflation and higher inflation expectations occurring towards the end of the business cycle.Money and company growth using credit (loans) takes time to make its way through the economic system, from making prices rise to raising expectations on inflation. Thus, commodities usually outperform at the end of the business cycle.Rising bond prices generally raise stock prices in recovery, with falling commodity prices confirming an economic expansion phase is in play. As the expansion matures and begins to decelerate, watch for bonds to turn down first (as interest rates rise), followed by stocks.Finally, it is after commodities outperform stocks and start turning down, this signals the end of an economic expansion with the probable start of activity decelerating, then slipping into an impending recession.Retail traders can keep reading about the economics of interâmarket analysis and asset diversification. Though, they will not solve these key issues, every option trader trading with USD $25-$50K or less, must deal with for retail asset allocation purposes:

… if you can afford to diversify …

Where can I learn how to trade options profitably using Intermarket analysis with retail asset allocation methods? Follow the link below, entitled âConsistent Resultsâ to see a profitable retail option traderâs portfolio that is set up to cycle in and cycle out of Intermarket relationships, between asset classes.Why is it possible? Iâm using optionable ETFs (Commodity, Currency, Emerging Market and REIT), as well as optionable broad based/sector Equity Indexes, to trade the volatilities of each respective asset class. I do not need to trade Commodities and Currencies directly.Â Remember, volatility can be added to/reduced from the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or, ALL at the same rate.

Options Trading Strategies – Book Review – Sheldon Natenberg, Option Volatility and Pricing

admin — Tue, 15 Dec 2009 10:24:23 +0000

As with most books on the topic of how to trade options, the amount of material to get through can be daunting. For example, with Sheldon Natenberg’s Option Volatility & Pricing, it is about 418 pages to digest. There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number. The percentages represent how much each chapter makes up of the 418 pages in total, excluding appendices.1 The Language of Options. 12, 2.87%.2 Elementary Strategies. 22, 5.26%.3 Introduction to Theoretical Pricing Models. 16, 3.83%.4 Volatility. 30, 7.18%.5 Using an Option’s Theoretical Value. 14, 3.35%.6 Option Values and Changing Market Conditions. 32, 7.66%.7 Introduction to Spreading. 10, 2.39%.8 Volatility Spreads. 36, 8.61%.9 Risk Considerations. 26, 6.22%.10 Bull and Bear Spreads. 14, 3.35%.11 Option Arbitrage. 28, 6.70%.12 Early Exercise of American Options. 16, 3.83%.13 Hedging with Options. 16, 3.83%.14 Volatility Revisited. 28, 6.70%.15 Stock Index Futures and Options. 30, 7.18%.16 Intermarket Spreading. 22, 5.26%.17 Position Analysis. 32, 7.66%.18 Models and the Real World. 34, 8.13%.Focus on chapters 4, 6, 8, 9, 11, 14, 15, 17 and 18, which makes up about 66% of the book. These chapters are relevant for practical trading purposes. Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective.4 Volatility. Volatility as a measure of speed in context of price in/stability for a given product in a particular market. Despite its shortcomings, the definition of volatility still defaults to these assumptions of the Black-Scholes Model: 1. Price changes of a product remain random and cannot be engineered, making it impossible to predict price direction prior to its movement. 2. Percent changes in the product’s price are normally distributed. 3. As the product’s price percent changes are counted as continuously compounded, the product’s price on expiry will become lognormally distributed. 4. The lognormal distribution’s mean (mean reversion) is to be found in the product’s forward price.6 Option Values and Changing Market Conditions. Use of Delta in its 3 equivalent forms: Rate of Change, Hedge Ratio & Theoretical Equivalent of the Position. Treatment of Gamma as an option’s curvature to explain the opposite relationship of OTM/ITM strikes to the ATM strike having the highest Gamma. Dealing with the Theta-Gamma inverse relationship, as well as Theta being intertwined synthetically as long decay and short premium with Implied Volatility, as measured by Vega.8 Volatility Spreads. Emphasis is on the sensitivities of a Ratio Back Spread, Ratio Vertical Spread, Straddle/Strangle, Butterfly, Calendar, and Diagonal to Interest Rates, Dividends and the 4 Greeks with specific attention on the effects of Gamma and Vega.9 Risk Considerations. A sobering reminder to select spreads with the lowest aggregate risk spread versus the highest probability of profit. Aggregate Risk as measured in terms of Delta (Directional Risk), Gamma (Curvature Risk), Theta (Decay/Premium Risk) and Vega (Volatility Risk).11 Option Arbitrage. Synthetic positions are explained in terms of manufacturing an equivalent risk profile of the original spread, using a mix of single options, other spreads and the underlying product. Clear caution that transforming trades into Conversions, Reversals and Adjustments are not risk-free; but, may raise the trade’s nearer-term risks even though the longer-term net risk is lowered. There are material differences in the cash flows of being long options versus short options, arising from the Skew bias unique to a product and the interest rate built into Calls making them disparate against Puts.14 Volatility Revisited. Different expiry cycles between near-term versus longer-term options creates a longer-term volatility average, a mean volatility. When volatility rises above its mean, there is relative certainty that it will revert to its mean. Likewise, mean reversion is highly likely as volatility drops below its mean. Gyration around the mean is an identifiable characteristic. Discernible volatility traits make it essential to forecast volatility in 30 day periods: 30-60-90-120 days, give the typical term to be short credit spreads between 30-45 and long debit spreads between 90-120 days. Reconciling Implied Volatility as a measure of consensus volatility of all buyer/sellers for a given product, with inconsistencies in Historical Volatility and predictive constraints of Future Volatility.15 Stock Index Futures and Options. Effective use of Indexing to remove single stock risk. Distinct treatment of the risks for stock-settled Indexes (including impact of dividend/exercise) separate from cash-settled Indices (absent of dividend/exercise). Explains logic for Theoretically Pricing the options on Stock Index Futures, in addition to pricing the Futures contract itself, to determine which is economically viable to trade – the Futures contract itself or the options on the Futures.17 Position Analysis. A more robust method than just eye balling the Delta, Gamma, Vega and Theta of a position is to use the relevant Theoretical Pricing model (Bjerksund-Stensland, Black-Scholes, Binomial) to scenario test for changes in dates (daily/weekly) before expiration, % changes in Implied Volatility and price changes within and near +/- 1 Standard Deviation. These factors feeding the scenario tests, once graphed, reveal the relative ratios of Delta/Gamma/Vega/Theta risks in terms of their proportionality impacting the Theoretical Price of specific strikes making up the construction of a spread.18 Models and the Real World. Addresses the weaknesses of these core assumptions used in a traditional pricing model: 1. Markets are not frictionless: buying/selling an underlying contract has restrictions in terms of tax implications, limitation on funding and transaction costs. 2. Interest rates are variable, not constant over the option’s life. 3. Volatilty is variable, not constant over the options’ life. 4. Trading is not continous 24/7 – there are exchange holidays resulting in gaps in price changes. 5. Volatility is linked to Theoretical Price of the underlying contract, not independent of it. 6. Percentage of price changes in an underlying contract does not result in a lognormal distribution of underlying prices at distribution due to Skew & Kurtosis.To conclude, reading these chapters is not academic. Understanding techniques discussed in the chapters must enable you to answer the following key questions. In the total inventory of your trading account, if you are …

Options Trading Mastery: Effects of Volatility on the Time Spread

admin — Mon, 14 Dec 2009 19:48:45 +0000

When purchasing a time spread, the investor should pay attention to not only the movement of the stock price, but also the movement of volatility. It plays a very large roll in the price of a time spread, which is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.
Option Volatility
Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads. Let us start with option volatility.
We measure an option’s volatility component by a term called Vega. Vega, one of the components of the pricing model, measures how much an option’s price will change with a one-point (or tick) change in implied volatility. Based on present data, the pricing model assigns the Vega for each option at different strikes, different months and different prices of the stock.
Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 Vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick).
Keep these facts in mind as we continue to discuss Vega:
1. Vega measures how much an option price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at-the-money options.
4. Vega is a strike-based number. It applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.
It is important to note that an option’s volatility sensitivity increases with more time to expiration. Further out-month options have higher Vegas than the Vegas of the near term options. The further out you go over time, the higher the Vegas become. Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that Vega values increase as you move out over future months.
The at-the-money strike in any month will have the highest Vega. As you move away from the at-the-money strike in either direction, the Vega values decrease and continue to decrease the further away you get from the at-the-money strike. Remember, Vega (an option’s volatility component value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike.
The chart below shows Vega values for QCOM options. Observe the important elements. The stock price is constant at 68.5. Volatility is constant at 40. Time progresses from June to January. Finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time and how the value decreases as you move away from the at-the-money strike.
Chart 3- Vega
Stock Price 68.5 Vol. 40
Strike June July October January
50 0 .008 .064 .114
55 .004 .030 .102 .153
60 .023 .063 .135 .184
65 .053 .090 .157 .205
70 .056 .094 .165 .215
75 .032 .077 .154 .213
80 .011 .052 .142 .203
Another important fact about Vega is that it is a strike-based number. This means that the Vega number does not differentiate between put and call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. Therefore, the Vega number of a call and its corresponding put are identical.
The chart below shows the Vega values for calls and the corresponding puts. As you can see, these values match up in every instance.
Chart 6
Strike Price-Call Vega-Put Vega
June
60 .023 .023
65 .053 .053
70 .056 .056
July
60 .063 .063
65 .090 .090
70 .094 .094
October
60 .135 .135
65 .157 .157
70 .165 .165
January
60 .184 .184
65 .205 .205
70 .215 .215
Vega can also calculate how much a specific option’s price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved. Multiply that number times the Vega and either add it (if volatility increased) to the option’s present value or subtract it (if volatility decreased) from the option’s present value to obtain the option’s new value under the new volatility assumption. The calculation works on individual options and can analyze the value of the time spread.
Apply Vega to Time Spreads
Now, let us apply the concepts of Vega to the Time Spread. When you apply the Vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher Vega will increase more than the closer month option with the lower Vega. That widens or increases the spread.
The chart below shows a time spread and its reaction to increasing volatility. Each time that implied volatility increases, the value of the time spreads increase. This increase would naturally favor the buyer.
Chart 4
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 30 1.09 2.09
65.5 40 1.43 2.75
65.5 50 1.77 3.41
65.5 60 2.11 4.05
65.5 70 2.49 4.60
If an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.
Of course, the Vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher Vega will lose value more quickly than will the nearer month option with its lower Vega. In the chart below, you will see how decreasing volatility affects the time spread’s value.
Chart 5
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 70 2.49 4.60
65.5 60 2.11 4.05
65.5 50 1.77 3.41
65.5 40 1.43 2.75
65.5 30 1.09 2.09
Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.
We discussed how to use Vega to calculate an option’s price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult.

Options Trading Lesson: Seller Risk & Reward

admin — Mon, 14 Dec 2009 07:27:34 +0000

The seller of a time spread buys the nearer month option and sells the outer-month option in a one-to-one ratio. To profit from the sale of the time spread, the seller must look for two things.
The first is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher Vega in the out month option. This will cause the spread to contract or lose value and will be profitable for the time spread seller.
The second thing a seller should look for is a movement in stock. A time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. As long as the stock moves in either direction away from the strike, the seller’s position could be profitable if time decay does not outperform the stock movement.
Time, unfortunately, never works in favor of the time-spread seller. The nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value, which produces a loss for the time spread seller.
Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long). This is due to the out month option’s higher Vega which creates an expansion in the spread and increases its value resulting in a negative for the spread seller.
The seller, in theory, has an unlimited loss potential. The maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out-month call.
The out month call will be more sensitive to movements in implied volatility due to a higher Vega or volatility sensitivity component. If implied volatility increases, then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value – a negative for the seller.
The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, (s)he will be left short a naked or un-hedged option and a loss on the position.
If the seller can wait out the position, the lost extrinsic value of the short option is retainable. This option also has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.
Once the long option expires leaving the seller short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem.
While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they will probably not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case, the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

Options Trading Lesson: Closing the Time Spread Position

admin — Sun, 13 Dec 2009 22:38:16 +0000

It is important to remember that the time spread will leave you with several potential positions that can be altered by other options or stock in numerous ways.
There are a number of decisions you must make to clarify your understanding and goals. Being open to a number decisions can be a very good thing for the flexibility of your position, whether entering or exiting trades. In this example we’ll look at the position you have and the ways you can make your decisions.
First, it is important to understand what position you are going to be left with when the near-month option expires.
Second, you must form your opinion of what you think the stock is going to do (formulate a bullish or bearish lean) and then figure out the best way to take advantage of that opinion.
Next, you must figure out how to adjust your present position and change it into an advantageous position for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.
It is also important to note that you should make sure to go from a hedged position to another hedged position to ensure proper risk management.
Concluding Thoughts
The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is best used in stagnant periods when a stock is likely to remain in a tight price range. It is less expensive and less risky than most other premium collecting strategies thus is friendlier to investors who are short on capital and experience. It can also be used to take advantage of volatility changes and even some directional stock movements.
The time spread can leave you with a residual naked position that needs to be managed for risk at expiration of the front month option. As always, it is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before executing the strategy. Don’t take this too lightly.
The residual position does allow you many choices including closing out the position totally, or continuing the position by combining it with either stock or another option to create a new position that fits the investor’s new expectations for the stock.

Options Trading Mastery: Time Decay and Volatility Trading Opportunities

admin — Sun, 13 Dec 2009 08:12:38 +0000

When vertical spreads are mentioned, they quite often come with monikers such as ‘bull’ and ‘bear’. This lends most to think of vertical spreads as directional plays which is true. However, vertical spreads can be used to take advantage of two other potential trading opportunities – time decay and volatility movement.
If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. Knowing a little about them now, you will recall that a vertical spread has a limited profit potential but also a limited loss scenario for both the buyer and the seller. So, how do we use this covered trade to take advantage of time decay.
At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays away over time, you could set up a vertical spread by selling an at-the-money option and buying either the out-of-the-money option (creating a credit spread) or buying an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay away at a faster rate than either the in-the-money option or the out-of-the-money option due to the fact that the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.
Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea, but now there are a couple choices. Should you do the put spread or the call spread? Should you buy it or sell it? The decision of what to do from here should first be based on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you can’t expect the stock not to move at all. So even though you are playing time decay, you still want to form an opinion about in which direction the stock is most likely to move. By doing this, you’ve now give yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.
Now that you have picked which at-the-money strike you are going to sell and you’ve picked your anticipated stock position you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember both the vertical call spread and a vertical put spread allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up. For the bears, you can buy a vertical put spread or sell a vertical call spread. For each direction there are two choices to decide from. One is a purchase, one is a sale. The best way to decide which to do, other than your own style or comfort ability is a simple risk/reward analysis.
By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.
Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility. Volatility is a huge component of an option’s extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.
As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less. Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the spread.
So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.
As to how to set it up, you would follow the same guidelines as you would for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.
Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the spread will have to be constructed with the short option being the at-the-money.
As you can see, the vertical spread does not have to be used only in directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to both the buyer and the seller.

Options Trading Lesson: Spread Trading

admin — Tue, 01 Dec 2009 20:48:59 +0000

In options trading, there are some basic lessons that are the backbone of many other successful options trading strategies. How to engage in spread trading in options trading to enhance potential gains is one of these lessons.
Spread trading is a foundational tool that you should have in your options trading toolkit. It will allow you freedom and flexibility for enhanced profit and will give you defense against potential loss while reducing your overall risk. Now, let us look at this fundamental of options trading, the spread trade.
We have demonstrated how well options function in unison with a stock position. They enhance potential gains, provide profit protection and limit the risk of the entire investment. They enable us to manage risk in a single stock as well as an entire portfolio. But, as good as options are in conjunction with stocks, they can be even better when traded against each other.
Spreads are strategies that do not involve the use of any security other than another option. Their positives are that they are inexpensive, offer protection for both buyer and seller and are in effect automatically hedged trades.
Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay. A spread involves the purchase of one option in conjunction with the sale of another option. There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of movements in implied volatility and even time decay. There are calendar or time spreads, diagonal spreads, ratio spreads and also vertical spreads, which we will discuss in depth here.
Spreads are more advanced and sophisticated than the strategies discussed in our beginner product ‘OPTIONS 101.’ Where certain spreads, like 1 to 1 vertical spreads, can be less risky than a buy-write, there are more variables to consider and control which makes trading the spread more complicated.
When you trade a spread you are dealing with three elements: the spread as a whole (which you can buy or sell) and its component parts – the option you buy and the option you sell.
Although the cost of most spreads is relatively inexpensive to initiate, they can provide a large percentage return and there is protection (limits) to both sides of the trade. Therefore, even experienced investors can profit from learning about spreads and their investment potential.