Sunday, February 28, 2010

Alternative UpTick Rule

Washington, D.C., Feb. 24, 2010 — The Securities and Exchange Commission today adopted a new rule to place certain restrictions on short selling when a stock is experiencing significant downward price pressure. The measure is intended to promote market stability and preserve investor confidence.

This alternative uptick rule is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers to stand in the front of the line and sell their shares before any short sellers once the circuit breaker is triggered.

"The rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market," said SEC Chairman Mary L. Schapiro. "It is important for the Commission and the markets to have in place a measure that creates certainty about how trading restrictions will operate during periods of stress and volatility."

Short selling involves the selling of a security that an investor does not own or has borrowed. When shorting a stock, the investor expects that he or she can buy back the stock at a later date for a lower price than it was sold for. Rather than buying low and selling high, the investor is hoping to sell high and then buy low. Short selling can serve useful market purposes, including providing market liquidity and pricing efficiency. However, it also may be used improperly to drive down the price of a security or to accelerate a declining market in a security.

The alternative uptick rule (Rule 201) approved today imposes restrictions on short selling only when a stock has triggered a circuit breaker by experiencing a price decline of at least 10 percent in one day. At that point, short selling would be permitted if the price of the security is above the current national best bid.

Rule 201 includes the following features:

  • Short Sale-Related Circuit Breaker: The circuit breaker would be triggered for a security any day in which the price declines by 10 percent or more from the prior day's closing price.

  • Duration of Price Test Restriction: Once the circuit breaker has been triggered, the alternative uptick rule would apply to short sale orders in that security for the remainder of the day as well as the following day.

  • Securities Covered by Price Test Restriction: The rule generally applies to all equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.

  • Implementation: The rule requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.

* * *

The rule will become effective 60 days after the date of publication of the release in the Federal Register, and then market participants will have six months to comply with the requirements.

Here's a link:

Thursday, February 25, 2010

Graphing an Option's Evolution

One question I have about risk graphs is why each of the multicolored lines representing different time frames is different?

Thanks for the question Greg. The short answer is time decay. Remember, options are decaying assets and erode in value over time. In addition, the rate of time decay increases exponentially as expiration approaches. Even if all other variables remain constant (ceteris paribus in economic speak) throughout the trade, time decay will incrementally whittle away an option's value. Risk graphs attempt to portray the effect of time decay by showing two different lines: the current and expiration graph. In addition to the two default risk graphs, many software platforms offer the ability to add additional graphs giving you a snapshot of how the trade is expected to evolve between now and expiration. The iron condor risk graph displayed below depicts the profit/loss at various points in time.

[Source: MachTrader]

By viewing the relationship between the different colored lines we can infer if time decay is a benefit to the trade or a detriment. If the lines are rising as time passes (blue to red to green to black), then time is an ally. In greek speak we'd say the position in positive theta. Conversely, if the lines are falling as time passes, then time is an enemy and your position is negative theta.

For related posts, check out:

Tuesday, February 23, 2010

Utility of a Risk Graph

Yesterday's post asserted that most experienced option traders have a dualistic approach when selecting strategies. That is to say they assess both their outlook on the stock as well as their outlook on volatility. The ideal outcome for all option trades occurs when both volatility and the stock move in the right direction.

Part of the learning curve with options is familiarizing yourself with the effect of volatility on individual option strategies. Performing "what-if" scenarios and stress testing your option positions is very easily done using risk graphs.

A risk graph is an analytical tool which gives a visual display of the risk-reward characteristics of option positions. Most risk graphs offer the ability to adjust various inputs such as time to expiration and volatility so that traders can model the effect these changes will have on their position. In addition to helping traders understand the influence of time and volatility, risk graphs can also aid in position sizing. Since they give us the ability to calculate how much a position will lose if things move adversely, we can determine how much is at risk in each trade. This in turn aids in determining how many contracts to enter in the position (click image to enlarge).
[Source: MachTrader]

Nowadays most online brokers tailoring toward option traders offer some type of risk graph within their tools. In addition to these brokerage firms, there are also other trading platforms offering option analytical tools. Regardless of what source you use, risk graphs certainly deserve a spot in every option traders toolbox.

Sunday, February 21, 2010

An Option Trader's Thought Process

I received a question the other day in regards to using options to bet on changes in volatility. Though most seasoned readers are familiar with the many facets of option trading, let's take another look at how options are used by various market participants. Options are typically used to bet on direction, volatility, or a hybrid of the two. I suppose we could create another category for option plays seeking to exploit neither direction nor volatility, but time decay. We'll let that specific subject simmer in the idea vault for a while longer and focus today on the first two.

When contemplating an options trade, most traders first seek to determine whether or not they have a directional bias in the underlying stock. After determining their directional bias (bull, bear, neutral), many novice investors immediately proceed in selecting which strategy they want to use. If bullish they may opt to buy a call option. If bearish, they may simply buy a put option. While placing a trade based on your directional bias is important, due to the huge impact volatility has on an options price, it is also crucial to determine whether or not you have a bias on volatility. Does volatility seem too high or too low? Upon becoming more familiar with volatility, most veteran option traders use a dual approach of considering both their directional and volatility bias. For example, if one was bullish on the underlying stock and bullish on implied volatility, they would probably opt for a different strategy than if they were bearish on implied volatility, such as buying a call option versus selling a put option.

There are yet other scenarios where a trader may hold a bias on volatility, while lacking any significant bias on a stock's direction. Before jumping into a trade, first decide which variable you're trying to exploit: a stock's price direction, volatility, or both. Then select an option strategy that is poised to profit in the anticipated market environment.

Wednesday, February 17, 2010

The Crossroads

The SPX has managed to claw its way all the way back up to 1100 which is a crossroads of sorts. In addition to being a prior resistance level, we also having the 50 day moving average looming closely overhead. This mornings test of 1100 on the ES failed, so the bears have won the initial attempt to break above this key level. It will be interesting to see how the price action unfolds and whether or not the bulls can muster the strength to push back above the 50 day moving average thereby placing the SPX back into an uptrend. This would no doubt come as a disappointment to the bears and cause me to temper my enthusiasm for entering any additional bearish trades (click image to enlarge).

[Source: EduTrader]

Assuming we remain below this level, this week's retracement has certainly setup a more favorable risk-reward for those looking to enter bearish plays.

Tuesday, February 16, 2010

Earnings and Verticals

We've got Hewlett Packard set to report earnings tomorrow after hours. Any time a company reports earnings close to options expiration, it presents an opportunity for some interesting plays using front month options. Since there will be little time remaining between HPQ's report and February options expiration, it's a little bit easier to determine the expected move going into earnings. As shown in the graphic below, HPQ doesn't have a history of large earnings gaps, so I wouldn't be expecting anything too crazy over the next few days (click image to enlarge).

[Source: LiveVol Pro]

Friday night's Options Action gang highlighted using a vertical put spread on HPQ to profit from a bearish reaction following the announcement. The suggestion was to buy a Feb 48-47 put spread for $.30. Rather than giving my thoughts on HPQ specifically, let's broaden the conversation and discuss the notion of buying verticals into an earnings announcement. Is it a good idea?

My answer would be yes... with a caveat.

Let's start with the caveat - which is picking directions into earnings announcements. I think it's darn near impossible to accurately forecast which way a stock's going to gap after earnings. Consequently, I wouldn't spend a whole of time placing directional bets. However, if I were to do it, I certainly like the idea of using a vertical spread as opposed to buying calls or puts outright. By using a spread that involves both buying and selling options, one can drastically mitigate the affect of the post earnings volatility crush. That way I'm making more of a directional bet as opposed to a volatility one.

For related posts, readers can check out:
The Cycle of Implied Volatility
Bear Puts
Choosing Strikes for Bear Put Spreads

Monday, February 15, 2010

Run in With a Politician

I hope everyone had a great Valentine's Day. Over the weekend my wife and I took a road trip to California to visit with the in-laws as well as attend the Bold Fresh Tour in Pasadena. Though my parents were anything but political, I seem to have acquired an endless fascination for the whole political scene. On the drive down we stopped in Primm, Nevada for some grub (me) and shopping (the wife). Though it's the last place I'd expect to run into any one famous -or infamous depending on which side of the political aisle you come from- as we were entering the mall none other than Mr. Senate Majority Leader Harry Reid was walking out, preceded by a rather large body guard of course. Unfortunately before I could say anything to him, body guard number two pulled up in a large black suburban and whisked him away, leaving me to wonder what the odds were of meeting someone like that in the middle of no where.

I guess if I was really lucky it would have been a run in with Scarlett Johansson, but I digress...

My final thoughts for the trip:

Reid looks a lot older in person.
O'Reilly is a lot taller than I expected.
Beck is pretty dang funny.
The weather in California could almost make it worth living there...almost.

Wednesday, February 10, 2010

Mail Time- Clarifying Theta

I received an interesting question from Greg in response to yesterday's post:

I'm still unclear as to why in your SPY put ratio spread negative theta is a bad thing. I may be wrong, but when one sells options, one hopes that the time value premium will decay quickly so as to make the option less likely to be assigned (all other things being equal). Therefore, a negative theta would imply that there's a lot of time decay. Since in your spread you sold 2 puts and only bought one, negative theta- in this case- means time is on your side?

Thanks for the question Greg. Let's begin with clarifying positive and negative theta. If a trader owns a position that is negative theta, he will be losing money due to time decay. It doesn't matter what the position consists of. It could be something as simple as owning a put option or something as complex as being simultaneously long and short options of different expiration months and strikes. If the aggregate theta is negative, the position will be losing money overall due to time decay. So, negative theta never means time is on your side.

Consider the current value of the position highlighted yesterday:

Long (1) Feb 104 put @ $.67
Short (2) Feb 100 puts @ $.27

If we were to fast forward to expiration and assume these puts remain out-of-the money, I would lose $67 on the long put and gain $54 on the short puts. Net-net I'm losing money. Hence the trade is currently negative theta. Time is not on my side.

One other quick clarification. Negative theta does not necessarily imply there's a lot of time decay, it simply implies you're losing money due to time decay. How much you're losing depends on the size of the position. You could be losing $1 a day, you could be losing $1000 a day.

Tuesday, February 9, 2010

Extrinsic Value and the Bell Curve Phenomenon

I have to say I was quite overwhelmed with the responses to yesterday's question.

Please folks, don't every one speak up all at

Anyways, kudos to Jon for nailing down the answer. Though the SPY ratio spread was positive theta at inception, it has now turned theta negative.

Say what?

As a precursor to understanding how theta can often times flip with various types of option positions, one must first grasp the dynamics of option pricing and more specifically the relationship between extrinsic value and strike prices. One quick side note before we continue our stroll down option theory lane; extrinsic value is often times referred to as time value. Though they can be used synonymously, I prefer the term extrinsic value since time is not the only factor influencing this portion of an options price.

An options premium consists of two parts: intrinsic and extrinsic value. Thus we often use the formula P = IV+ EV. In other words, premium equals intrinsic value plus extrinsic value. While the two big factors that influence extrinsic value are time and implied volatility, strike price also plays a part. Consider the following graphic illustrating the relationship between the amount of extrinsic value in an options premium and strike price.

As you can see if one were to plot the amount of extrinsic value in a series of options expiring in the same month, it produces something similar to a bell curve. The gist of the graphic is extrinsic value peaks in at-the-money options and diminishes as the strikes move further in or out-of-the money. As a result, spreads that involve simultaneously buying and selling options with different strikes in the same month can often see their position theta flip.

Want More? Check out these related posts:
Gamma vs. Theta
Gamma vs. Theta Part II

Monday, February 8, 2010

Put Ratio Spread Update

In Gaming the Selloff with Put Ratio Spreads, we reviewed a February 1x2 put ratio spread on the SPY. Fast forward 2 weeks, tack on a 2% drop in the SPY and a largely unchanged VIX and what do we have?

A profitable trade.... so far.

Though there are a lot of moving parts with ratio spreads, the gist was to profit from a mildly bearish move in the underlying as well as a decline in implied volatility. While we haven't had much of a decline in volatility, the two weeks of time decay and drop in price have helped the trade mature into a decent sized profit.

[Source: EduTrader]

Remember, the biggest profit zone resides between 104 and 98 at expiration. If you don't mind the gamma risk that is assuredly building as we approach expiration next Friday, you may consider holding a bit longer. With the SPY currently residing at $106.55, the trade is negative theta. In other words, if SPY sits tight and we fast forward to expiration, we will actually give back some of our profits due to time decay.

First person to answer in the comments section why the position is negative theta gets bragging rights:)

Favorite Super Bowl Commercial

Tuesday, February 2, 2010

Delicious AAPL

The Options Action gang had a few thoughts regarding AAPL on Friday night. To set the stage they mentioned the fundamental catalyst of a potential 4G IPhone rumoured to be released sometime in the near future. Assuming this will be a positive event boosting the stock price higher, something similar to a risk reversal was suggested for those seeking to position themselves to profit from an increase in AAPL stock price. While investors could simply buy shares of AAPL, at $200 it's a bit pricey. Hence the suggestion to use the risk reversal variant mentioned.

The idea was to buy a July 200-230 call spread for $9.60 in an effort to profit if AAPL rises toward $230 over the next few months. To "finance" purchasing the call spread you could sell the July 170 put for $10.60 bringing the net credit received for the entire trade to $1.00. Check out the risk graph:

[Source: EduTrader]

I suppose if you're bullish on AAPL, it may be a trade worth considering. One point worth elaborating on is the whole notion of "financing" the call spread by selling a naked put option. The way the whole concept is pitched is a bit misleading. While it may make a trader feel better or think they have less risk when receiving $1.00 credit as opposed to paying $9.60 debit when entering the trade, the reality is the risk is increased by selling the July 170 put, not diminished. If our sole purpose on entering a trade was to make it "cheap" so we didn't have to pay a large debit, then we'd all be selling additional downside puts to finance bullish debit trades. If you decide to take this route, you must understand there is a significant amount of downside risk and though you're receiving a credit to enter the trade, your broker will still hold aside a percentage of the stock price in margin to cover the potential risk.

Just entering the AAPL 200-230 call spread has much less risk and capital required than if you were to tack on the short 170 put. If you label the risk graph you can see the individual components of the spread much easier.

Want More? Check out:

Monday, February 1, 2010

Rolling with Crude Oil

The recent multi-week selloff in equities has certainly not been an isolated event. We’ve also seen commodities taking it on the chin as well. Whether you want to blame the bearish move in crude oil on the resurgent dollar or as a sympathetic move to equities, the fact remains that oil has retraced approximately 50% of its run from the July lows of $58 to the January highs of $84. Today’s charts spotlight fibonnaci retracements on both a daily and weekly time frame of Light Sweet Crude Oil futures (click image to enlarge).

Crude oil Daily

Crude Oil Weekly

[Source: EduTrader]

For traders still maintaining a neutral to bullish outlook on oil, this weekly pullback certainly seems like a potential “buy the dip” opportunity. Those believing that the recent weakness in equities and commodities is just the tip of the iceberg may want to sit this one out.

When playing crude oil, my current instrument of choice is the United States Oil Fund (USO) due in part to the heavy liquidity in its options. The bid-ask spread on these options often trade penny wide making them quite efficient trading vehicles. Any trader who has had bullish plays on USO coming into this last selloff is no doubt taking some heat. As for myself I’ve had to shake and bake on a few naked February puts that have gotten a bit under water. One lesson I’d like to highlight that has been re-iterated to me over the last few weeks is the futility of holding short puts when they move too far ITM. So, let’s walk through a naked put play from an intrinsic/extrinsic value perspective. For simplicity purposes, I’ll refer to intrisic value as IV and extrinsic value as EV.

Suppose when USO was at $39.50, we sold a February 38 put option for $1.00 ($1 EV, $0 IV). As soon as USO drops below $38, the 38 puts begin to accrue intrinsic value. Let’s say USO later drops to $37 and the 38 put option is worth $2.00 ($1 EV, $1 IV). Currently USO is worth $36.17 and the 38 put option is worth $2.15 ($.15, $2 IV). Notice how as the put has moved deeper ITM, it has incrementally lost it’s EV while gaining IV.

What’s the point?

Most traders enter naked puts for the sole purpose of profiting from time decay. If you allow your short put to move too far ITM such that it loses most or all of its extrinsic value, you don’t stand to gain anything from time decay. Even if the stock moves sideways, the deep ITM won’t lose any of its value. In fact, the only way you would profit from that point forward is if the stock rises in value. So, what adjustment would I make if my short puts moved too far ITM?

Roll Down-

Close the short USO 38 Feb puts and sell a lower strike put that resides less ITM or perhaps even OTM. This puts you in a better position if the stock remains neutral throughout the duration of the trade as these options have more extrinsic value to lose compare to the 38’s.

Want more? Check out these related posts:
Rolling with My Homies
USO Posts
Naked Put Posts