0 valutazioniIl 0% ha trovato utile questo documento (0 voti)

27 visualizzazioni14 pagineOne of the biggest reasons investors are scared off by options is because they fully don’t understand them. It’s true, one of the toughest concepts to grasp for equity investors transitioning into options investing is understanding how option values are derived.
With stocks it’s very simple to understand, for every dollar the stock price rises you lose $1 per share…on the flip side for every dollar the stock price drops you lose $1 per share. This is referred to as a linear relationship.
Now, when it comes to options investing the relationship is non-linear. You see, not only are options influenced by the price movements of the underlying stock, but time to expiration, volatility and option strike price selection all play a major factor.
For example, there are cases when a stock price can rise and the call options lose value. If you didn’t know better you’d think that options were manipulated by market makers.

Sep 18, 2014

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One of the biggest reasons investors are scared off by options is because they fully don’t understand them. It’s true, one of the toughest concepts to grasp for equity investors transitioning into options investing is understanding how option values are derived.
With stocks it’s very simple to understand, for every dollar the stock price rises you lose $1 per share…on the flip side for every dollar the stock price drops you lose $1 per share. This is referred to as a linear relationship.
Now, when it comes to options investing the relationship is non-linear. You see, not only are options influenced by the price movements of the underlying stock, but time to expiration, volatility and option strike price selection all play a major factor.
For example, there are cases when a stock price can rise and the call options lose value. If you didn’t know better you’d think that options were manipulated by market makers.

© All Rights Reserved

0 valutazioniIl 0% ha trovato utile questo documento (0 voti)

27 visualizzazioni14 pagineOne of the biggest reasons investors are scared off by options is because they fully don’t understand them. It’s true, one of the toughest concepts to grasp for equity investors transitioning into options investing is understanding how option values are derived.
With stocks it’s very simple to understand, for every dollar the stock price rises you lose $1 per share…on the flip side for every dollar the stock price drops you lose $1 per share. This is referred to as a linear relationship.
Now, when it comes to options investing the relationship is non-linear. You see, not only are options influenced by the price movements of the underlying stock, but time to expiration, volatility and option strike price selection all play a major factor.
For example, there are cases when a stock price can rise and the call options lose value. If you didn’t know better you’d think that options were manipulated by market makers.

© All Rights Reserved

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Probability of Success

by Joshua Belanger

One of the biggest reasons investors are scared off by options is because

they fully dont understand them. Its true, one of the toughest concepts to

grasp for equity investors transitioning into options investing is

understanding how option values are derived.

With stocks its very simple to understand, for every dollar the stock price

rises you lose $1 per shareon the flip side for every dollar the stock

price drops you lose $1 per share. This is referred to as a linear

relationship.

Now, when it comes to options investing the relationship is non-linear.

You see, not only are options influenced by the price movements of the

underlying stock, but time to expiration, volatility and option strike price

selection all play a major factor.

For example, there are cases when a stock price can rise and the call

options lose value. If you didnt know better youd think that options

were manipulated by market makers.

However, this isnt true.

For an in depth explanation, feel free to go back to The Ugly Truth about

Buying Options and watch the How To Buy Options For Better

Results inspired from that article.

Moving on, the most interesting component pertaining to how options are

priced is implied volatility. But before I get into that, its important to give

you a little insight into options pricing theory.

Options are priced using a probability model. One of those assumptions in

that model is that equity prices follow a lognormal distribution.

In theory, equity prices cannot have negative prices and can rise

exponentially higherbecause of this, the skew is shifted more towards

the right. Now, the normal distributionwhich is commonly referred to

as the bell-curve is used to model returns.

For the most part, options are priced using the Black-Scholes formula or a

variation of it. The (Black-Scholes formula is only suitable for European

Style Options.

European Style options are simply options that can only be exercised at

expiration. Now, American Style options can be exercised at any time

before the option contracts expire.)

With that said, on my thinkorswim platform, the Bjerksund-Stensland

model is used because its able to get more accurate prices for American

options. However, the formulas are very similar.

Furthermore, the Black-Scholes formula uses the normal distribution in

their model. (But the inclusion of exponential functions makes the

distribution lognormal.)

If this isnt clicking yetjust take a look at this image below:

Option theory assumes that daily returns will follow a normal

distribution (outlined in red, the actual distribution is in blue).as you

can see, this isnt a perfect fit.

The next term you should familiarize yourself with is standard

deviation.

Now, standard deviation is the statistic used to measure the amount of

variability (randomness) around the mean (the highest point on the bell-

curve). The option pricing model uses standard deviation to measure

volatility.

In the above example we looked at a one year chart of daily returns (in %

terms) for Apple. The chart compares the theoretical normal distribution

to the actual distribution.,

The mean was 0.2% and the standard deviation was 1.37%.

So if the average daily return was 0.2% during the sample period, 34% of

the daily returns would be within the one standard deviation of 1.37%.

Now if you went from -1.37% to 1.37% that would include 68% of the

daily returns.

Lets assume that Apple is trading at $102 per share. A (+/-) 1 standard

deviation move would encompass about 68% of the normal distribution.

The theory is saying that on any given day,

Apple stock price will be within a +/- $1.40 move 68% of the time (given

the stock price at $102).

Now, to figure out what a (+/-) 2 standard deviation move would be,

simply multiply (+/-) $1.40 by 2. This is equal to (+/-) $2.80. According to

our sample, Apple stock price moves will be within a (+/-) $2.80 move on

a given day 95% of the time.

Lets take a look at another stock, Tesla Motors.

During this sample period, the the mean was .2% and the standard

deviation was around 3.44%.

If Tesla is trading at $279 per share, 68% of the time, the daily price move

will be within (+/-) $9.60 according to the normal distribution.

Takeaways So Far

Options are priced using a probability model.

The option pricing formula assumes that returns are normally

distributed.

Standard deviation is used as a volatility measure.

Implied volatility is the direct measure of how much the market

thinks the underlyings price might change. Its a reliable metric to

predict the range of future price changes.

How good are the assumptions?

Stock returns do not follow a normal distribution. If you look at the Tesla

chart above, youll notice daily returns around the mean occurred more

often than the model anticipated. In addition, there were several more

outsized returns than the model anticipated.

Looking at the Apple chart, there were more negative than positive

returns. Both charts experience fatter tails, notice at the end of the

normal distribution the odds of extreme price moves are very small.

However, in reality, extreme price moves in stocks happen a lot more

often than the normal distribution assumes. A quick look at the Tesla

chart above will show you what I mean.

Heres another assumption:

The option pricing formula assumes that volatility is constant. In practice,

youll notice that each option strike has its own volatility.

In fact, option volatility or implied volatility is not derived from historical

price returns.Implied volatility is derived from the flow of options.

Why does implied volatility vary amongst option strike prices?

Well, for one reason, market participants know that stock price returns

dont follow a normal distribution. As youve seen from the previous

charts abovestock price returns have fatter tails.

Also, one of the driving factors behind implied volatility is supply and

demand. For example, On September 12, 2014, there were some rumors

circulating that Google might have an interest in Ebays PayPal.

The thought was that Googles Wallet was sort of a failure and the

emergence of Apple Pay would take market share away from them. Of

course, this was all speculation, but that didnt stop the option market

participants from placing their bets.

On that day, there were nearly 220,000 Ebay options traded4.3x usual

options volume. The 30 day at-the-money implied volatility jumped 5.6

points to 27.9%. This increase in option volatility was driven by the

demand for option premium.

By the way, in the above examples, we were looking at volatility in terms

of daily returns. However, options are expressed in annualized returns.

To convert annualized volatility to daily volatility, take the annualized

volatility and divide it by the square root of the number of trading days

(252). For example, .279/15.87 = .0175 or 1.75%. In EBay, a one standard

deviation move is a +/- 1.75%.

As mentioned, demand for options shifts implied volatility. The more

demand for an option, the more expensive the options becomeon the

flip side, if there is large selling in options, volatility drops.

What else?

Well, uncertainty causes option volatility to also increase. This typically

happens ahead of an earnings announcement, a company product

announcement, pending FDA announcement etc.

Implied volatility can spike off news rumors, like the one mentioned with

EBay. It can also spike due to rumors or chatter like an activist might be

involved or the stock has become an M&A target and a whole bunch of

other stuff.

Bottom line, uncertainty creates option volatility to increase.

Of course, the price action in the stock could also drive speculators to pay

up for options in fear that they might miss the next big move. For

example, GoPro has risen from $40 per share to nearly $70 over the last

month.

On, 9/11/14, The October $100 calls were $0.35 bid at $0.40 ask. Thats

another 40% plus move needed in a months time! Could the stock really

go from $40 to $100 in two months? Sure, but you have to think that

some investors are feeling euphoric.

To be honest, some of the best opportunities are those in which you can

spot that euphoria. You see, when Im selling option premium, I try to find

trades in which the market has to do something mind-blowing to beat me.

One of these opportunities happened recently ahead of the big Apple

product announcement. Now, this was heavily anticipated and some

believed it was going to be the biggest product launch theyve had in

yearsthere was a ton of rumors on what they might be rolling out.

I think everyone knew that they would introduce the newest version of

the iPhone. Other speculation was on an Apple TV or some kind of

wearable. There was a lot of buzz around it in fact, it was even reflected

in the way the options were priced.

With the stock trading at $98.38 on the day before the announcement, the

$99 straddle was implying around a +/- $4.20 move by Friday.which

was over a 4%.

Keep in mind, ahead of this announcement there was a great degree of

uncertainty, how would the market react to their new products? Was this

going to be a game-changer like the iPhone or iPad?

One thing was sure, once the news was fully digested, implied volatility

was expected to come in pretty hard.

By the way, if you are stuck on what the implied move meansmake sure to

review Dont Trade Earnings Before You Read This

I was looking for a trade that benefits from time decay and the inevitable

decrease in implied volatility.

In this opportunity, I was looking at this a short strangle:

Note: These are the closing prices of the strangles on August 8, 2014

The first trade was selling the $102 calls and $94 puts for a premium of

$1.36 (weekly options expiring that Friday)

This means my break-even points would be $103.36 (an all-time high)

and $92.64 (September contracts expiring in 11 days)

The second trade was selling the $103 calls and $92.5 puts for $1.51.

This means my break-even points were 104.51 and $91

Technically, my risk is not defined because Apple could theoretically go

to infinity or zero

However, weve already witnessed how accurate theory is.

Some of you might be thinking that selling strangles is very risky. In some

cases, it can be.

However, youve always got to look at the stock youre involved in. For

example, there is always overnight risk, the stock could have a huge gap

up or down.

So Ill walk you though my thought process

Apple is a $600 billion dollar market cap company that actually makes

moneyfor the stock to have a massive gap up or downa lot would need

to happen. Its not like Apple is an M&A target for anyonethey are the

ones who do the acquiring.

Even though my risk was theoretically unlimited, I really didnt think

there was a lot of overnight and pre-market risk.

Also, Apple is a lower priced product after its split a few months ago. That

means the naked options will not take up as much buying power as it

would have before when it was a $600 stock.

In this case, I was expecting implied volatility to come in hard and

fastthis is not something I was planning on holding till expiration.if

things go as planned, Id be out in less than 24 hours.

Well, on September 9th the announcement was madeApple displayed a

bigger, new iPhone, Apple Pay and the Apple iWatch. Some people loved

the conceptssome people hated them.

The stock moved from being negative to positive to negativeresulting in

a -$0.37 change in the stock price from the previous day.

But guess what? The option premiums got absolutely crushed. At the end

of the day, the price of the first strangle (-1 102 call/ -1 94 put) could

have been bought back for $0.34 and the price of the second straddle (-

103 call/ -1 92.5put) could have been bought back for 73 cents.

As you can see, my bet was not on the Apple product announcement as

much as it was on how the option participants were expecting the Apple

announcement to play out. Like they say, a good poker player doesnt play

his cardshe plays his opponent.

Why get out that day and not look to capture all of the premium? Well,

this particular play was based off the idea that the option market was

overestimating the impact of the product announcement.

I also knew that after an event, the uncertainty disappears and implied

volatility drops. Once that happened there was no reason to be in the

position.

I achieved the best return on capital in the shortest amount of time with

the highest chances of success. Staying in that position changes my risk

dramatically and exposes to me to gamma risk.

A common reason why short premium option trades dont work for

investors or traders is because they sit in them too long trying to get

every penny possible. This is why I wrote, Greater Profits In Less Time

On Your Option Trades

Looking at the longer term implied volatility chart, you can see how

quickly the volatility came back in. In regards to those weekly options, the

ATM straddle went from 44% to 27% in one day.

Its vary rare, but sometimes high implied volatility is justified depending

on the underlying and youll want to avoid.

However, if you want to create long term success with options, especially

in todays market where euphoria or fear take over. Its situations like

that, which make selling option premium allows you to get the laws of

probability on your side!

Key Takeaways For Your Success

Unlike options theory, option volatility or implied volatility is a

function of supply and demand

Uncertainty or binary events causes implied volatility to move

higher

After an event, implied volatility gets sucked out like a vacuum

because the uncertainty disappears

Selling strangles does not make sense with every stock, risk defined

strategies like iron condors and butterflies could more appropriate

for your account and risk tolerance.

Theoretically risk is not defined when selling strangles. However,

given the right market conditions and a stock that isnt overly

vulnerable to overnight or gap risk.. it can be a very profitable over

the long term.

Try to identify why the implied volatility is high and if you feel its

justified to take on the risk.

When selling premium its important to not over leverage. For a

review, read Why Size Matters; Especially In Options Trading

Make no mistake about it, investing successfully with options is not easy.

However, part of becoming profitable is identifying opportunities and

then trying to take advantage of them. Situations like this example in

Apple dont happen everydaybut when they do, will you be ready for

them?

When Im entering short premium trades my thought process is that the

market is gonna have to beat me with something exceptional for me to

lose money. With that said, I dont believe in selling premium blindly

without a good reason.

How about you? Do you tend to mix it up between premium buying or

selling? Or do you stick to one method or strategy? Id love to hear your

thoughtsIll be hanging out in the comments section below.

If you enjoyed what you read and you want to continue learning more on how to to become successful in financial markets using options, visit

http://www.OptionSIZZLE.com

You can also download your FREE report that teaches you The #1 Secret On How You Can Find Tomorrow's Best Trades Today!

Joshua Belanger is the founder of OptionSIZZLE.com and his dream is to not only create wealth, freedom & options for himself, but for you as well.

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