Options for Rookies

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2011-01-27T15:10:54-06:00

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Implied Volatility and Beta

2011-01-27T03:45:00-06:00

Mark,

Isn't using IV (implied volatility) for statistics the same as using Beta as a measure of risk for stocks? I.e., if the stock dropped sharply and it's beta increases, but not the risk, it's actually a better price now. Same here - if the market declines today, does it really mean that tomorrow will be an even riskier day, as told by IV? If not it eliminates the need to trade fewer contracts on high IV times.

Dmitry

***

Beta and volatility are not comparable. Yes, in a broad sense you can say they measure a stock's volatility and tendency to undergo large moves. But the differences are very significant.

Beta MEASURES the PAST volatility of a single stock when compared with the volatility of a group of stocks. IV is an ESTIMATE of FUTURE volatility for an individual stock (or group of stocks).

Beta is RELATIVE and depends on the volatility of it's comparative index (SPX or DAX) when we talk about volatility in the options world, it is an independent measure. In other words, beta not only depends on the volatility of the individual stock, but it also depends on the volatility of the group.

Not the Risk

You said that the stock price declines, beta rises, and 'not the risk.' Why do you believe that risk is less just becasue the stock is trading at a lower price? Okay, the total that can be lost is less because the sock price is nearer to zero. So in that sense, risk is less.

However, risk is most often measured in terms of probability of losing money on the trade and not only in terms of dollars lost. Many traders believe a declining stock is more likely to decline further than reverse direction. That's the basis of technical analysis. Once support is broken, the bottom cannot be known. Trend followers jump on the bandwagon when stocks make big moves - in either direction. I do NOT agree that the lower stock price suggests that owning the stock is less risky.

Remember Enron? As the price declined, people bought the now 'less risky' stock - only to discover that risk had increased, not decreased.

There is a psychological rationale for buying stocks that fall. Investors think about the fact that they were planning to buy at a price above the current level, so it must be a good, less risky purchase now. Unless the stock has not broken support, there is no evidence that this is true. There is always that feel good felling when you catch the bottom, but in my opinion, it's is too risky to make that attempt.

Getting back to beta

IV is an ESTIMATE of future volatility for an individual stocks or group of stocks. Whereas implied volatility is very likely to increase as the market falls, there is no reason for beta to change unless it independently becomes more volatile than it used to be. Beta could decline if the individual stock moved less that its customary percentage of the index against which it is being measured.

When IV rises on a market decline, it is a fact that market participants believe that the market will be riskier tomorrow. The evidence is clear and overwhelming. Traders pay higher prices for options - and those option prices are what determines the implied volatility. Why do they pay those higher prices? Because they are afraid that tomorrow will bring more downside. They may be wrong, but that is the expectation. And IV is a measure of expectations.

Traders buy options when they want to insure a position. They buy options when afraid. They buy options when speculating. Whatever the individual reason, the 'marketplace' buys options in anticipation of something bad happening. That makes IV higher.

Remember when markets fall, they sometimes fall hard. That's why people expect tomorrow to be riskier after a big decline. I see nothing wrong with that idea. Sure it's okay to fade the down move and sell a bunch of puts into a big decline. You are getting a pumped price, but you are selling to the buyers who are far more afraid than you. I have no reason to believe they are any smarter, but it does take courage to fade the crowd when selling into a falling market. That's why there is a higher reward for option sellers who are willing to take the risk.

One reason for trading fewer contracts (as a premium seller) in a falling market is fear. The prices are attractive, we may be hoping that the decline will end, but there is that nagging fear of the huge bear taking hold of the marketplace. I suspect it's not that higher IV per se that makes trades sell fewer options under such circumstances.

885

Responsibilities on an Options Educator

2011-01-26T03:46:00-06:00

Teaching is an educational experience for everyone involved. There was a time when I believed that when the instructor explained something in simple language and the students did not display looks on their faces that suggested they were completely lost, that all was well. That was a mistake on my part. Many times people are embarrassed to ask questions. And today, with so much education available over the Internet, the classroom can be impersonal.

One never knows what beginners are thinking. I hope my friend, SD is not offended by any of today's post. This is a classic example in which he took only the parts of our discussion that he liked (make the trade) and ignored anything about the trade that he didn't like (risk management), or possibly didn't understand. He's here seeking helpful ideas for uncomfortable situations.

My comments are in bold.

***

Hi Mark:

I had an iron condor position on AAPL with a January 2011 expiration: 290/300P; 350/360C. It was very scary.

Very scary! That is all you need to know. You do not want to own such positions. Why would you continue to own a position that frightens you? They are frightening for a reason - and that reason is the possibility of losing far more than you can afford on this trade.

I felt like I jumped from the air plane and the parachute opened just before hitting ground!

In the real world, that would be too late. The chute must open much earlier than that. The time to seek an exit is early enough for the chute to open, or before the trade has taken too much of your money. Again I ask: why would you subject yourself to such feelings? It's obvious that you do not pay any attention to risk. You must ask yourself why this is true. It cannot continue.

I thought my positions would gradually diminish in value like it did last two months.

Explanation: He is trading an iron condor, and for the past two months all went smoothly. Time passed, the options lost value, and he made money. This trader apparently drew the conclusion that if it worked for two months, it would always work, and that he had found a method for printing money.

This is one of those things that I cannot understand. Surely 'everyone' knows that if something occurs once or twice that it is not guaranteed to happen again. If a fair coin lands on heads twice in a row, is there any reason to believe it will be heads next time? Of course not. We know better.

So why should a trade be different? Why should a trade be profitable 100% of the time? My correspondent recognized that AAPL had moved too far. He was scared and felt as if he were going to crash. However, there was no effort to escape. He did not attempt to use the parachute - he only mentioned how it would have felt. He was a deer caught in the headlights unable to move and unable to make a rational decision.

Here is a trader who is willing to sit tight with a position, hoping it works because it worked on two previous occasions. I get the 'hoping' part. Undisciplined traders spend a great deal of time hoping. The part I don't get is the correspondence with me. I cannot help. I'm the person who told him repeatedly that holding positions when they become uncomfortable is not viable. 'Scared'? That's way beyond uncomfortable.

The point is that he never learned the lessons. He never understood that danger is real and that it doesn't always disappear to provide a happy ending.

Here's the message I sent to him in response to his line that he thought the value of the iron condor would diminish: It only diminishes when the stock does not make a major move. the iron condor does not always work as you hope. Remember there are traders who hold the opposite position - and they are happy when the stock makes a big move. The stock market is not designed to make you happy.

But this month was different. Steve Job's sick leave announcement on Sunday really helped. I felt like Rodeo riding on a wild bull, I had hard time holding the bull.

A recognition that things were different this time, but no recognition that he should have behaved differently. Bad news for AAPL saved him one day, but the next day, good earnings pushed the stock higher. Did he exit when he had the chance? I don't know.

A 'hard time' riding on the back of a bull. The metaphors are good, but the lack of discipline and the lack of attempting any risk management are traits that no trader can have. It is far too easy to blow up a trading account, and depending on good luck is one of the quickest ways to accomplish that.

I don't want to pick on someone who is learning to work with options and to trade some of the strategies. But the bottom line remains the same: Traders who ignore risk are not going to survive. This is a business of probability, and unless someone earns a quick, lucky fortune and then retires, that trader is going to have a very difficult time.

Please show me something more steady.

That's easy. Take less risk. Trade smaller size. Evaluate other strategies. But to insure steadiness, you cannnot ignore risk. There is nothing I can do to help, if you do not manage risk with skill.

I had smooth ride during previous two months owning AAPL spreads, so I thought same will happen in January. Anyway lesson learned: Indexes only from now on.

Now we come to the advice part. He traded iron condors without understanding how they work. He did not understand risk, apparently believing that options always lose value over time, and that selling them is almost guaranteed to work. In other words, the market never allows option buyers to make any money. It makes me want to cry in anguish.

And the lesson learned? That's more of the same bad thinking. He lost one month, so he will never do this again. He will change to indexes. That may produce less volatility in the portfolio, but it's hardly the cure. One winning or losing trade is not the basis for deciding what works and what doesn't.

***

I am upset at a basic level. I did not believe it possible that someone would take a small portion of a learning opportunity (an iron condor strategy may be profitable) and ignore the rest (it's not always profitable and risk management is the key ingredient to any success). Sure I often write about iron condors. But I always write about risk management, adjustments, and avoiding ruin. Why did all those portions of the lessons go unheeded? This is a prime example of why paper trading and months of practice is an excellent way to get started with an option education.

I learned something important from my friend: Don't take things for granted. Be certain someone understands the lessons. Ask questions, and hold the conversations. Don't wait for the rookie traders to do all of the asking. Anticipate problems.

884

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Legging into an iron condor: A Good Idea?

2011-01-25T03:45:00-06:00

Mark,

Can you please provide some in depth info on what would the preferable steps to leg into an IC - by spread - would be?

Example. if I open the put side today and next week index moves higher I sell the call side, that's great. But what if next week index moves lower? Roll-down the puts? Take losses and wait for another opportunity? Sell the calls at current prices?

My second question is: from your experience, would an IC constructed around 1 standard deviation OTM be really ~68% probability of keeping all the premium (given we do not make adjustments, in plain theory)? Thanks.

Dmitry

***

In depth discussions are not always possible. That's the stuff of which lessons and book chapters are made. However, I'll offer the major points in enough detail, that it should satisfy your needs.

As it turns out, you do not need a lot of information about legging into iron condor trades.

Legging into iron condors

1) Here are the major points - everything else on this topic is far less meaningful.

I do not like the idea of legging into iron condor trades by selling puts first. It simply doesn't work as well as it should - when considering the risk involved. I know that's not good news for the trader who usually has a bullish bias, but there are good reasons.

When the market rallies, IV tends to shrink. When IV shrinks, the value of the call spread that you are planning to sell also shrinks. By that I mean it increases in value by less than you anticipate. Often much less because it is an OTM spread. I'm assuming that the iron condor trader is not looking to sell options that are CTM (close to the money).

It takes a significant upward move for that OTM call spread to increase in value by enough to compensate the trader for taking the leg. If you do sell the put spread first, and the market cooperates, it's often better to buy back that put spread, take the profit, and forget about getting a little better price on the call spread.

It's different with calls. If you correctly (i.e., you are correctly short-term bearish) sell the call spread first, then you have the opposite effect. If the market declines, the put spread widens faster than expected and you have an iron condor trade at a good price.

Thus, unless bearish, I suggest not legging into iron condor trades.

Managing the single leg

2) If you don't get an opportunity to sell the second leg of the iron condor, I suggest forgetting about it and managing risk for the one credit spread that you did sell.

Let me point out something that seems 'obvious,' but may not be obvious to everyone. More than that, a significant number of traders may have never considered this simple idea: Once you own the full iron condor position, my experience tells me that it is far more efficient to forget that it is an iron condor and manage risk as if it were two separate trades: one call spread and one put spread.

Thus, I recommend trading the situation described above as a put spread. The fact that you did not collect any option premium by selling the call spread no longer matters.

[If you had sold the call spread, and the market declines, the only important consideration is knowing when to buy back that call spread by paying a small price . Waiting for it to expire worthless is far too risky. Sure, it expires most of the time, but on those occasions when you get the big bounce (and that's what you (Dmitry) are in the market to find, isn't it?) there is no point in taking a good-sized loss on the call spread when it could have been covered by paying $0.20 - or another low price that suits you.

That's why I suggest managing the put spread as you would normally manage such a spread. I understand that you are primarily a stock trader and have not traded a bunch of these, but there is no single best way to manage the risk. My advice is DO NOT allow the fact that the call spread was not sold influence your decisions.

Yes, you can roll it down; yes you may be uncomfortable with the trade and exit at a loss. Yes you may sell a call spread now - but that is my least favorite adjustment method and I strongly recommend that you not do that. I base that on your bullish personality, and for you, losing money in a rising market would make you very unhappy. Much more so than losing in a falling market. These pshychological factors may not be a legitimate of scientific trading, however I truly believe that a successful trader does not place him/herself in a situation that can result is a very unhappy outcome. My strong guess is that if you were to lose a given sum, you would be far unahppier losing on the upsdie than the downside.

Standard Deviation

No. The chances of keeping the entire premium are nowhere near that 68%.

If you sell an option that is one standard deviation (SD) OTM, then yes, it will be out of the money approximately 68% of the time when expiration arrives. But don't ignore the fact that it may be ITM far earlier than expiration (and then finish OTM), and you would probably elect to adjust or exit, rather than clsoe your eyes and wait for expiration.

More importantly, you are selling a call and a put. The probability that the put finishes OTM is that 68%. The probability that the calls finishes OTM is also 68%. However, you have both positions and the probability of finishing ITM is 32% for either option. these probabilities are additive.

Conclusion: The probability that either the put or call will finish ITM is ~64% and the chance that the iron condor will expire worthless is only 34%. That is nothing near the 68% that you mentioned.

It gets worse. If you decide to determine (see yesterday's blog post) the probability that the underlying stock or index will move to touch either the put or call strike price during the lifetime of the options, you will discover that the probability of touching is much higher than the probability of finishing ITM. Assuming you would make an adjustment, the probability of keeping the entire sum is now far less than 34%

Iron condors are riskier than they may appear at first. That's why risk management is so important.

883

Probability of Profit

2011-01-24T03:45:00-06:00

Hi Mark,

I would like to know how to correctly calculate (and use) the "probability of profit" tool...

Everywhere I look amongst the options sellers I read about it, and, behind the obvious, I think it may be an useful tool, but only if correctly understood (and used).

Do you calculate it by yourself? Do you trust any site in particular?

Thanks, as always
Roberto

***

Hi Roberto,

'Probability of profit' is not something I calculate. Too many variables are involved (see below).

However, these items can be calculated

a) Probability that an option will finish in the money (i.e., be ITM) at expiration

b) Probability that any underlying asset will move to touch the strike price (i.e., the option becomes ATM or ITM) of any of your short options at any time during its lifetime, even when it does not 'finish' ITM

c) Probability that an underlying will move to touch any specific price (presumably your target exit price) at any time during the lifetime of the option. And you can set the 'expiration' date of the option to coincide with your planned exit date - for traders who prefer not to hold through expiration.

We cannot determine probability of profit because certain events may occur and each of them affects the final outcome: profit or loss. For example, you may make an adjustment or exit quickly with a small profit.

There is no way to determine WHEN the underlying may reach the point at which you plan to exit. You can determine the pobabilit of reaching that price, but the time elapsed before that occurs determiens whether you earned a profit [If you exit when the option is still OTM for example, you could have a profit if enough time has elapsed]

There is no way to know the implied volatility of the options at whatever future time you would choose to exit. If you close the position on at unknown date and when options are trading with an unknown implied volatility, there is no way to know if the position will be profitable.

No. I do NOT calculate this myself. Some brokers offer the tool that calculates 'the probability of touching.' I prefer to use, and trust, the free software made available by Peter Hoadley.

To make it work, set the strike price (or any other stock price of interest) and expiration day (or any other date. If you plan to exit early, there is no reason to use the option expiration date. Use your planned exit). Select a volatility for the calculations, with your best bet being the current IV of the specific option that concerns you.

The calculator output gives the probability of touching at some point. It does not give probability of profit. Note: Even when option finishes ITM, it may be a profitable trade - if it is ITM by a small amount.

882

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