Bflakaz Weekend Review
May 16, 2014
Recap of Previous Week's Trades
- QQQ -85 shares @ 87.54, covered 88, loss = -$37.72
- IWM -75 shares @ 111.20, covered 112.45, loss = -$93.75
- QQQ +2 JUN14 89.63 calls @ 0.95, out @ 0.74, loss = -$42
- DE +3 JUN14 92.5 calls @ 1.02, out @ 1.28, profit = $72
- NFLX -8 JUN14 295/300/400/405 iron condor @ 0.82 (TEST)**
Management of Current Positions
NFLX
Ok, this is going to get a little complicated. Time for an in-depth explanation of a specific option trade.
First, what is an option contract? An option contract is a type of derivative (levered asset) that is an agreement between buyer and seller. The buyer of a call option has the right, not the obligation, to buy a security (in this case, shares of stock) from the writer at a certain price, known as the strike price, on or before a specified date, the expiration. The buyer of a put option has the right, not the obligation, to sell a security to the writer at the strike price on or before expiration. Each contract is good for 100 shares of the underlying stock, and the holder of a contract can exercise the right any time before or on the expiration date.
When observing option prices, it is helpful to know some terms that help determine extrinsic vs intrinsic value. Strikes that are close to the underlying security's current price are known as "At the Money (ATM)," and have no intrinsic value. Strikes at this range usually have a Delta of about 0.5, or a 50% of expiring "In the Money (ITM)," or with intrinsic value. Strikes far from the ATM strike are known as "Out of the Money (OTM)," and have a much smaller chance of expiring ITM.
Intrinsic value, in the option world, just means being rational. For example, XYZ Corp is currently trading at $50. I own a call option that expires in 30 days at the 45 strike. It would be a good idea to exercise my right to buy 100 shares of XYZ at $45, or I could sell my call option on the open market for a substantial profit as well. Since the contract is ITM, it has intrinsic value because it can immediately be exercised for a profit.
Extrinsic value means that it has no immediate value to an investor. Extrinsic value begins to rapidly decline in the last 60 days to expiration, because the chances of the contract expiring ITM begins to diminish. More on that later.
Here's a look at an option chain for General Electric (GE):
Now there's how options are priced. There are 5 main factors, or "sensitivities," that determine the price of an option, notated by financial Greek letters. Underlying price (Delta), volatility (Vega), time value (Theta), price change sensitivity (Gamma), and interest rates (Rho).
The only three that really matter are Delta, Theta, and Vega. Delta is determined by standard deviations on a bell curve. If you have no statistical background, it's simply a curve of probabilities. In this case, probabilities of expiring ITM.
Let the underlying price of the security be u. According to standard Gaussian Theory, the price of the security at the time of expiration will have a 68.2% chance of being within -1o and 1o, or within 1 standard deviation. There is a 95.4% chance of being within 2 SD, and 99.7% of being within 3 SD.
So then there's Theta or Time Value. Essentially, the more time there is to expiration, the more time there is to "be right" and have an option contract become ITM or gain intrinsic value. Extrinsic value, "the chance to be right," dwindles as time nears expiration, therefore so does option premium (the price paid for a particular contract). Theta decays geometrically, as exemplified by this chart:
The most rapid decline in Time Value occurs in the last 30 days to expiration. Don't worry, this will all come full circle soon.
Then there's the all important Vega, or Implied Volatility. Option premium is largely derived from how volatile price swings in the underlying security are. More volatility = increased risk = higher option premium. For example, a stock like Zillow (Z) has larger price fluctuations than General Electric (GE), therefore, the premium in Z options will be much greater than premium in GE options, regardless of underlying stock price differences (Z being at around 100 and GE at 26).
So how does this fit into the trade? The plan is this: sell an option spread of both puts and calls with a wide range between the sold strikes in order to capture the decay of time value, remain delta neutral, and utilize higher volatility for a better payout resulting from higher option premium. That's a mouthful, so hopefully a visual representation will clarify:
The top model is the risk profile of the trade while the bottom model is the visual representation of the aforementioned statement. The risk profile shows our profit and losses upon expiration based on the underlying price. The spectral map shows our % market gain at underlying prices with days to expiration (DTE). Theta is shown by the curve becoming more green as time passes. Since IV (Vega) in the underlying is high (40%), losses within the 1SD curve are insignificant. And the position is Delta neutral since a rise or fall in underlying price will hurt market returns, until expiration of course.
So what we end up getting is an 80% chance of collecting the entire premium sold for the trade, what's call net credit. It can also be described as being having a Risk/Reward Ratio (R/R) of 1/.20, or 5/1: five dollars of risk for every 1 dollar rewarded. That sounds bad, but when you consider it's statistical chance of "being right," that's actually pretty good. Higher IV lets us widen our strikes beyond 1SD while still collecting a good net credit.
Part of every trade is the timing in which you place your position. According to the chart of NFLX, it looks like an alright time to make this kind of trade.
NFLX appears to be consolidating, based on the chart and the RSI. That means having a Delta neutral position won't be as risky.
**TEST means that this trade isn't actually being put on. Trading option spreads based on SD is totally new to me, so I'm not going to risk hard-earned profits on something I've never exactly done before.
Now that you (anyone who reads this, which is probably nobody) understand how options work, maybe you can see why Math is actually important and can actually make you money. Who knew, right? Since this trade has a R/R of 1/.20, that means it has a return of 20% of capital, with and 80% chance of that occurring. So, if you were able to successfully trade one of these spreads every month / 30 days, you would have an annualized return of 240% ROC. That's incredible! You would be able to turn $25,000 (fully invested) into $85,000 in a year!
Let the underlying price of the security be u. According to standard Gaussian Theory, the price of the security at the time of expiration will have a 68.2% chance of being within -1o and 1o, or within 1 standard deviation. There is a 95.4% chance of being within 2 SD, and 99.7% of being within 3 SD.
So then there's Theta or Time Value. Essentially, the more time there is to expiration, the more time there is to "be right" and have an option contract become ITM or gain intrinsic value. Extrinsic value, "the chance to be right," dwindles as time nears expiration, therefore so does option premium (the price paid for a particular contract). Theta decays geometrically, as exemplified by this chart:
The most rapid decline in Time Value occurs in the last 30 days to expiration. Don't worry, this will all come full circle soon.
Then there's the all important Vega, or Implied Volatility. Option premium is largely derived from how volatile price swings in the underlying security are. More volatility = increased risk = higher option premium. For example, a stock like Zillow (Z) has larger price fluctuations than General Electric (GE), therefore, the premium in Z options will be much greater than premium in GE options, regardless of underlying stock price differences (Z being at around 100 and GE at 26).
So how does this fit into the trade? The plan is this: sell an option spread of both puts and calls with a wide range between the sold strikes in order to capture the decay of time value, remain delta neutral, and utilize higher volatility for a better payout resulting from higher option premium. That's a mouthful, so hopefully a visual representation will clarify:
The top model is the risk profile of the trade while the bottom model is the visual representation of the aforementioned statement. The risk profile shows our profit and losses upon expiration based on the underlying price. The spectral map shows our % market gain at underlying prices with days to expiration (DTE). Theta is shown by the curve becoming more green as time passes. Since IV (Vega) in the underlying is high (40%), losses within the 1SD curve are insignificant. And the position is Delta neutral since a rise or fall in underlying price will hurt market returns, until expiration of course.
So what we end up getting is an 80% chance of collecting the entire premium sold for the trade, what's call net credit. It can also be described as being having a Risk/Reward Ratio (R/R) of 1/.20, or 5/1: five dollars of risk for every 1 dollar rewarded. That sounds bad, but when you consider it's statistical chance of "being right," that's actually pretty good. Higher IV lets us widen our strikes beyond 1SD while still collecting a good net credit.
Part of every trade is the timing in which you place your position. According to the chart of NFLX, it looks like an alright time to make this kind of trade.
NFLX appears to be consolidating, based on the chart and the RSI. That means having a Delta neutral position won't be as risky.
**TEST means that this trade isn't actually being put on. Trading option spreads based on SD is totally new to me, so I'm not going to risk hard-earned profits on something I've never exactly done before.
Now that you (anyone who reads this, which is probably nobody) understand how options work, maybe you can see why Math is actually important and can actually make you money. Who knew, right? Since this trade has a R/R of 1/.20, that means it has a return of 20% of capital, with and 80% chance of that occurring. So, if you were able to successfully trade one of these spreads every month / 30 days, you would have an annualized return of 240% ROC. That's incredible! You would be able to turn $25,000 (fully invested) into $85,000 in a year!
Trade Setups for the Upcoming Week
Watch NFLX and look for other opportunities... that sounds vague but I pretty much have a blank white board right now. I think that markets are headed for the usual Summer doldrums and we will pull back a little, maybe a lot, in the next couple months.
Some Side Notes
Maybe if this post garners readers who are interested by statistical analysis (HIGHLY DOUBTFUL), I will post more technical and challenging stuff, mostly on Economics and Macro trends. Oh yeah, the boring stuff!
No comments:
Post a Comment