Archives for June 2018

What Makes an Option an Option?
By Bill Johnson 

Humorist Artemis Ward once said, “It ain’t so much thing things we don’t know that get us in trouble. It’s the things we know that just ain’t so.”

The options markets are filled with myths and misperceptions that prevent traders from using them to their fullest potential. One of the biggest misconceptions is that of cheap and expensive options. If you ask most traders, they’ll tell you that a cheap option is any that cost three dollars or less. While an expensive option cost more. In other words, they’ll have an arbitrary line in the sand to differentiate between cheap and expensive options.

However, professional traders know that it’s the extrinsic value, or the time value, that makes an option an option. If you have an option that’s made up entirely of intrinsic value, it’s not even an option – it’s stock. For instance, let’s say the underlying stock is trading for $120. If the $100 call is trading for $20, it’s entirely made up of intrinsic value and no extrinsic value. There’s not a single option in that deal. This is a condition called “parity,” which just means the option is trading equivalently to shares of stock. And if it’s trading just like stock, there’s no option in it. Even though it may look like an expensive option, it’s nothing but cheap shares of stock with a free insurance policy attached.

To see why, let’s say you bought this call while your friend bought shares of stock. If the stock price falls from $120 all the way down to $100 at expiration, your friend loses $20 and so do you. There’s no difference at all. However, if the stock continues to slide, your friend continues to lose while you’re limited to just the $20 loss. Because your losses are limited to $20, it’s as if you have an insurance policy that you didn’t have to pay for. That’s why you’ll rarely find options trading at parity unless you’re really close to expiration.

However, let’s say this $100 call was trading for $21 rather than $20. Now there’s $20 of intrinsic value and one dollar’s worth of extrinsic value. How much is this option?

Most new traders will say it’s a $21 option. A professional trader will tell you it’s a one-dollar option because that’s the amount you’re paying for the insurance policy. It’s this one-dollar value that will separate you and your friend’s performances. For instance, if the stock falls to $100, your friend loses $20 – but you’ll lose $21. You’re worse off by one dollar because that’s what you paid for the “option” or the right to walk away from the deal. In other words, you’re not required to buy the shares of stock, but your friend already committed to it.

If the stock’s price continues to slide below $100, your friend continues to lose, but you’ll limit your losses to $21. It’s the one-dollar extrinsic value that you paid for the “insurance” policy.

Understanding the art and science of options trading is necessary for success, and the interplay between intrinsic and extrinsic values is a great start. Most traders know the relationships, but if you look closer, they may know things that just ain’t so.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

The Power of Using Vertical Spreads to Roll
By Bill Johnson 

In a previous article, I talked about the power of rolling your long call options up as the stock price rises or rolling your put strikes down if the stock price falls. By rolling, you can lock in gains but still hold on for bigger profits. You capture the best of both worlds, as you’re not trying to time the tops and bottoms, but instead are capturing the bulk of the stock price movement — all while greatly limiting risk.

However, new traders often break a roll into two separate trades, and that’s a mistake. For instance, let’s say a trader buys a $50 call for $5. If the stock price rises sufficiently, he may wish to roll it to the $55 strike by first selling the $50 call, say for $7. Once that trade is executed, he’ll immediately place a second trade to buy the $55 call, say for $3.

By selling for $7 but spending $3, the trader has received a net credit of $4 between the two trades. Because he initially spent $5, he’s holding the $55 call for a net debit of one dollar. In other words, by rolling to the $55 call, the trader has reduced his maximum loss from the initial $5 price to only one dollar. However, he still has unlimited upside potential. By rolling the position, he can hang on for bigger profits while continually sweeping cash into the account. On his next roll, he’ll be in a position where he has a guaranteed profit – but will continue to earn more money if the stock price continues to climb.

The trader did the right thing by rolling from the $50 call to the $55 call; however, he went about it the wrong way. By breaking the roll into two separate trades, it subjected him to execution risk – the risk of adverse stock price movement between trades.

To see how execution risk works, let’s go back to the rolling trade where the trader ended up with a net credit of $4. But let’s say while he’s setting up his first order to sell the $50 call, the stock price dips a little bit, and he ends up receiving less than $7, say $6.90. Next, as he’s setting up his order to buy the $55 call, the stock price begins to tick back up. Rather than paying $3, he ends up spending $3.10. Now he ends up with a net credit of $3.80 rather than $4, and it was strictly due to adverse stock price movement while he was setting up the trade – that’s execution risk. How can this be prevented?

Rather than placing two separate trades, the trader should have placed a vertical spread by simultaneously selling the $50 call and buying the $55 call. In trading terms, he’s selling the 50/55 vertical spread for a net credit of four dollars. However, once the trade is executed, he won’t be holding a short vertical spread. Why?

The short $50 call from the vertical spread cancels the original long $50 call. Those end up disappearing from the account. The only position left is the long $55 call — exactly the same result as when he split up the two trades. Well, if it’s the same result, what’s the benefit?

By using a vertical spread, the difference between the two option prices – the $4 credit – tends to remain constant regardless of what’s happening to the stock’s price. If the stock price dips a little bit while he’s setting up the order, he’ll receive less money for selling his $50 call, but he’ll also pay less for his new long $55 call. The result is that he’ll still receive the $4 credit he was expecting. On the other hand, if the stock price rises while he’s setting up the order, he’ll spend more for the $55 call, but he’ll also receive more for the $50 call he’s selling. Again, the result is that the net $4 credit will remain the same.

Avoiding execution risk is the reason professional traders always use simultaneous trades to execute any type of roll, whether moving to different strikes or different expirations. Of course, depending on the roll, they won’t always be using a vertical spread. It may be a calendar spread, butterfly, or any other number of strategies. By understanding execution risk, it gives another powerful benefit of understanding options strategies: You may not plan to use the strategies by themselves, but they may be invaluable tools for rolling the positions you use most often.

Execution risk is another small force that works against you while you put the power of rolling in your favor. Make the two forces work together, and it’s money in the bank.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here