ATM and OTM Options

At-the-money and out-the-money options’ premiums in most cases have small to no intrinsic value embedded in them.

Let take for example MSFT. The stock is currently traded at $28.77

MSFT $29 March call is currently traded at .56

MSFT $30 March call is traded at .22

There is no intrinsic value in any of the mentioned options. If you decide to buy them, you are  essentially paying for the time to be right and to compensate the seller of the premium for the risk he is taking.

Options are bought for three main purposes: leverage, better risk control and hedging. In this post, I am going to focus on the first two.

At this point of time, MSFT is trading at $28.77.

MSFT $29 Call is currently offered for .56. The delta of that particular contract is .46, which  means that for the next 1 dollar upward move in MSFT to 29.77, the $29 March call premium will increase by .46 to 1.02. A 3.5% move in the underlying asset (the stock) results in 82% move in the March $29 call. (it does matter how fast this move will happen, because options are wasting assets and as the time passes the time premium declines with the pace of theta. For this particular call option theta is currently at -.0119, which means that the option premium will decline by .0119 per day, ceteris paribus).

Risk management for an option trader should not be any different than the risk management for a stock trader. Assume that your trading capital is 100k and you are willing to risk .5% of your capital on every trading idea; therefore you are putting on risk $500 every time. In stock trading knowing your risk per trade helps to define the size of your position (how many shares you can afford to buy). In the options’ world knowing your risk per trade helps to define how many contracts you can afford to buy. Every time when you purchase an ATM or OTM option, you should assume that you will lose the whole premium that you pay. Therefore never risk more than you can afford to lose. In this case .5% of your capital or $500 per idea.

You should be a buyer of premium (calls or puts), when

– you have a directional bias: you expect the underlying assets to make a substantial move; for example you might expect a stock to be bid up in front of its earnings’ report date.

– when you expect the IV of your option to increase; What makes an IV of one option to increase? Simply explained – an imbalance between supply and demand in favor of the demand; There are more buyers than sellers for that particular option contract. The impact of IV is measured via vega, which shows the move in the option premium for each percentage point move in the IV.

The current IV of MSFT $29 March Call is 20.5% with a vega of .0316. If the IV doubles from 20.5% to 41%, the premium of that same call option will increase approximately by 20.5*0.0316 = .65.A $.65 increase caused just by the increase in the IV. Assuming there is no change in the stock’s price and the increase in IV happens overnight, the premium of that option should become .56+.65 = 1.11.

When does IV tend to rise?

IV of calls tends to rise in expectations of earnings. As the event approaches, the perceived risk increases and there are more buyers of premium. When I am bullish on certain stock, I like to buy calls 10 to 15 days before the earnings announcement. In this case I have two out of three elements on my side – delta (assuming the stock move in the expected direction) and vega (the increase in the IV). The only element that is against me is theta, but its negative effect is often more than offset by a sizable move in IV.

In the majority of the cases I make sure to sell my calls on the day before the earnings announcement date or earlier. Holding through earnings is usually a gamble, but there are cases when it could be done (I leave that for another post). The reason I tend to sell before the earnings announcement is called volatility crash – an immediate and humongous drop in the IV of an option contract, which affects negatively the premium. Many have lost money in options despite being right on the direction of the underlying asset. People buy a day or two before the earnings report is due, hoping to make a quick gain from a potential gap up on the news. There is no free lunch. In the majority of the cases, those people overpay in terms of IV. If the increase in the stock is not big enough to offset the drop in the IV, the option holder’s position will be in red.

The IV of put options tends to increase in expectation of earnings and when the underlying asset declines in value. Isn’t that perfect. You are bearish on certain stock, it drops and in the same time the IV of the purchased put increases. This is usually the case with the exception of the after earnings announcement volatility crash.

Options are wasting assets and when you are a buyer of premium it is preferable to give yourself more time to be right. The choice to buy 20-day or 180-day option will depend on your goal, analysis of the underlying stock and risk preference. When you are relying mainly on an increase of the IV in front of an earnings announcement, shorter-term options are preferable as the demand for them is bigger and therefore the potential for an increase in the IV higher.  When your intention is to capture a nice size of the move of the underlying stock, it is better to use longer-term options, so you can have more time to be right.

This was the first post of a series of posts,  in which I intend to explain how I use various options strategies, starting from the most simple to the more sophisticated ones. In the next post, I will explain the specifics behind buying  in-the-money options.

Dr. Steenbarger on booking losses before they occur

There is a meaningful difference between trading to win and trading to not lose. The average person feels more psychological pain over a loss than they feel pleasure over a gain–particularly once they have already “booked” that gain mentally.

When we enter a trade, we expect to be paid out. Mentally, we book a potential profit. When a loss materializes, it is the unexpected event–and we respond more strongly to the unexpected than to the familiar.

What is the solution to this dilemma? The answer, surprisingly, is to book losses before they occur.

It’s human nature to not want to think about such unpleasant things as losses. But by knowing our maximum possible loss in advance and by mentally rehearsing what we’ll do on those occasions when the loss occurs, we normalize the losing process. That divests it of its emotional grip.

We can never eliminate loss from life or trading; nor can we repeal the basic uncertainties of markets. What we *can* do is develop an edge in the marketplace and, over the course of many trades, let that edge accumulate in our favor.

Source: http://traderfeed.blogspot.com/2006/09/trading-to-win-vs-trading-to-not-lose.html

The danger of leverage

In the United States and many other industrial countries, the recent financial crisis contributed to the longest and most severe economic contraction since the Great Depression. The rapid expansion in the use of borrowed money, or leverage, by households in recent years, is one factor that may help account for the virulence of the downturn.

Household leverage ratios: Debt/Disposable income

Going forward, the efforts of households in many countries to reduce their elevated debt loads via increased saving could result in sluggish recoveries of consumer spending. Higher saving rates and correspondingly lower rates of domestic consumption growth would mean that a larger share of GDP growth would need to come from business investment, net exports, or government spending. Debt reduction might also be accomplished via various forms of default, such as real estate short sales, foreclosures, and bankruptcies. But such deleveraging involves significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores.

Source: FRBSF Economic Letter, Reuven Glick and Kevin Lansing

Richard Love on Superperforming stocks

First consideration in buying a stock is safety. Safety is derived more from the good timing of purchase and less from the financial strength of the company. (All stocks decline in bear markets. When there is no risk appetite, there are no buyers.)

Most stocks are price cyclical. Buying stocks as the market rebounds from bear market lows is the safest time and it offers the best opportunity for large capital gains. (Sellers cover their short positions, large size buyers are stepping in and indexes are rising above their rising 50 dma)

A winning combination in potential Super-performing stock is rapidly rising earnings, a small supply of stock, low P/E, and a product that promises strong future growth. (Investor’s job is to decide 1) when to buy; 2) what to buy) and 3) when to sell; the future best performing stocks have already doubled in value and are close to new 6 months high)

Some of the strongest price moves have been a result of severe imbalance between limited supply and huge demand of investors. Opportunities for a big gains in stock market are most likely to occur in relatively small companies than in companies with many millions of shares outstanding. Look for small company introducing a unique product that is likely to become widely used. This is the combination that has time after time resulted in dynamic growth.

Financial leverage in a stock is often responsible for high volatility in the stock’s price. Companies with high % of debt in their capitalization tend to have very volatile earnings. A relatively modest increase in income in such companies leads to disproportional increase in EPS.  Airlines and retailers are best examples of high leveraged companies. During periods of recession, when profits decline for most businesses, companies that have large amounts of debt sometimes have no profits at all. But as the national economy emerges from recession, corporate sales and profit margins improve. The % increase in profits can usually be larger than for stocks with small leverage. Highly leveraged companies, then, are even more business cycle sensitive and often are buying opportunities when the stock price is depressed.