Tag archives for options trading

When you are looking to get a better selling price for stock you own or you want to generate income, you write covered calls. On the flip side, when you are looking for a better buying price for stock you want to own or you want to generate some income, you write put options. The major difference between the two options trading strategies is that you don’t need to own the underlying stock before writing puts.

The trade command is ‘sell to open’. You get paid the option premium after placing the trade. After that, you wait and watch till the expiration date. If the price of the stock drops, you get to buy your stock at the strike price (and keep the premium). What if it doesn’t drop? You get to keep the premium anyways and can write more puts if you want.

Wondering when to write puts? There are two main scenarios when you write puts:

1 – You believe that the stock will increase in price or hold steady. In this case you will get to pocket the premium and you have the chance to write more puts.

2 – You want to own the stock even if the price declines and you arent expecting it to take off anytime soon.

There are a few risks you should bear in mind before writing puts:

1- Your stock could increase significantly while you are waiting to exercise your puts.

An example: Lets say you wanted Apple stock (AAPL) at around $105. Its trading at $120 currently. You think its an ok buy at $120 but you think its a much better buy at $105. In your estimates, its fairly valued at $140. So, you write some put options for the $105 strike price. In between Apples quarterly earnings come out.

They just blew past the analyst estimates and the stock is now at $150. In this scenario, you chose to buy a volatile stock like Apple at a lower price but it zoomed past your fair value estimate and you could do nothing but watch. In situations where you think that the stock could large move upwards at any point and you are not willing to miss out any gains you should buy the stock outright rather than writing puts.

2- Your stock drops to your strike price and you get to exercise your option. But, it continues to decline after you buy it.

An example: You think that Microsoft (MSFT) is a buy at $30. Its currently at $35 and you write puts for $30. Around the expiration MSFT makes a downward move and you get to buy the stock at the price you wanted. But in the few months you hold it MSFT continues its downward move to $24.

In this case, you got a better buy price than you would’ve if you had just bought the stock outright but you are still holding shares of stock that are depreciating. At this point, you have decide whether you think MSFT is worth holding longer term if the decline continues.

Article Source: Articles Engine

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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.

Article Source: Articles Engine

Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227

Since the Straddle’s profit potential depends on its price from purchase time to expiration, the investor should be aware of the factors that affect the Straddle;s price. Several factors affect a Straddle’s price. The first is, of course, stock price. The stock’s price dictates the value of both components of the Straddle – the call and the put – affecting the Straddle price as a whole. As the stock price moves, the prices of the call and the put will fluctuate via the current Deltas of the options and thereby affect the price of the Straddle.

As the stock moves higher, the price of the call will increase while the price of the put decreases. They do not move linearly, meaning that as the stock continues higher, the call’s value increases progressively more while the put’s value decreases progressively less. This non-linear effect is because of the option’s changing Delta.

The call Delta increases as the stock goes up while the put Delta decreases. This opposing effect continues until the call gains value dollar for dollar with the stock (once its Delta reaches 100) indefinitely. At the same time, the put value-loss stops because the put now has no value (as put Delta approaches 0).

The opposite is true if the stock trades down. The call will lose value progressively slower until it reaches $0. Meanwhile, the put will gain value at an increasing rate until the Delta becomes 100. Then the put will gain dollar for dollar with the stock indefinitely. The chart below illustrates the effect of stock movement on the dollar value and Delta value of the Straddle.

Again, we will use the July 65 Straddle as an example. The Straddle will be worth $4.10 ($2.10 for the call, $2.00 for the put).

Stock/ Call/ Call Delta/ Put/ Put Delta/ Straddle
57.50 .42 15 7.81 -86 8.23
59.50 .78 24 6.16 -77 6.94
61.50 1.35 34 4.17 -67 6.06
63.50 2.11 45 3.46 -56 5.57
65.50 3.13 56 2.47 -44 5.60
67.50 4.35 66 1.69 -34 6.04
69.50 5.77 75 1.11 -25 6.88
71.50 7.37 83 .71 -17 8.08
73.00 9.09 83 .43 .12 9.52

A second factor that affects the pricing of a Straddle is implied volatility. As implied volatility increases, the value of the Straddle increases. The price of both calls and puts increase as implied volatility increases. A Straddle will feel a double effect when volatility increases because the strategy employs two options working together and not against each other.

When a strategy uses two options working against each other, the effect of implied volatility on the strategy is the difference of its effect on each option. This is different from a Straddle where the two options are working together. This combines the effect of implied volatility on each option.

Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option’s volatility sensitivity component or Vega. An option with a $.05 Vega will increase five cents in value for every tick that implied volatility increases. It will decrease in value five cents for every tick that implied volatility decreases.

A call and its corresponding put will have the same Vega. That is, if the July 65 call has a .10 Vega, then the July 65 put will also have a .10 Vega. Remember, Vega is calculated by the strike price and does not differentiate put or call. Now that we have confirmed this concept, we can use it to calculate how much our Straddle price will change with a movement in implied volatility.

The Straddle combines a call and its corresponding put doubling the Vega effect. This means that the Vega of a Straddle is the addition of the Vega of the call and the Vega of the put. Since the put and call Vega are the same, we simply times the Vega of the strike by two.

Look back at our example. If the July 65 call has a .10 Vega, then the July 65 put must also have a .10 Vega and thus the July 65 Straddle will have a .20 Vega. This means that for every tick that implied volatility increases, the July 65 Straddle will increase $.20 in value. Conversely, for every tick that volatility decreases, the July 65 Straddle will decrease in value. The chart below shows how the Straddle-value changes at different implied volatility levels.

Price/ Vol.Level Call Put Straddle Vega
65.50 30 3.13 2.47 5.60 .174
65.50 40 4.05 3.39 7.44 .180
65.50 50 4.96 4.31 9.27 .182
65.50 60 5.88 5.23 11.11 .184
65.50 70 6.80 6.15 12.95 .184

When you study the chart, you can see that as implied volatility increases or decreases, the value of the Straddle increases or decreases by the amount of the Straddle’s Vega multiplied by the amount of tick change in implied volatility.

Finally, time is another major factor affecting the price of a Straddle. Time takes a toll on all options. Its effect is even more pronounced on the Straddle which that combines two options for the same period. A Straddle will see twice the rate of decay that a single option will. From previous discussions, we should be familiar with the option decay chart and its non-linear curve. As time goes by, the Straddle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m.

The implication to the buyer and seller is obvious. The passage of time decreases the value of the Straddle and thus always favors the seller. Time works against the buyer. The buyer has until expiration to get either a large stock or implied volatility movement to offset the price paid for the Straddle.

Article Source: Articles Engine

Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227

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