Butterfly Options » Options Trading

Options Trading Mastery: Buyer Risk & Reward

admin — Tue, 26 Jan 2010 12:04:31 +0000

Like most trades, time spreads have a maximum loss for the buyer. You can only lose what you have spent. If you paid $1.00 for the spread, your maximum potential loss is $1.00. If you bought the spread for $2.00, the maximum potential loss is $2.00.
The buyer of a time spread will purchase the out-month option while selling the nearer month option of the same strike in a one-to-one ratio. Since the out-month option will have more time until expiration than the nearer month option, the out-month option will cost more. This means the buyer will put out money (debit spread) that makes sense. The buyer can only lose the amount of money they spent to purchase the spread. Thus, the buyer’s maximum risk is the cost of the spread.
The buyer can profit in several ways. First, as a time spread, the buyer can profit by the passage of time. Options are wasting assets. As the nearer month option decays more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.
Second, implied volatility can increase. As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher Vega) than the nearer month option that the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.
Third, the buyer can make money due to stock price movement. As stated before, a time spread’s value is at its maximum when the stock price and the spreads strike price are identical (at-the-money). You can have an increase in value if you own an out-of-the-money or in-the-money time spread, and the stock moves either up or down toward your strike. As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.
The buyer’s risks are obviously the opposite of the rewards. You cannot stop or reverse time, so the buyer of the spread can never be hurt by time. Implied volatility, however, can decrease as easily as it can increase. A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher Vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.
In the same way that stock movement in the right direction can be profitable for the buyer of a time spread, stock movement in the wrong direction can be costly. As the stock moves away from the spread’s strike, the spread decreases in value. That will create a loss for the buyer of the spread.

Key to Options Trading Success

admin — Mon, 25 Jan 2010 11:31:28 +0000

Lately, I have been asked about what I think is the single key that determines if you would make it as a rich man in options trading.
This is an extremely interesting question as I am not someone inclined to believe that any single reason constitutes to the success in anything at all. However, that got me thinking hard and reflecting on my own success in options trading. Then I decided to frame the question a little bit more academically. All things equal, what is the single key to options trading success? All things equal meaning everyone has perfect control over their emotions and will execute flawlessly all orders that they are required to without human errors and that market conditions as well as options trading knowledge is equal amongst all.
Imagine a group of options traders who knows all the options strategies available in options trading and exposed to the same market conditions. What will determine which one or ones of them makes a profit?
I came to a conclusion about what I think is the key to options trading success and that is the exact same key to stock trading success; the ability to pick stocks that will perform exactly as you would like it to.
Yes, sad but true, it’s the same thing in stock trading. You make money only when you buy stocks that goes up or short stocks that goes down.
In options trading, you only make money when you apply bullish options strategies on stocks that go up, bearish options strategies on stocks that go down, neutral options strategies on stocks that remain stagnant or volatile options strategies on stocks that stage quick and explosive breakouts.
You only lose money in options trading when you apply bullish options strategies on stocks that goes down, bearish options strategies on stocks that go up, neutral options strategies on stocks that breaks out and volatile options strategies on stocks that remain stagnant.
This single condition for losing money in options trading is, all else equal, the only key to options trading success; the ability to pick the right stocks or the ability to predict the future direction of a stock or index correctly.
Yes, being able to predict future market or stock direction accurately and consistently is an important skill in investing and is a far more fundamental skill set than knowing all the options strategies there is.
If that is the case, why options trading?
Well, even though the key to success in options trading is largely the same as the key to success in stock trading or any other forms of investment or trading, options trading does have a few tricks up its sleeves to help put the odds in your favor.
First of all is leverage and protection. The ability to risk lesser capital for the same profit or a lot more profit with the same capital already puts the benefit of risk in your favor. Even credit strategies can be low risk if proper stops are used.
Secondly, is the ability to make a profit in more than one direction! Yes, since the key to success in options trading is the ability to “guess” the correct direction the underlying stock or index is going to take, won’t your chances of success be dramatically increased if you could profit in more than one direction? Yes, you only get that in options trading.
For instance, a Bull Put Spread is a bullish options strategy that makes a profit when the stock goes upwards, remains stagnant OR drops a little! Yes, all 3 directions! Won’t your chances of success be dramatically increased with strategies like that?
Yes, the key to stock options ( http://www.optiontradingpedia.com/stock_options.htm )trading success is the ability to pick the right stocks which translates into the ability to accurately and consistently predict the future direction of the underlying stock. Nobody can do that consistently and that is why options trading puts the odds of success in your favor through options strategies that profits from more than one direction.

What Is Options Trading?

admin — Sun, 24 Jan 2010 11:41:07 +0000

An option contract is an agreement between two parties to buy/sell an asset (In this case, the asset refers to stock) at a certain price and specific date.
It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.
There are two types of option contracts – Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.
A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.
Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.
If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.
The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.
The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.
Outcomes: Let’s imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.
Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium – more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.
All in all, there are more than 50 strategies you can deploy in options trading by combining many different strike prices and expiration. But do you need to know all?
The good news is you do not have to!In fact, most of them allow you to make money very slowly or limited.

The Many Benefits of Option Trading

admin — Sat, 23 Jan 2010 13:09:25 +0000

Option as a strategic investment is fast becoming the choice of many. The benefits that option trading offers are many and we shall discuss the same here. Option trading having many benefits it is actually a wonder as to why it was not a sought after means for investment for so long.
1. Option trading is not as risky as it seems if traded wisely. In case of option you do not require as much finance as you would do for stocks. As far as hedge is concerned, option trading seems to be the most reliable of them all. In case of option trading you have an insurance throughout he day, all seven days a week and not until the close of the market.
2. Option is very cost effective. You could be in a similar position as you would have stocks but by putting in much less as investment but the catch is that the investor needs to be careful and select the right call option so as to be in the same position as he would be with stocks. This stock replacement strategy is very cost effective.
3. Option as a strategic investment offers to its investors a high return on its investments. The return investors make on the right selection in option trading is far greater than any stock investment. Option can get you about 60-70% and even more on your investments and in the same scenario your stocks may give you a return of only about 10-15%. But there is a flipside to this. When option give you such high rate of return it is only when you have made the right choice but a wrong selection on the other hand can get you back by the entire 100%. So the returns are good but only when you take calculated risks.
4. Option as a strategic investment provides the investor with multiple options so as to attain their aim. Option offers the investors various alternatives if planned and executed well. An example to quote here would be how a margin would have to be paid if short selling is to be done. At times the margin quoted by the brokers is so high that the investor finds it difficult to go ahead with his plans. Then there are those who do not allow short selling by the investor thus again the investor going back to square one as far as his investment plans are concerned. This puts the investor in the back seat as he is unable to execute his plans and here is where the option trading comes into play. You wouldn’t find any broker who says that the investor cannot purchase puts when the market seems to be falling. This would give the option trader an advantage and he would be able to reap the benefits later.
An option trader can invest in the market not only when it moves up or down, when the prices are almost steady, a trader can also use the time factor where the prices are not moving significantly as a profit making opportunity. Thus it is only the option trader who gets a share in the pie in every kind of market.

Options Trading Mastery: Getting Out or Rolling the Position

admin — Sat, 23 Jan 2010 00:29:13 +0000

The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence as was used in the selection and management processes.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes that must be addressed. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In this scenario, in order to close out the spread, one would just let it expire. Both options finish out of the money so no residual position will be left over.
If the spread finishes fully in the money, (at maximum value) that is with both options in-the-money, then both options will be exercised. You will exercise your long call and your short call will be assigned. They will cancel each other out and you will be left with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
The difficult scenario is when the stock closes in between the two strikes of the spread. This scenario, the closing of the stock between the two strikes creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money.
When both options expire in-the-money, they are both exercised-one creating a long stock option, the other creating a short position thus canceling each other out. This is not the case here. Here, one option, the one that is in-the-money will leave a residual stock position and since the other option is out-of-the-money, it will not be able to be used to offset the residual stock position created by the expiring in-the-money option.
There are two actions that could be taken. Choice number one involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. Giving up a portion of the profits may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk (albeit short-lived because you are doing this late on expiration day of the expiring month) that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. If that happens, you will now be naked the residual stock position. Of course, if there is still time, you could always trade out of the option then but that is very risky. However, if the stock is at a relatively safe distance from the out-of-the-money you may want to just close out the in-the-money option and let the out-of-the money option expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this is being done at the very end of the day on expiration day. These options only have minutes of life left. So, knowing this, the risk is somewhat mitigated, but still there none the less.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, you would be best advised to trade out of the spread entirely.
Again, as stated before, if the stock closes either with the spread fully in-the-money, or fully out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position. We discussed above how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
Then, if you have 10 July 50 calls and you exercise them you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

Options Trading Mastery: Rolling the Position

admin — Fri, 22 Jan 2010 11:48:35 +0000

The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In order to close out the spread, an investor would just let it expire. Both options finish out of the money so there is no residual position left over.
If the spread finishes fully in-the-money (at maximum value), meaning both options in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
Investors encounter a difficult scenario when a stock closes in between the two strikes of the spread. This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. When both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. This is not the case here. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
Two actions are possible in this scenario. One involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. This risk is short-lived because you are doing this late on expiration day of the expiring month. If this happens, you will be naked in the residual stock position.
If there is still time, you can always trade out of the option, but that is very risky. If the stock is at a relatively safe distance from the out-of-the-money option, you may want to just close out the in-the-money option and let it expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this takes place at the very end of the day on expiration day. These options only have minutes of life left. The risk is somewhat mitigated, but still there nonetheless.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, it is best to trade out of the spread entirely.
As stated before, if the stock closes either with the spread fully in-the-money or out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position.
We discussed how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
If you have 10 July 50 calls and you exercise them, you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

Options Trading Mastery: Vertical Spread Recap

admin — Thu, 21 Jan 2010 23:34:51 +0000

Vertical spreads can have various names. The same vertical spread could be called several different things by several different people. We have used two terms only: vertical call spread and vertical put spread. Each of these two spreads allows for two positions, long and short.
The long vertical call spread is constructed by buying one call option with a lower strike price while simultaneously selling another call option in the same month with a higher strike price. In a one to one ratio this trade, the long vertical call spread, is labeled a bullish trade. This means that when engaging into a long vertical call spread, the investor expects the stock to increase in value. An investor who engages in a trade with the expectation of the stock going up is said to be bullish. Thus, a long vertical call spread is a bullish trade.
For example, you are long a vertical call spread if you buy 10 August 35 calls and sell 10 August 40 calls. The proper way to describe this would be “long the August 35 – 40 call spread.” Using our previous example of the August 35 – 40 call spread, we assume that you bought the spread for $2.80. At expiration, you know that you can lose a maximum of $2.80 if the stock closes at $35.00 or below. At expiration, you will gain your maximum profit if the stock is $40.00 or over. Your maximum profit is defined as the difference between the two strikes minus the amount you paid for the spread.
Vertical spread’s maximum profit = (difference between the two strikes) – (amount paid for spread).
In this case, the difference between the two strikes equals $5.00. That $5.00 minus the $2.80 you spent on the spread leaves you with a maximum potential gain of $2.20, and represents a 78.5% return. The potential maximum loss is $2.80 or the full value of the investment.
The chart below shows what this spread will do over the course of a range of stock values.
A short vertical call spread is constructed by selling a call with a lower strike price, while simultaneously buying a call in the same month with a higher strike price. Since owning a vertical call spread created a long position for the owner, then the seller of the vertical call spread must be short. An investor who takes a short position anticipates a decrease in the price of a stock and is considered to be bearish on the stock. Thus, a short vertical call spread is considered a bearish position.
Using our example, say you are short 10 August 35 calls and long 10 August 40 calls. The short vertical spread is set up in the proper ratio and in the same month. For the sale of the spread you received $2.80. Your maximum potential gain is the $2.80 that you received from the sale and would be obtained if the stock closed $35 or below.
The maximum loss is calculated by taking the difference between the two strikes and subtracting the sales price of the spread from it. The difference between the two strikes is $5.00 (40-35). From that we subtract the price of the spread which is $2.80 and we are left with $2.20. This $2.20 is the maximum potential loss for a seller of this spread. The formula is given as: The difference between the two strikes – the price of the spread = total potential maximum loss.
The maximum profit for the seller of a vertical call spread is attained when the price of the stock closes at or below the lower priced strike. And the maximum loss is attained when the stock closes at the higher strike.
The vertical put spread functions in much the same way as the vertical call spread just in the opposite direction. Like the vertical call spread, the construction of the vertical put is done in a one to one ratio. The vertical put spread is constructed by purchasing one put and simultaneously selling another put in the same month but in a different strike.
A long vertical put spread is considered to be a bearish trade. This means that the purchaser of a vertical put spread is expecting the stock to go down. Further, a long vertical put spread is considered a debit spread which simply means that the purchaser had to put out money to buy the spread. Now, if the stock proceeds down, the spread’s value will expand. As stated before, a spreads maximum value is equivalent to the difference between the strikes. On the other hand a spreads minimum value is $0.
In the case of a put spread, maximum value is attained when the stock trades at or below the lower strike. Conversely, a put spread’s minimum value is attained when the stock trades to the higher strike.
For example, suppose we purchase the August 50-55 put spread for $3.00. To set up this trade, we would have bought the August 55 put and sold the August 50 put. If the stock trades down to 50 or below at expiration, the spread will be worth its maximum value of $5.00 (difference between the two strikes: 55-50).
Since you bought the spread for $3.00 and it is now worth $5.00, you have a $2.00 profit which represents a 66.6% profit on your $3.00 investment.
On the downside, the most you can lose is the $3.00 you spent for the spread and this will happen if the stock closes $55 or above. If the stock was to close at $55, the August 55 put would be worthless because it would be equal to the stock price thus valueless. The August 50 put would also be worthless being that it is $5.00 out-of-the-money. The difference between these two values would obviously be $0. Below, the chart shows the value of the spread at different stock prices.
A short vertical put spread is constructed by purchasing a put with a lower strike price while simultaneously selling a put with a higher strike in the same stock in the same month and in a one to one ration. For example buying one Feb 65 put while selling one Feb 70 put or buying 10 May 20 put while selling 10 May 30 put. It is considered to be a bullish trade because the seller expects the stock to go up or increase in value. Further, it is considered a credit spread meaning that you receive cash into your account upon execution of the trade.
Say you were to sell the June 50 – 60 put spread for $5.50. As the seller, your maximum profit will be the $5.50 you received for the sale of the spread. The maximum profit will be attained if the stock closes at $60.00 or above. At that level, both the June 50 and 60 puts will be worthless because both will be out-of-the-money. Thus, the spread will have no value.
The maximum loss of the trade will be defined by the difference between the two strikes minus the amount you received from the sale of the spread. In this case, the difference between the strikes is $10.00 (60 strike – 50 strike). The spread was sold for $5.50 so $4.50 is the maximum loss of the position to the seller.
In conclusion, vertical spreads provide the buyer and the seller an excellent percentage return while, at the same time, provide limited loss scenarios. Vertical spreads allow for two types of bullish trades, the purchase of a vertical call spread or the sale of a vertical put spread. On the other hand, vertical spreads offer two bearish trades; the purchase of a vertical put spread and the sale of a vertical call spread.
So, if you want to take advantage of a directional stock movement (either up or down) but you are not interested in taking a longer term, possibly capital intensive position, then look to using the vertical spread due to its favorable risk reward scenario.

Options Trading In A Nutshell-The General Idea Behind Options Trading

admin — Thu, 21 Jan 2010 23:34:50 +0000

Perhaps among the most difficult and maybe the riskiest type of trading is option trading. Many experienced traders realize that option trading does not suit all traders. It selects its own type of people, generally the risk takers. And the trade itself requires skills and thinking unique only to people who won’t fold under extreme risks. Most experts recommend this kind of trading only to those people who have enough risk capital as it carries with it substantial risks.By default, it is also speculative. So if you are a person who doesn’t want to speculate too much, you might as well find another kind of security which will work better for you. However, stopping the idea of entering this trade right now is as risky as not knowing anything about it. It carries with it risks, that’s true,for sure, but it is also a very rewarding venture. You should try to understand something on it such that you would be able to decide whether to go for options trading or not.Since it is always risky, option trading also offers advantages that may not be available with different types of trades. Among its premium advantages is the flexibility it lends its investors. Each lender has the option to trade at a specific price within a specific period.It is also, when comparing the two, a more advantageous type of trade due to its high leverage it offers. Depending on the location, each option may cover a few underlying assets. In the U.S.A., for instace, each option may represent for 100 underlying assets. Thus, this strategy affords the holder the ability to profit from several assets within a single option.So tell me about an option?An option is a type of security, generally closely comparable to bonds and stocks. It is, in itself, a binding contract, that is monitored by and through strict terms and conditions. Basically, options are contracts that owners will buy or sell at a certain price prior to or on a certain date. An option is usually an additional price tag to a certain asset or item because it is a reservation for the purchase or sale of a certain asset.Options are also occasionally called derivatives. This is because the value of an option is based from the value of the underlying asset.To better understad this topic, lets look at the example below:Say you have thought about purchasing a real estate property which is valued at several hundred thousand dollars. However, when you first negotiated with the owner, you did not have enough money to buy the property on the spot. So you made a deal with the owner to pay an extra $5,000 to keep the deal for you for the length of 60 days. The extra money you put in is referred to as the options. In case you don’t want to pursue with the sale, the owner of the real estate is not allowed to force you to buy the property nor can the law impose the sale on you. However, you would still have to shell out the price of the option.In conclusion, when thinking about buying a property with an enclosed option, you will have the right to continue with the sale or to turn down the sale. You are not mandated to do either of the two. But be aware, you may lose 100% of your total investment in options trading which is the value of the option itself.

Options Trading Mastery: Time Decay and Volatility Trading Opportunities

admin — Tue, 19 Jan 2010 12:10:21 +0000

When vertical spreads are mentioned, they quite often come with monikers such as ‘bull’ and ‘bear’. This lends most to think of vertical spreads as directional plays which is true. However, vertical spreads can be used to take advantage of two other potential trading opportunities – time decay and volatility movement.
If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. Knowing a little about them now, you will recall that a vertical spread has a limited profit potential but also a limited loss scenario for both the buyer and the seller. So, how do we use this covered trade to take advantage of time decay.
At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays away over time, you could set up a vertical spread by selling an at-the-money option and buying either the out-of-the-money option (creating a credit spread) or buying an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay away at a faster rate than either the in-the-money option or the out-of-the-money option due to the fact that the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.
Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea, but now there are a couple choices. Should you do the put spread or the call spread? Should you buy it or sell it? The decision of what to do from here should first be based on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you can’t expect the stock not to move at all. So even though you are playing time decay, you still want to form an opinion about in which direction the stock is most likely to move. By doing this, you’ve now give yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.
Now that you have picked which at-the-money strike you are going to sell and you’ve picked your anticipated stock position you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember both the vertical call spread and a vertical put spread allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up. For the bears, you can buy a vertical put spread or sell a vertical call spread. For each direction there are two choices to decide from. One is a purchase, one is a sale. The best way to decide which to do, other than your own style or comfort ability is a simple risk/reward analysis.
By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.
Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility. Volatility is a huge component of an option’s extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.
As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less. Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the spread.
So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.
As to how to set it up, you would follow the same guidelines as you would for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.
Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the spread will have to be constructed with the short option being the at-the-money.
As you can see, the vertical spread does not have to be used only in directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to both the buyer and the seller.

Currency Options – 3 Secrets of Options Trading for Huge Gains!

admin — Mon, 18 Jan 2010 23:48:46 +0000

Many traders love the idea of currency options, they have unlimited gains and limited risk sounds great in theory, but in practice 90% expire worthless!
This article is all about how the pros use currency options to generate big consistent gains and how the losing majority don’t understand the odds of success.
This article will give you 3 powerful ways to make huge money in currency options
Don’t gamble with options!
Consider this simple scenario.
You’re betting on a horse race and you have a 3:1 favourite and you have a 15:1 outsider.
Which one is the better bet?
Well, bet on the outsider and you have bigger winning potential, but betting on the favourite gives you a better chance of winning.
How often do you see a betting shop go broke?
Not very often they know the odds of success and the betting odds reflect this. It’s obvious! Bet on the favourite.
Currency options and odds
In currency options though traders continually take the outside long shot bet.
They buy options way out of the money with short time to expiry and this means the odds of winning rely on lady luck.
If you want to put the odds in your favour you need to trade options for less potential gains but greater odds of success and this involves keeping in mind two points:
1. Buy at or close to the money
Don’t take the long shot; buy at or in the money options, in strongly trending markets.
This way you have time for the trend to take a correction and move in the right direction and keep in mind a trend in motion is more likely to continue than reverse.
If you do this, the odds are more in your favour and that what currency options’ trading is all about.
Brokers and guru’s like to tempt you with the long shots and appeal to your greed, Don’t listen, stay with at or in the money currency options and only trade trending markets this scenario is where your chances of success are highest.
2. Get time on your side
FACT: The shorter the time to expiry of currency options the greater the affect of time decay.
Many traders think these options are cheaper (they are in terms of cost) but not in their odds of success!
Make sure you give yourself plenty of time and keep it on your side.
Buying in or at the money currency options with a lot of time value costs you in terms of profit potential. However, potential that does not become cash in your bank is just that – potential.
Keep in mind the horse betting scenario earlier. Do you know someone who bets on the outsider and wins consistently? I don’t.
Keep profit potential realistic
Ok, so you have less profit potential, but you have greater odds of success.
Now let’s look at the best strategy of all.
3. How to trade with odds of 90% success
Consider this 90% of currency options bought expire worthless.
On the other hand, the person who has sold the option has profit odds of 90%.
The real way to make money is selling options. What options do you sell?
You guessed it already! Options out of the money with short time to expiry.
In reality option selling looks a bad bet – unlimited risk for a limited reward, but keep in mind the odds are hugely stacked in your favour.
Huge consistent gains
To sell currency options you need to be well capitalized and take short term swings against you. However, if you sell out the money options with time decay killing them and you spread your risk, you can pile up huge gains over time.
The above is not rocket science! Its common sense, you don’t get anything for nothing in financial markets and limited risk and the unlimited rewards of currency options comes at a cost.
Understand this and you are well on your way to making big gains in currency options.
If you are small trader be patient and take the high odds of success for lower potential gains. If you are large trader sell options and take advantage of the majority of mug traders who are keen to give you their money.
Currency options can make you money follow the above and get the odds on your side, that’s all you can do in financial trading and over time you could pile up some huge profits. Good luck!