Option Selling

Iron Condors and Volatility

Question:

In your lesson you said that volatility is not good for options trading since you trade within  a statistical mean. If you do condor trades don’t you need volatility?  Won’t you make more money or will out of the money be the same at any price?

My answer:

The higher the volatility, the higher the option prices.
But in a condor, volatility is not as important as price action.
If volatility drops, we can exit the condor trade faster. But if it rises it just means we have to be in the trade longer. Volatility is more important in trades like calendars where it can destroy the trade if it drops too much.

Difference Between Stock Options and Futures Options

Obviously, there is a difference between stock options and futures options, and the primary differences are in flexibility as well as overall risk.

Let’s first review what futures contracts are as opposed to stock options. Futures contracts are standardized contracts that guarantee to buy or sell a specific commodity of standard quality, at a particular date in the future. This sum will be at market price. Contracts are traded on what are called future exchanges. So right away we can tell that futures contracts are not direct like stocks or bonds. They are still considered securities, but with a different type of contract.

Price for futures contracts is determined by what is referred to as instantaneous equilibrium, that takes into account basic supply and demand as well as competitive buy and sell orders on the market. The asset here may not necessarily be commodities; it can be anything from securities to intangible assets or even stock indexes. The future date is referred to as the delivery date. The settlement price refers to the official price of the contract at the end of a trading day.

1. One significant difference between futures contracts and stock options is that futures give buyers an obligation to fulfill delivery according to the contract’s terms, and the obligation for the seller to deliver the asset as agreed. The only escape here is if the holder’s position is closed before the expiration date. Whereas stock options are flexible by their nature, futures contracts require obligation. Futures are known as exchange-traded derivatives, as the exchange company’s clearinghouse plays the part of counterparty on all of the futures contracts.

2. Another major difference in these two contracts is the way in which gains are received. In options trading, a gain can be realized by exercising when the option is deep ITM, or by going to the market and taking an opposing position, or by waiting until the expiration and then collecting the difference in prices (in this case asset price and strike price). However, when it’s time to collect gains on futures positions, you will notice that these gains are “marked to market”, which means the change in the value of positions will be automatically handled at the end of every trading day.

3. Volatility is also traded differently. With equity options volatility makes the price of the option go up, in the futures it is the opposite.

4. Futures options also have many more strike prices than normal equity options.

5. Volume can also vary from option to option just generally many more equity options are traded than futures options.

Freeze Congress Salaries Until We See How Their Laws Turn Out

In a bold move, Mayor Bloomberg of New York called to free Congress salaries. He did it in response to Congress wanting to limit Wall Street bonuses but I happen to agree with him.

I think Congress should have term limits. 4-6 years and you are done. Go back to your job/business/etc. The founders of this nation were all citizen representatives. These people in Congress today have to inclination what the common man in their district is going through. They are not informed about the issues enough to vote properly and they care about getting reelected than doing any good.

They vote their own pocketbooks. And that is a hainous crime. I am really sick of Dems and Repubs fighting and attacking one another just because of party lines. I don’t care what party you belong to but your loyalty should be to the people.

It’s obscene that Congress passed salary increases for themselves when we were in the middle of 2 wars, an economic downturn, and “on the verge of economic collapse”.

I forgot the number but the recent Congress took more days off than any previous session of Congress including the infamous “Do Nothing Congress”. They make more money and they work fewer less. are they not ashamed of themselves? Or do they sit in their private conferences and just laugh at us for allowing them to basically rob us blind?

Let’s have some accountability in Congress. Let’s make some benchmarks and have Congress’ compensation tied to those benchmarks.

• If they balance the budget, they all get $20,000 for the year.
• If the number of high school students that go to university increases by 5% then get $10,000 a year.
• If GDP is positive, then get $10,000 for the year.

We have over 10% unemployment, yet Congress, most of whom are already millionaires, makes over $200,000 a year, gets the best medical plan around, and gets all their living expenses paid for.

What a shame.

2009 Investment Returns

OptionGenius.com reports a positive return on investment of 47.18% for 2009 and a 5.73% ROI for December.

Houston, Texas, January 20, 2009 – OptionGenius.com, a stock option selling advisory service for individual investors, reported monthly gains for December 2009 of 5.73% and a gain of 47.18% for the year of 2009.

Founded by Allan Sama, OptionGenius.com lets anyone see Sama’s actual option trades and adjustments through real-time updates; by making the same trades themselves, OptionGenius.com members can enjoy the average 8% to 10% monthly returns Sama consistently achieves. Even with the Dow down 34% in 2008, Sama and his members made 102.14% for the year.

By limiting the number of trades to only those with a 75% or higher probability of success, OptionGenius.com (http://www.optiongenius.com) has far outpaced the stock market the past few years.

The trades for December were in

• SPX – the S&P 500 Index
• RUT – the Russell 2000 Index
• MNX – the Mini NASDAQ 100 Index

While Sama continues to make above average gains, he does not promise any home runs. In fact, while other advisory services proclaim trades that net 100-1000%, Sama aims for 10% on each trade.

“As an option seller, I look for base hits. I want a couple singles and maybe a double each month. I use strategies that bring me consistent income month after month, no matter what the market is doing. It could be up, down, or sideways and I can still profit” says Sama.

To learn more about OptionGenius.com or to try the service for $1.00, visit http://www.optiongenius.com.

What is an Exchange Traded Fund (ETF)

An Exchange Traded Fund (ETF) is a type of investment fund that is traded on stock exchanges.  This type of fund is similar to stock, and holds assets at about the same price as the net asset value.  

The first ETF in the business was introduced in the early 1990s and were called Spiders (SPY).  This ETF tracked the S&P 500 index.  The Qubes (QQQQ) came a few years later and this tracked the 100 largest non-financial companies on the Nasdaq. Some of the biggest players in the ETF market today include State Street Global Advisors, Barclay’s Global Fund Advisors and Vanguard.  Of course there are many types of ETFs, and they can track everything from the United States stock market to just parts of the stock market, like large or small stocks or specific industries.  ETFs even track foreign markets, individual countries, and commodities.

 There are hundreds of ETFs to choose from.  An Exchange Traded Fund combines the valuation feature of mutual funds (the same kind that can be bought or sold at the end of each day for a net asset value) with a tradability feature of a closed-end fund (the type that trades throughout the day with prices different than the net asset value).  Closed-end funds are not actually ETFs even though they are all traded on an exchange. 

 ETFs offer investors a chance at undivided interest (with simple and lucrative operation like traditional mutual funds) with a little bit extra protection: ETFs can be bought and sold every day like stocks, just as you would find with a broker-dealer.  Another difference is that Exchange Traded Funds do not sell or redeem shares at net asset value.  Therefore, financial institutions purchase and sell ETF shares in large blocks, which can run anywhere from 25,000 to 200,000 shares.

 ETFs offer other advantages such as easy diversification, lower expense ratios, and better tax efficiency (due to their index fund-like operation).  ETFs are less expensive than other financial products because of the lack of management and because of fewer expenses in meeting shareholders purchases and redemptions, as well as lower marketing costs.  They are also very flexible in terms of buying or selling.  Because they are publicly traded, shares for ETFs can be bought on margin and sold short.  Investors can also take advantage of hedging, stop orders and limit orders. Options are also traded on most major ETFs.

 You may want to look into the flexible and potentially lucrative market of Exchange Traded Funds, especially if you are just starting to invest your own money.  They may look and act like stocks but they give you a whole world of opportunity, as they combine the best features of many different types of funds. 

 As ETFs become more and more popular several mutual funds and hedge funds are beginning to have ETFs are part of their portfolios.

How Wide Should Your Strikes Be In A Credit Spread?

Got the following question this week:

First, thank you for providing a great service. I have been trading options for about a year and have learned a lot from your tips and alerts.

Now, I have a question about position sizing.  I am trading $100k of my funds using your alerts. When you send out an alert I multiply the number of contracts by 10 when putting on the trade. My question is: instead of just multiplying the contracts, can I use a combination of increasing the contracts and/or increasing the width of the strikes?

 

For example, if the alert was to sell 2 SPX 1200/1210 Calls, instead of selling 20 10 point spreads, could I sell 10 20 point spreads? What would be the pros/cons of doing something like this?

It seems to me, if I widen the strikes, then when I need to make an adjustment, I could sell the near strike and buy the next strike as opposed to rolling the whole spread. Is there any advantage to this other than lower commissions and (possibly) better fills? More risk? I feel like I am missing something or not really thinking the strategy all the way through.

Thanks,
Adam

My reply:

How Does Option Time Decay Work?

What is option time decay and how does it work in the context of stock options?  Option time decay is denoted by using the Greek word theta. Theta continues to be one of six indicators in option trading known as the Greeks. 

Options are a decaying asset. Option time decay is a feature of all options that basically means that an option will lose value as time goes on and it gets closer to expiration. So when you are looking to buy an option, the more time until expiration means the more the option will cost versus an option that has less time to expiration in which the underlying can move.

Theta specifically measures the sensitivity of an option’s value according to the passing of time.  Another way of saying this is that theta is the ratio of change in an option price according to the fleetingness of time before the expiration.  An easy way to remember this principle is to think of options as living assets that are wasting away as they age.  The value of an option naturally declines as time goes on.  If an option is fast-approaching the expiration date and is not ITM (In-The-Money) then its value will quickly decline, since it’s highly unlikely it will turn out to be profitable. 

Option time decay really starts to pick up speed in the last 30 days before expiration, assuming that the option isn’t already OTM or Out-of-The-Money).  How about options that are deep In-The-Money?  Ironically, in this case time value actually decays even more rapidly.  Why?  Probably because the market thinks these options are too expensive to hold especially when compared to other strike prices.  Therefore, holders of deep ITM options are wise to discount the time value (for a contract quickly approaching expiry) in order to attract new buyers.  The best way to remember this principle is this: the more certainty about an option’s expiry value you have, then the lower the time value is.  Likewise, the more uncertainty as to the option’s expiry value, then the greater the time value you get. 

This is an important part of choosing when and where to buy selling options.  Theta or option time decay is not precisely the same thing as Time Value, though they are related in thought.  The meaning to take home is basically that the time to expiration will have a major impact on the price of the option.  As the option comes closer to expiry then its chances of becoming more profitable are actually decreasing, and counting against it. 

Besides, predicting a stock price eventually becomes easier as every day passes and seems to resemble the last.  Therefore, it’s the time value that is decreasing as maturity approaches (and particularly so once past the 30 day mark). As the option ages, it loses what is called extrinsic value.

For an OTM contract, the option is made up of extrinsic value anyway, so understanding this time principle is paramount.

When trading options, the amount of time left for an option is what can make or break you. Look at a chart of a stock moving in an uptrend and you can tell it is going higher, but you cannot tell how high it will go and by when. If buying options, buy yourself enough time to be right on your bet.

When selling options, selling close to expiration limits your risk. The farther away from expiration you sell, the more premium you get but you do not get the quick decay benefits of option time decay until there are less than 40 days to expiration.

This is why I like to refer to selling options as “Selling Time”. As time passes, the options you have sold lose value. Making money while sitting around. Not a bad job if you can get it. And you can, if you sign up for my service.

Option Trading Books Reading List

What are Some Good Books on Option Selling?

What should you do if you are interesting in learning more about option selling?

The best way to get started is to read a few good books on the subject.

When I first got started I went to an expensive seminar. After two days I knew enough about options to be dangerous – to my myself. After trying to trade options based on what I had learned at the seminar I realized, after losing a lot of money, that there was more to it.

So I started researching books on options, videos online, websites, etc. Here are some of the best books I found on options and trading in general.

Options Books

One of the most advertised books is The Complete Guide to Options Selling: How Selling Options Can Lead to Stellar Returns in Bull and Bear Markets by James Cordier and Michael Gross. It goes into detail about option writing strategies that can improve your profit. It reviews all of the basic mechanics of selling options and profiting as well as strategies that are insider-quality, easy to follow, and that have a high-probability approach. The book is written to appeal to the new investor, not a mathematician. In this book you can look forward to learning why selling options is more profitable than buying, and specific strategies for selecting various types of markets. Keep in mind that this book is about futures options, not equity options.

One of the first books I got was Options As A Strategic Investment by Lawrence Mcmillan. I would say this is the “bible” of options books. Why? Because it is huge and covers all the basics of option trading and then some.

Most option books cover the basic strategies but they leave out when you should use these strategies and what to do when the trade goes bad. Very few books talk about adjusting trades. The best one I found that does is The Option Trader’s Handbook – Strategies and Trade Adjustments by George Jabbour and Philip Budwick.

My favorite book on Option Selling is Generate Thousands In Cash On Your Stocks Before Buying or Selling Them, by Samir Elias. I myself have only used a couple chapters of this book but it was a very interesting with good ideas.

Wall Street Money Machine by Wade Cook is also a good read. But read this book for motivation only. Most of the examples and numbers in this book were over exaggerated but still, I liked it and enjoyed it when I was starting out so you might too. Most of the book was on covered calls.

A couple other “should” read book on option volatility are Option Volatility and Pricing by Sheldon Natenberg, and The Volatility Edge in Options Trading by Jeff Augen. Both are technical and for advanced options traders.

Books On Trading

How To Trade In Stocks by Jesse Livermore is a must read. Livermore was the best stock trader of all time and his strategies are now copied by just about every firm on Wall Street.

Trade Your Way To Financial Freedom by Van Tharp is good to give you some basic guidelines on trading.

Trading For A Living by Alexander Elder is also very good. I have all of Elder’s books even though they focus a lot on technical investing, he does show how traders with different styles can all make money if they get the basics right.

Google (GOOG) Going to $600

A little over a year ago I went to one of those free trading seminars provided by companies that want you to sign up for their coaching or training.

The concept they were teaching was day trading and so it did not interest me very much, but a couple things the speaker said were very interesting. The guy’s name was Tom Busby.

He said that once a stock breaks a hundred $ level for the first time it zooms up 10%.  For example, once a stock breaks through $100 it is going to $110. When it breaks through $200 it is going to $220, etc.

I had heard this before somewhere so I started looking it up. It turns out that Jesse Livermore mentioned this in one of his books. Livermore was probably the best trader of all time.

So now with two reference points I decided this was something worthy of looking into. So I started doing some research.  It turns out, that this theory/rule is true.

I checked with over 40 companies that broke through either $100, $200, or $300 and  84% of then did eventually hit $110, $220, or $330. The average time it took was 4 months. Some did it much faster and the slowest took 8 months, but it got there.

One thing I noticed is that this does not work all the time. It works only in bull markets. And this was also a limited sample.

If this theory holds, then Google (GOOG) is poised to hit $660, and Apple (AAPL) is going to hit $220. As I write this, Apple (AAPL) is already above $209 so $220 is not much of a stretch.

How should you play this?

1. You can buy the stock and wait.

2. You can buy a call option on Google (GOOG) at 660 with at least 4 months of time left to expiration.

3. You can sell puts month after month until Google (GOOG) starts to decline.

All 3 methods have their pluses and minuses. I am already long the stock, and have sold the Jan 560/570 put spread. As long as the bull market stays intact, I can sell more puts.  When Google (GOOG) breaks below the 50 day moving average, I plan on selling my stock and looking for another company to play.

November 2009 Trade Results

Another positive month.

November gave us returns of +5.34%.

To me anything above 5% is a great month. Of course any month with a positive return is good, but 5% or above is better. 

November is usually a good month for option sellers because of all the extra holiday time. It is also close to the end of the year whan many traders and fund managers take extra time off, especially if they have had a good year. With the S&P being up over 20% so far this year, many managers are feeling pretty good about themselves. It doesn’t come close my yearly results of over 40% so far this year with one month left to go but, hey, let them be happy – it’s the holidays.