Trading Equity Options Week 2 - Craig Formantastytrader.net/downloads/Week 2 Slides.pdf · Week 2 . Craig E. Forman 2 Disclosure All investments involve risk and are not suitable

Copyright© 2019

Craig E. Forman All Rights Reserved www.tastytrader.net

Trading Equity Options

Week 2

Craig E. Forman www.tastytrader.net 2

Disclosure

All investments involve risk and are not suitable for all investors. The past performance of a security, industry, sector, or market of a financial product does not guarantee future results or returns. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker or the Options Clearing Corporation at 1-888-OPTIONS or visit www.888options.com.

Any strategies discussed here, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. The author of this presentation, and the content of the website www.tastytrader.net are in no way approved, endorsed, supported, or affiliated with tastytrade. We are a third party with interest in the tastytrade content, and the purpose of the information presented here is for education only. The ideas presented here are solely the views of the author, and are meant to enhance the ability of the individual investor in managing personal investments using the strategies and ideas set forth by tastytrade.

Craig E. Forman www.tastytrader.net

Topic Summary

• IV Rank

• Key measurement parameters; POP, BPR, ROC, EXT

• Margin

• The Option Chain

• The Option Greeks

Delta, Gamma, Theta, Vega, and Rho

• Synthetics

• Option Spreads

• Credit and Debit Spreads

• Defined Risk vs. Undefined Risk Spreads

• Naked Puts and Calls

• Covered Calls and Covered Puts

3


IV Rank

• IV tends to be at different levels for different underlings. So when we

compare two underlyings, we need at way to look at RELATIVE IV.

• IV Rank (IVR) is the relative position of the current IV as compared to the

low-high IV range from the past year (or other interval) FOR THAT

UNDERLYING. It compares current IV to past IV.

• We don’t use IV data for expiries less than 8 DTE due to upcoming earnings.

• An IV centered between the 52 week low and high IV is Rank 50.

• IVR = Current IV – 52-week Low IV (Expressed as 0 to 100)

52 Week High IV – 52-Week Low IV

4


Key Measures: POP, BPR, ROC, EXT

• POP = Probability of Profit

An estimate of the probability that the trade will be profitable (at least 1 cent) at

expiration. We generally look for high probability trades.

• BPR = Buying Power Reduction

This is the amount of capital that the broker reserves in your account to cover the

potential risk on a trade (both for you and your broker).

• ROC = Return on Capital (used for trades where max profit is known)

Maximum possible profit / BPR.

• EXT = Extrinsic (or time) value in trade. This is the amount in dollars of

extrinsic (or time) value in the options position at entry. Extrinsic value will

always decay over time.

5


Types of Margin

Margin and BPR are similar terms, but margin is historically associated with stock and

BPR is used with options. Both refer to use of leverage; you can take on more risk than

your Net Liq. All trades with risk reduce your buying power because the brokerage firm

must set aside some of your account equity in case your positions move against you.

• All option traders must be approved for margin trading. This is necessary because

short option positions can lose more than the initial investment.

• Buying stock w/margin typically uses 50% of value in BPR; balance can be borrowed

• Reg-T Margin – Used for most option traders with small to medium sized accounts.

• Portfolio Margin – Used for larger accounts and more experienced traders. Much

more liberal than Reg-T margin. You have to have a minimum acct value and pass a

test to get it (ask me if you need help in prep or want some sample tests).

• SPAN Margin – Used for futures accounts, similar to Portfolio Margin, very liberal.

6


The Option Chain

7

An Option Chain is

a way of presenting

the various options

that can be traded

on an underlying.

Calls on the left,

Puts on the right.

Weekly expirations

are marked in

Yellow, others are

Monthlys

(3rd Friday)

Implied Volatility

and Expected Move

for each expiry is

on the far right.


Reading the Option Chain

8

• The option chain shows you the bid-ask spread on each option.

• There are expirations monthly (3rd Friday) + Weekly expirations.

• The bid is the price at which you could sell the option contract, and the ask is the

price at which you could buy the option contract. The difference is the bid-ask spread

and is a measure of liquidity.

• When you are trying to trade an option contract or spread, you usually try to buy or

sell it somewhere near the midpoint of the bid-ask.

• Since each option contract controls 100 shares, you have to multiply the price shown

in the chain by 100 to get the price of 1 contract.

• The options chain always shows you the bid and ask prices. The other columns can

be configured to show you additional information such as mark price, volume, open

interest, IV, Greeks, etc.


The Option Greeks – Δ, ϴ, ѵ, Γ, ρ

• The option greeks are Delta, Theta, Vega, Gamma, and Rho

• Understanding the option greeks can help you set expectations for option

positions based on your assumptions

• Allows you to place trades that minimize risk based on your assumptions.

• Delta Δ = Impact of underlying price change on option price.

• Theta ϴ = Impact of time on option price; we generally want positive theta.

• Vega ѵ = Impact of implied volatility change on option price.

• Gamma Γ = Impact of price change on Delta; the first derivative of Delta

with respect to price. This is like the accelerator for Delta.

• Rho ρ = Impact of interest rate change on option price – Negligible at this

time due to extremely low interest rates.

9


Delta – Δ

• Delta tells how sensitive the position is to price. Tells you how much $ the

option or position will move with a $1 up move in the underlying. Sign tells

you if position is net short or long; magnitude represents directional risk.

• Option Delta has a range of -1 to +1 • Positive delta is Bullish, Negative delta is Bearish.

• ATM options have a +.50 or -.50 delta (we just call this “50 delta”).

• OTM options have less than .50 delta, ITM options have greater than .50 delta

• Delta is a proxy for how much the option acts like stock (a .75 delta call acts like 75 shares of stock)

• Delta is a proxy for how much the option acts like stock (a .75 delta call acts

like 75 shares of stock)

• 100 shares long stock = +100 delta; short 100 shares stock = -100 delta.

• Delta is approximately equal to the probability of the option expiring ITM.

10


Delta as seen in the Options Chain

• Note that the sum of the put and call deltas (not including sign) is always 1.

• Note that for each line, the Prob ITM (probability of expiring ITM) is

approximately equal to Delta.

11

Calls Here

Prob ITM Expiry Strike Price

Deltas add to 1.0 on each line (disregarding the sign)

Puts Here


Put Delta as a Function of DTE (Days to Expiry)

12

OTM Put

ITM Put


Gamma –Γ

• Gamma tells us how delta changes as the underlying price changes. It is the

first derivative of delta. It is like an accelerator for delta.

• Gamma is the change in delta for a $1 up move in the underlying.

• A positive gamma will cause delta to rise as the underlying rallies and fall as

the underlying moves lower (it moves WITH the underlying).

• A negative gamma will cause delta to rise as the underlying moves lower,

and fall as the underlying rallies (it moves OPPOSITE of the underlying).

• ATM options have the most gamma, ITM and OTM options have less.

• The further time until expiration, the smaller the gamma.

• As gamma approaches expiration, it explodes for options that are ATM, so

holding short options near the money into expiry is risky.

13


Theta – ϴ

• Theta tells us how sensitive the position is to the passage of time.

• Theta is the dollar amount by which an option or position’s price changes

each day due to the passage of time.

• A positive theta position benefits with the passage of time (MAKES $$).

• A negative theta position is hurt by the passage of time (LOSES $$).

• Long options have negative theta, short options have positive theta.

• Theta is the PROFIT ENGINE for short premium trades (selling options).

• ATM options have the most theta; ITM and OTM options have less theta.

14


Time Decay for Options

Note: Time value is much higher for ATM options, and accelerates its decay

approaching expiry. For OTM options, time value is lower, but decay slows

down as expiry approaches. This is why selling ATM options brings in so more

premium, and why closing short OTM options early makes sense.

15

ATM Options – Days to Expiry


Time Decay for “Teeny” Options

• Teeny options are options that are far out of the money and sell for very low price

(like $.20 or less). If you sell these options, you have to wait until expiry to squeeze

the last few cents out of the option.

• You have to wait until expiry to make most of your profit while there is always risk

that the underlying price will move against you and your short option that you

collected $10 per contract for is going to cost you like $500 to buy back.

• Risk/reward is lousy. When options get to a low price like $.10 or $.05, you should be

closing them to take the risk off the table. Many trading firms will even give you free

commissions to close a cheap short option.

16

Teeny Options –

Decay slows down

when option price

gets very low


Vega – ѵ

• Vega tells us how sensitive the position is to a change in Implied Volatility.

• IV is the volatility that the market is PREDICITING that volatility will be,

based on the options prices.

• Vega tells us for every 1% up change in implied volatility, how much the

option price or position price will change, in dollars.

• A positive (+) Vega position benefits from increase in IV.

• A negative (-) Vega position benefits from decrease in IV.

• Long options have positive Vega, short options have negative Vega.

• ATM options have the most Vega, ITM and OTM options have less Vega.

• The further the time to expiration, the more Vega an option will have, and

the more sensitive it is to volatility changes.

17


Vega – ѵ

18


Put Call Parity and Synthetics

• Puts & Calls are related. This allows us to create “synthetic” positions.

• Synthetic positions allow you to get long or short using far less capital.

• Stock(S) – Strike Price(x) + Carry Cost = Call – Put or S = C – P + x

• You can get synthetically short or long a stock using just options!

• Synthetic long stock: buy the ATM Call and sell the ATM Put (S = C – P + x)

• Synthetic short stock: buy the ATM Put and sell the ATM Call (-S = P – C + x)

• You can use this to price a stock by just looking at option prices.

• You can get synthetically short or long a stock using just options!

19

x = Strike Price (120):

120 call - 120 put =

2.685 – 1.760 = .925

S=.925+120=120.925

What was stock price?

120.92


Option Spreads

20

• When we trade options, we often trade option spreads, which may have 2, 3,

or 4 legs. Over time, if we add to the position we can have many legs.

• Option spread trades can be entered as a single order on your trading

platform. This can save on commissions and are easier to execute.

• Spreads can contain puts, calls, or both puts and calls.

• Spreads can be bullish, bearish or neutral.

• With an option spread, the puts and calls are options on a single underlying.

• The option legs may have the same expiry or different expiries.

• Option spreads have names such as vertical, calendar, butterfly, iron condor,

ratio spread, etc.

• We can easily analyze our overall options position by looking at the Greeks.


Credit and Debit Spreads

21

• Spreads are either put on for a credit or a debit.

• A credit means you collect $$ for placing the trade because you take on risk.

• A debit means you are paying $$ to put on the trade because you are paying

someone else to take on risk.

• Credit and Debit spreads have nothing to do with profit and loss.

• You will start to see profit and/or loss on a trade only after it is placed.

• When the trade is closed, you have a realized profit or loss.

• Credit and Debit spreads can be identical in risk profile. But as a practical

matter, we usually pick one over the other depending on volatility and our

mechanical trading rules. Many traders like to put on trades for a credit.


Defined Risk vs. Undefined Risk Positions

22

• Option spreads can be either risk defined or risk undefined.

• A single long option has defined risk – limited to the amount you paid.

• A single short option is a naked position; risk is large.

• For a short call, theoretical risk is unlimited to the upside and for a short put,

theoretical risk is $100 x strike price to the downside.

• A defined risk spread means you know the max loss upon entry.

• An undefined risk spread means you have very large risk.

• Your buying power reduction is much larger with undefined risk trades.

• Some undefined risk trades cannot be placed in an IRA.

• You can always change an undefined risk trade into a defined risk trade by

buying cheap options as protection (but it will cost some $).


Short Options – Naked Put and Call

• If you sell an option without an offsetting option it is called “selling naked”.

• You are then said to be “short” the option contract.

• Naked short options are ALWAYS directional and use a lot of buying power

• Naked short puts may be done in an IRA, but naked calls cannot.

• Naked short puts are BULLISH and naked short calls are BEARISH.

23

Outlook Put Options Call Options

Assignment Risk Assignment Risk

Bullish Sell (short) Obligated to Buy

Stock Buy (long)

No Obligation

Cannot get assigned

Bearish Buy (long) No Obligation

Cannot get assigned Sell (short)

Obligated to Sell

Stock


P/L Graph – Buying and Selling Stock

24

• P/L Graph shows how your P/L changes with underlying price change.

• These graphs generally show the P/L at expiration.


P/L Graphs– Buying and Selling Naked Options

25


P/L Graphs Morph into Expiration Graphs as Expiry Approaches

26


Covered Calls - Bullish

• If you own stock, you can reduce cost basis by selling calls against it.

• Covered calls are ALWAYS bullish positions.

• Covered calls give you a little protection to the downside.

• You give up the unlimited upside of owning naked stock.

• Typically, you might look to sell calls slightly OOM, 30 to 60 days out.

• Max profit occurs if stock is at or above strike price at expiration.

• If calls expire ITM, your stock is “called away” and you book a profit.

• If calls expire OTM, you keep the premium, and can sell calls in next cycle.

• If you are near expiration, and you are near call strike price, you can buy

back your short calls and roll them out to extend duration.

• You can do covered calls ATM, OOM, or ITM. All will increase POP!

27


Covered Puts - Bearish

• If you are short stock, you can reduce cost basis by selling puts against it.

• Short stock with short puts are ALWAYS bearish positions.

• Covered puts give you a little protection to the upside.

• You give up the unlimited upside of being short naked stock.

• Typically, you might look to sell puts slightly OOM, 30 to 60 days out.

• Max profit occurs if stock is at or below strike price at expiration.

• If puts expire ITM, your short stock is “assigned”; you buy it back at a profit.

• If puts expire OTM, you keep the premium, and can sell puts in next cycle.

• If you are near expiration, and you are near put strike price, you can buy

back your short puts and roll them out to extend duration.

• You can do covered puts ATM, OOM, or ITM. All will increase POP!

28


P/L Graphs– Buying and Selling Covered Stock

29

COVERED PUT

Short Put Short Call

COVERED CALL

Note the same

P/L Graphs Note the same

P/L Graphs

Covered Call Covered Put


Covered Stock vs. Short Naked Options

• A covered call has the same P/L graph as a short put.

• A covered put has the same P/L graph as a short call.

• Why would you choose one over the other?

• How do dividends affect your position in the covered call, the naked put?

• What happens if you are short stock and a dividend is paid?

• What happens when the short option expires?

• Demo - Look at covered call vs short put on TOS, using a cash secured

(IRA) acct, and a Reg-T Margin account.

• What is Max Profit, Max Loss, POP, BPR, ROC for each?

• Which is the better way to trade, covered stock or short puts?

30


Example: Covered Call vs. Short Naked Put

31

Example comparing a Covered Call (1SD OOM) vs. same strike Short Put

Underlying:_____ Price:______ Strike Price: _____ Option DTE:_____

Covered Call Strategy: Buy 100 shares, sell 1 Call 1SD OOM

Stock Price Covered

Call Price

BreakEven

=

Cost Basis

Max Profit

(if called) Max Loss

Cash Acct

BPR

Cash Acct

ROC

(if called)

Reg-T Acct

BPR

Reg-T Acct

ROC

(if called)

Selling Put Strategy: Sell one Put using same strike as above

Sold Put

Price Net Credit

BreakEven

= Strike –

Credit

Max Profit if

Put expires

OTM

Max Loss Cash Acct

BPR

Cash Acct

ROC if Put

expires OTM

Reg-T Acct

BPR

Reg-T Acct

ROC if Put

expires OTM


Homework – Week 2

• Answer the options chain questions on the next slide.

• Think about discussion questions on the last slide.

• Watch these segments:

Best Practices 2/2/15 Key Metrics | POP & ROC

Best Practices 1/26/15 Buying Power Reduction

Market Measures 8/27/12 Margin vs. Portfolio Margin

Best Practices 10/16/17 Ways to Make Money Trading Options

What Else Ya Got 10/21/14 Theta Decay – A Visual Explanation

Best Practices 4/3/17 Comparing Long Stock to Short Puts

Options Jive 8/1/17 Covered Call Mechanics

Market Measures 4/8/13 Covered Call vs. Short Put

• If doing the tastytrade Beginners Options Course, do:

Section 2: Trade Entry Concepts and Section 3: Basic Strategies Part 1

32


Homework: Option Chain Questions

• Which Dec 15 call would you buy if you wanted it to act like 100 shares long stock?

• How much would it cost and how much long stock would it be equivalent to?

• Which Dec 15 put would you sell if you wanted it to act like 100 shares of long stock?

• How much would it cost and how much long stock would it be equivalent to?

33


Discussion: Questions to Think About

34

• What theta would you like to see in your trades (positive or negative)?

• When trading options on margin, do you pay margin interest to the broker?

• What option greek(s) would you tend to watch the most, the least?

• With short premium (short puts and calls) do we want IV to move ↑ or ↓?

• Given stock XYZ at $50, position delta = -$30, how much and in which

direction does your P/L move with a $2 increase in price of XYZ stock?

• Explain in words what a “delta neutral” position would be.

• Why would we trade an undefined risk spread if we can define our risk?

• You sold 10 put contracts, each option has theta = -.08. How much did your

P/L move and in which direction after 2 days assuming no other changes?

• Why are IVR and IVP more useful measurements of volatility than IV?

Documents

Trading Equity Options Week 2 - Craig Formantastytrader.net/downloads/Week 2 Slides.pdf · Week 2 . Craig E. Forman 2 Disclosure All investments involve risk and are not suitable