Tuesday, May 26, 2009

Sunny California

I'm going to be out of town for the rest of the week, so not sure how frequently I'll be able to post. Here's my view of the S&P 500 before I take off.

Today's bounce further validated 880 ish level as formidable support. For us to really get the party started on the bear side we need to take out 880. On the upside 930 ish and coincidently the 200 MA seem to be worth watching as resistance.

Good luck on your trading!


Sunday, May 24, 2009

Natty Gas Naked Puts

Since highlighting the strong breakout within Natural Gas, we've seen a significant retracement. Ideally I like to see an uptrending stock retrace between 38.2% and 61.8%, so witnessing the UNG retrace over 75% of it's prior swing does temper my enthusiasm a bit.

However, for those still somewhat bullish on the Nat Gas space, this retracement can be viewed as another opportunity to enter bullish plays. Let's explore a conservative naked put sell.

UNG @ $13.70
Sell the June 13 put for $.60
Max Reward = $.60
Max Risk = $12.40
Breakeven = $12.40
Initial Margin Requirement = $3.32
ROI = 60/332 = 18%
Keep in mind your broker's margin requirement may deviate from mine and the the margin requirement may rise if the stock drops.
Trigger: You many want to wait for UNG to stablize and start to bounce before pulling the trigger.
Here is the risk graph:

Best case scenario: UNG remains above $13 at June expiration (3 weeks), the put expires worthless, and you keep the $.60 premium

Worst case scenario: UNG resides below $13 at expiration, causing you to purchase 100 shares at a cost basis of $12.40. Given that $12.40 is BELOW the current 52 week low in UNG- it doesn't seem that bad of a price to be long UNG

Thursday, May 21, 2009

Bear Call Recap

We had some nice follow thru to yesterday’s bearish reversal. One of my bearish strategies of choice is a bear call spread (i.e. selling call spreads). As the market staged an intraday reversal yesterday I entered some RUT June bear call spreads. The purpose was two-fold:

1. I’ve already got quite a few bullish trades primarily on commodities which had nice profits after Monday and Tuesday’s strong moves (AGU, USO, ANR, ICE…). Typically after the market stages a strong rally, I like selling OTM call spreads on an index such as the RUT to serve as a hedge for my existing bullish trades. That way if the market proceeds to drop in price, the profit from my call spreads helps to offset any profit I give back on my bullish trades.

2. Even if I didn’t have any existing bullish trades, the topping action (slowing momentum & lower pivot high) of the RUT justified entering a bearish trade on its own merits.

Here’s the trade:
RUT June 550-560 call spread
STO 550 Call for $2.85
BTO 560 Call for $1.85
Net Credit = $1.00
Max Reward = $1.00
Max Risk = $9.00
Prob of profit = 90%

Here are a couple risk graphs for the spread.

With this trade, I’m essentially betting the $RUT will not be above 550 at June expiration. With today’s downdraft, the spread is already down to $.50. Once the spread declines to around $.20, I'll close the position to lock in the gain.


Wednesday, May 20, 2009

An Ominous Sign?

Today's intraday reversal came as a smack in the face to the bulls. Could it be a sign of more downside or just another headfake to sucker in the bears? Only time will tell, but bare minimum it should inhibit a sense of caution in the bulls. Retail, mentioned yesterday, had a pretty sick intraday reversal on higher than average volume. Here's a smattering of charts to keep an eye on (click to enlarge).

I'll highlight a few naked put & credit spread trades later in the week.


Tuesday, May 19, 2009

Retail Retracement

The Retail industry exhibited relative weakness during last week's sell off, as it dropped all the way to it's 50 day moving average. Had you been bearish on retail stocks, that obviously would have worked out rather well. With the strength we've seen so far this week, the RTH (Retail Holdrs) has staged a nice little retracement back up to prior support (on lower than average volume). For those of you who believe the retail space will continue to weaken going forward this retracement can be looked at as an opportunity to reload on bearish trades.
From a broader perspective the whole consumer discretionary sector (XLY) didn't do so hot last week. So in addition to retail stocks, restaurants also got hammered and are in the midst of a retracement. It may not be a bad idea to take a peek at some restaurant charts for bearish retracement patterns as well (CMG, DRI, CBRL). I'd like to see the market soften up a bit more this week before I get too trigger happy with bearish trades, but I'll be keeping retail & restaurants on the radar.


Monday, May 18, 2009

MythBusters- Cheaper to let Options Expire?

The fourth installment to our Options Myths series will cover:

Myth #4: It's cheaper to let options expire!

Not really sure how pervasive this myth is, but I'm sure a few people have been duped into letting an option expire and realizing it's NOT always cheaper. So, let's jump in.

The first problem with making blanket statements about options, such as myth #4, is there are so many different types of strategies and scenarios that it's darn near impossible to state that one technique is better ALL the time. Are there scenarios where allowing an option to expire is cheaper? Sure, but there are many more scenarios where allowing an option to expire is much more expensive.

Expiration Recap:
At expiration an option is either Out-of-The-Money or In-The-Money. All OTM options expire worthless and all ITM options are automatically exercised. As an option trader, there are only 4 different scenarios that may play out with your option positions at expiration:
-Long OTM option
-Long ITM option
- Short ITM option
- Short OTM option

Long OTM options:
If you're long an OTM call or put option that remains OTM, riding to expiration will merely lose you more money as the option value will continue to erode until it expires worthless at expiration.

Long ITM options:
What if I'm long an ITM call or put? Will riding to expiration and letting the option expire be cheaper than exiting prior to expiration?
The answer is no! As stated, ITM options are automatically exercised, thus riding an ITM call (put) to expiration will result in you having to buy (sell) 100 shares of the underlying stock. Coming up with capital to buy (short) shares is obviously much more expensive than merely selling the option before expiry.

Short ITM options:
Suppose I'm short an ITM call or put. Would riding to expiration be cheaper than closing them out prior to expiration? The answer is NO!
Short ITM Calls would automatically be assigned, resulting in me having to SELL 100 shares of stock at the strike price. The margin required to short 100 shares is going to be greater than whatever it costs to close out a short call prior to expiration.
On the other hand, allowing a short put option to expire ITM will result in having to buy 100 shares at the strike price. The capital outlay required for that is obviously going to exceed the minimal cash required to close the trade.

In the case of a covered call (long 100 shares & short ITM call), you may want to ride to expiration and allow assignment, but it's not necessarily cheaper than closing prior to expiration as the myth purports.

Short OTM options:
And that brings us to the 4th and final scenario- riding short OTM options to expiration. This is the most common scenario where it is cheaper to ride an option to expiration. For example, suppose I'm short a naked OTM put option with a week to expiration that is worth $.05. Consider the following 2 scenarios:

Close now
Buy to Close put for $.05
Pay Commission

Ride to expiration and watch expire worthless
Save $.05
No Commission

Although it would be cheaper to ride to expiration, that assumes the option remains OTM. What if the stock undergoes a gigantic move the last few days before expiration, resulting in your short option moving ITM by a dollar? That option which was trading at $.05, is now trading at $1.00. In retrospect you will kick yourself for not buying it back at $.05 when you had the chance. That's the risk you run with trying to eke out every last penny of a short option's premium. My experience has taught me to buyback any short options that are almost worthless (maybe $.15 or less). Might not be a bad idea for you to at least consider the benefits of foregoing the last few dollars in exchange for eliminating risk.


Thursday, May 14, 2009

Old King KOL...

... was a merry old soul, and a merry old soul was he.

Commodity ETF's serve as effective vehicles for equities traders to gain exposure to the commodities market. Overall commodities have exhibited relative strength vs. the broader market over the past few weeks

A few days back we highlighted the UNG ETF, which tracks Natural Gas. Let's continue our commodities discussion by highlighting coal. KOL, the Market Vectors Coal ETF is structured to:
"...replicate as closely as possible, before fees and expenses, the price and yield performance of the Stowe Coal IndexSM. The Index provides exposure to publicly traded companies worldwide that derive greater than 50% of their revenues from the coal industry"

The Stowe Coal Index is comprised of 32 coal stocks. Some of the bigger players (and index weightings) within the index are:
JOYG - Joy Global Inc (6.5%)
CNX - Consol Energy Inc (6.27%)
BTU - Peabody Energy Corp (5.73%)
BUCY - Bucyrus International Inc (4.55%)
MEE - Massey Energy Co (4.48%)
ANR - Alpha Natural Resources (3.5%)

Weekly Chart KOL:
1. Along with other commodities (Oil, Nat Gas, etc...), KOL experienced a precipitous downtrend starting in July 2008- The bears (supply) were in complete control
2. Starting in November there began to be an equilibrium between supply & demand as the stock transitioned into more of a sideways consolidation.
3. May's breakout suggests that the Weekly chart may be transitioning into an uptrend.

Daily Chart KOL:
Strong volume helps to confirm the validity of the breakout.

So if you're looking for bullish stocks, the coal sector may not be a bad place to start.


Wednesday, May 13, 2009

Calls vs. Married Puts

So let's pick up on Tuesday's synthetics post with an in depth look at long calls vs. married puts.

Remember, the basic formula for synthetics is:
S = C - P

If we swap this around we could say that:
C = S + P

In other words, a Long Call is the synthetic equivalent of a Married Put (long stock + long put), when the call & put have the same strike & expiry.

I'm going to use MSFT, which was highlighted on Friday's Options Action, as an example.

In contemplating a bullish type trade on MSFT, our Options Actions pals pointed out that implied volatility on MSFT options was relatively low. Take a look at the IV-HV chart.
Current IV (gold line) is at 35%, while 30 day Historical volatility (blue line) is at 46%. Although MSFT IV has come in drastically over the past few months, it's not really an isolated incident as IV has come in on just about everything (take a glimpse of the VIX). Although IV seems cheap compared to 30 day HV, 10 day HV (not shown)is at a mere 24%... So not sure if options are a definite buy here, but we must admit they're the cheapest they've been since back in September 2008.

Remember when IV is low, options are relatively cheap & potentially under priced. When IV is high, options are relatively expensive & potentially overpriced. B/c of the low IV, *cheap* options, they compared buying straight calls to buying puts (for those already long the stock).

MSFT is currently trading at $19.75- Let's compare buying the July 17 calls vs. owning the stock & buying a July 17 put.

Long calls
17 Jul call @ $3.00
Net Debit/ Max Risk = $3.00
Max Reward = Unlimited

If at expiry the stock is below $17, the call will expire worthless resulting in a $3.00 loss.

Married Put
Long 100 shares stock
Buy 17 Jul put @ $.35
Net Debit/Max Risk = (19.75 - 17) + .35 = $3.10
Max Reward = Unlimited
If at expiry the stock is below $17, I can exercise my put and sell my stock at $17 resulting in a $2.75 loss on the stock. I will also lose $.35 of extrinsic value on my put option resulting in a total loss of $3.10 - roughly the same amount as the long call.

Although the risk-reward characteristics are identical, the Married Put obviously costs more due to purchasing 100 shares of stock. As a result most would prefer to simply buy the call option.
The biggest benefits I see with understanding synthetic relationships is it allows me the ability to trade more efficiently and find lower cost alternatives. As discussed, a few examples would be-
1. Naked Put instead of Covered Call
2. Long Call instead of Married Put
3. Put or Call Spread instead of a Collar


b2b - Back 2 Breakout

With today's gap down, we're now on our....dare I say it?.... 3rd day down. Haven't seen a three day retracement since all the hullabaloo (read: insane rally) started in March. So what's it mean?

So far I'd say buyable dip - after all- EVERY dip has been buyable since the March lows. Definately too soon to say this uptrend is done- bears don't really have a technical case yet. NO double top, NO head & shoulders, NO slowing momentum. Overbought yes, but let's be honest we've been overbought for a long time- so that viewpoint doesn't really hold salt right now. The bull has skewered the overbought crowd left and right over the past month (I've got the wounds to prove it..... May bear call spreads *sigh*).

As the S&P 500 is pulling back, I'm drawn to the 875 level which was formidable resistance on the way up. One would assume it then becomes formidable support on the down. It also served as a breakout point on May 5th. Oft times those that missed buying a breakout are granted a second change by way of a retracement or retest of the breakout point. We're not only seeing this in the S&P, but many other bullish charts. Take a look-


Tuesday, May 12, 2009


Friday's Options Action included a conversation on equivalent positions, such as married puts vs. long call trades. Understanding equivalents or synthetics is quite useful when playing in the options realm. Synthetics have identical risk-reward characteristics, thus one can be used as a substitute for the other. For example:

1. Covered Calls & Naked Puts can be synthetics
2. Long Calls & Married puts can be synthetics
3. Long Stock & Long Call/ Short Put combo can by synthetics

Basic Equation:
Let's look at a few formulas to illustrate. For the following formulas S = Stock, C = Calls, P = Puts. P & C must represent the same underlying and have the same expiry date & strike price for the formula to hold true.

S = C - P

One can create a synthetic long stock position by buying a call (C) and selling a put (-P). For example:
Long 100 shares SPY @ $91 = Long 91 June call + Short 91 June put

The equation holds true because at expiration if SPY are above $91, the 91 put expires worthless, the 91 call is assigned and I buy 100 shares @ $91. If SPY is below $91, the 91 call expires worthless, the 91 short put is assigned and I go long 100 shares @ $91. Regardless of the stock price I will be long 100 shares SPY @ $91! Take a look at the risk graphs:

We could use a little algebra and change the formula:

S = C - P

S - C = - P In other words, S - C (covered call) = -P (Short Naked Put). This is again assuming the call and put are the same strike with the same expiry date.

I've already discussed naked puts here.

Here's another:

S = C - P

S + P = C In other words, S + P (Married Put) = C (Long Call option)

This formula brings us back to the subject at hand. A married put can be considered a synthetic long call. In my next post, I'll elaborate on Married Put vs. Long Call trade on MSFT.

Saturday, May 9, 2009

Sector Spotlight: Natty Gas

This past week we've seen commodities exhibit relative strength vs. the broader market. In particular I want to highlight the resurgence in the Natural Gas sector ETF.

"The United States Natural Gas Fund, LP ("UNG") is a new way for investors and hedgers to manage their exposure to energy...UNG is an exchange traded security that is designed to track in percentage terms the movements of natural gas prices. UNG issues units that may be purchased and sold on the NYSE Arca."
Over the last 5 days UNG has run up around 25%, while the SPX has rallied a mere 5% - an obvious out performance.

1. Break of the down trend line
This downtrend line has been intact since around OCT 2008. Breaking a 7 month trend line is significant in showing a shift in sentiment.

2. Break of the 50 MA
UNG hasn't been above the 50 MA since July 2008, when it initially broke down and started its swift descent. The fact that it's finally mustered the strength to pierce the declining 50 MA bodes well going forward.

3. Increase in volume
High volume helps confirm the validity of any breakout, since the more buyers that step up and participate, the higher the odds it continues higher. High volume also helps indicate institutional money flow. You can bet it wasn't just a consortium of individual investors like you and I pushing UNG higher the last few days. With volume surging to 3x the daily average , some of the big boys were accumulating shares.

Some of the bigger companies within the nat gas sector that have followed the bullishness of the UNG are: APA, APC, DVN, EOG. Keep an eye on those going forward.


Thursday, May 7, 2009

Gamma Facts

Gamma, the third letter of the Greek alphabet, is one of the more esoteric Greeks which measures the rate of change of Delta. Delta has been covered in depth in two prior posts. If you missed those posts you can review them here & here.

Delta ranges between 0 and 100 based on whether the option is ITM, ATM, OTM. Thus, as the underlying price fluctuates, delta changes as well. This is where Gamma comes into play.

Gamma measures the rate of change of Delta for a $1 change in the price of the underlying.

Gamma Essentials:

1. Gamma is usually expressed in deltas gained or lost per $1 change in the underlying. Suppose I own the following option on XYZ which is trading at $40:

July Call Delta = 50 Gamma = 5
If XYZ stock rises (falls) $1, my delta will change to 55 (45).
If XYZ rises (falls) another $1, my delta will change to 60 (40).

2. Whereas Delta is positive for calls, and negative for puts, Gamma is positive for both. Consider the following scenario:

ABC trading at $50
○Long 50 call, delta = 50, Gamma = 5
○Long 50 put, delta = -50, Gamma = 5
If ABC increased to $51, the calls will move ITM and puts will move OTM. Because the Gamma is +5, the new delta of both call and put can be calculated by adding 5 to their respective deltas:
○Long 50 call, delta = 55
○Long 50 put, delta = -45

3. Gamma is highest for short term options and lower for long term options.

The May options have a gamma around 5, June options are around 2, October options have gamma around 1, and Jan 2011 option's gamma is sitting at a measly .5.

4. Gamma is highest for ATM options and lowest for ITM or OTM options. In other words, the delta of ATM options changes much quicker than the delta of ITM or OTM options.

AAPL is currently trading around $132.50. As a result the May 135 calls (considered ATM) have a Gamma of 5. May 125 call's gamma = 3. May 145 call's gamma = 1

5. Gamma can be considered the ally of option buyers and enemy of option sellers.

ALLY of Buyers:

When owning positive gamma positions (think straddles/strangles), gamma serves to make you longer as the market rises, and shorter as it falls. Let's analyze 2 examples:

Long call trade on MNO, currently trading at $50.

Long Jul 50 call, Delta = +50
MNO moves to $55, Call delta moves to +70
○As the stock price moves in my favor, I get longer and longer (more delta), which makes me profit more quickly

MNO moves to $45, Call delta moves to +30
○As the stock price decreases I get less long (lower delta) which makes me lose money at a slower rate.

For a long call trade, Gamma is the characteristic of options that causes your position to get longer (profits accelerate) as the stock rises, and less long (losses decelerate) as the stock falls.

Straddle on MNO, currently trading @ $50
Long Jul 50 call, Delta = +50, Gamma = 5
Long Jul 50 put, Delta = -50, Gamma = 5
Net Delta = 0

MNO rises to $51
Long Call Delta = +55
Long Put Delta = -45
Net Delta = +10

MNO falls to $49
Long Call Delta = +45
Long Put Delta=-55
Net Delta = -10

For a straddle trade, Gamma is the characteristic of options that causes you to get longer as the market rises, and shorter as the market falls.

ENEMY of Sellers:

Gamma can be considered the enemy of option sellers. When owning negative gamma positions (think iron condors), gamma serves to make you shorter or more bearish as the market rises, and longer or more bullish as it falls. This is not a recipe for profits when the market is undergoing significant moves, such as the recent rally. Let's analyze 2 examples:

Naked Put on XYZ, currently trading at $50

Short Jul 45 put, Delta = +20 (I make $20 per $1 increase)
—XYZ moves to $55, Short Put delta moves to +10
○As the stock price moves in my favor, I get less long (lower delta) which results in making money at a slower rate.
—XYZ moves to $45, Short Put delta moves to +40
○As the stock price moves adversely (decreases) I get longer and longer (higher delta) which results in losing money at a quicker rate

6. Typically in positive Gamma trades we seek (realized) volatility, as the more the underlying moves the better your chances for raking in profits.

Examples of positive gamma trades are long calls/puts, straddles and strangles, and ratio backspreads. In each of these we're usually better off if the stock undergoes a large move in price.

7. On the other hand with negative Gamma trades we shun (realized) volatility, as the more the underlying moves the worse your chances for raking in profits.

Examples of negative gamma trades are short calls/puts, short straddles and strangles, Iron Condors and Butterflies. In each of these we're usually better off if the stock doesn't undergo a large move in price.

In our next installment on Gamma we'll review the relationship between Gamma & Theta, as well as review how Gamma plays out on a risk graph.

Tuesday, May 5, 2009

MythBusters- Naked Puts

Here's the third installment of our Option Myths Series.

Myth #3: Never Sell Naked Puts!

Although I've already covered selling naked puts ad nauseum, it merits our attention once more (it was one of the myths debunked by our Options Action pals). If you want to peruse previous posts on this strategy, click here.

Rather than rehash the intricacies of naked puts, let's just recap a few key characteristics:

1. If selling Naked Puts is risky, then buying stock is riskier!

2. Naked Puts are synthetic Covered Calls

3. Would you rather buy a stock at the current price, or have someone pay you to buy it at a discount? This can be accomplished by selling naked puts.

4. The two biggest drawbacks to selling naked puts are the limited reward (sucks if the stocks stages a huge rally) and large theoretical risk (can be mitigated by proper position sizing & trade management).

USO has been a recent fave of mine for selling naked puts. Here's a recap of my most recent trade on it:

Trade Rationale: Oil is currently in an uptrend with a symmetrical triangle. I’m anticipating a continuation of the trend (Neutral to Mildly Bullish). I also don’t mind buying shares of USO if it falls.
Strategy: Sell Short term, OTM put options (USO @ $29.65, selling 27 puts):
Sell 5 May 27 Puts for $1.00
Net Credit = $100 x 5 = $500
Max Reward - $500
Max Risk = $2600 x 5 = $13000 (This is merely theoretical risk – Oil is not going to $0 in 5 weeks!)
Exit Strategy
Buyback puts at $.20 or better
Allow assignment if USO drops beneath $27 by May expiration (results in buying 500 shares @ $26 cost basis). Then I could sell covered calls against my long stock position.


Monday, May 4, 2009

Credit Crisis

Sunday, May 3, 2009

Condor Sweet Spot

In retrospect May expiration cycle turned out to be great for iron condor traders. The decreasing realized volatility as well as decreasing Implied volatility the market experienced over the past month or so have been just what the IC doctor ordered.

SPY IC example:
Trade Inception: Beginning of April
SPY @ $85
95-99 Call Spread @ $.36
75-71 Put Spread @ $.38
Net Credit = $.74
Max Rewar d= $.74
Max Risk= $3.26

Decreasing Implied Volatility: Iron Condors are a negative Vega trade. As such, they profit as Implied volatility falls. From an implied vol standpoint, the ideal scenario would be to enter when IV is high, and then have it plummet once you're in the trade. Remember as IV falls, option values fall. As IV rises, option values rise.

Suppose you opened a May IC on April 2nd on the SPY. My personal preferance for IC's is to enter about 4-6 weeks out (April 2nd puts you 6 weeks out from expiration). At the time Implied Vol, as measured by the VIX was around 42. Since the VIX closed at 35 on Friday, we've seen a nice 7 point or 16% decrease since April 2nd. That is obviously an environment that would have beneficial for short vega trades such as the Iron Condor

Decreasing Realized Volatility:
In addition to being negative Vega, the Iron Condor is Delta Neutral and Negative Gamma. As a result, the quieter (low realized vol) the underlying stock the better. I essentially want the stock to go dead in the middle of the Iron Condor range. The first chart below shows the SPY 30 day HV (the blue line) was around 45% about a month ago and is currently hovering around 36%.

1. SPY HV was 45% 1 mo ago
2. SPY HV is currently 36%

Now, whether or not we continue to see the $VIX and realized vol of the SPY diminish remains to be seen. Obviously me telling you what happened in hindsight is SO much easier than using foresight to predict how the market plays out in the next month. However, if I had to take a bet, I would rather be in the camp saying the VIX will be sideways to higher in a month rather than lower (particularly if the market finally does put in a deep retracement as typically market down = VIX up).

Bottom Line: If you were wondering what type of environment would be ideal for iron condor traders you just saw it over the last month.