Thursday, November 29, 2012

The Calendar Spread Options Strategy - What Is It? How Do I Profit From Its Use?

Calendar spreads are one of the key non-directional strategies used by options traders to make money in any market. They are used in low volatility environments when a stock is not expected to move much in the next month or so (depending on the length of the trade) and/or when its options' implied volatility is expected to rise.

What are they?

A calendar spread involves the purchase of an option in one month and the simultaneous sale of an option at the same strike price in an earlier month, for a debit.

For example, let's say IBM is $200 on 1 February. We could purchase the April 200 call for $4.00 and sell the March 200 call for $3.00; a net debit of $1.00

Why would we do this?

The time decay on short term options should (usually, if the near the money) be higher than long term ones. Therefore we expect the March option in the above example to decay more quickly, widening the gap between it and the April options' values; and thus the value of the position.

For example lets say that IBM is still $200 on 28 February. The March call would be valued at around $1.75, all things being equal; the April call at $3.00. Hence the spread rises to $1.25. This is due to the March call falling by 42%, but the longer term April call only falling by 25%.

What are the risks?

The main risk is that the underlying stock moves too far up or down.

Notice that in the above examples we assumed the stock stays at-the-money at $200. And indeed calendar spreads are very profitable if they stay at the money.

Unfortunately the world isn't like that, and so let's look at the example above should IBM move to, say, $220 on 28 February.

Well our call options would both fall in value. The April one to $1.50 (rather than $3 in our at the money example). And the March one to $0.75 (rather than $1.75). Hence the calendar spread is now $0.75, a loss on our $1.00 original investment. The same effect works if the stock falls to, say, $180. A loss would ensue.

The reason for this is time value in options falls as a stock moves further away from the money. Hence any difference in time decay in absolute terms (and hence the value of the calendar spread) falls the further away from at the money the stock moves.

Why else would we do this?

The more subtle reason is volatility.

If we assume in the above example that implied volatility rises just after the original purchase; from around 15% to 25%, say. What would happen to our calendar spread?

Well, the April 200 call, originally $4.00, would rise to $5.50. And the March call from $3.00 to $4.00. Hence our calendar spread would rise from $1 to $1.50.

Therefore, one reason we would put on a calendar spread is if we believe implied volatility will rise.

The risk is, of course, that it falls.

Conclusion

Calendar spreads are a great way of profiting in low volatility 'boring' markets.

In future articles we will consider possible adjustments should the trade not go our way, and variations such as directional and double calendar spreads.

Sunday, November 25, 2012

Learn to Trade Options

Option trading can enhance your portfolio returns if used properly. Many traders use options as a speculative gambling adventure. Options are actually used for risk control and hedging. Professional traders use option systems as a risk aversion tactic.

Options are available on equities, exchange traded funds, currencies and commodities. No matter which assets you are trading, options can be used to enhance your position. An investment in time is required to learn how to use options but once you learn the basics the more complex aspects will come easy.

There are two kinds of options, puts and calls. You can buy them or sell them. The novice investor should stick to buying for starters. When buying options the risk is limited to the premium paid for the option.

If you buy a call it gives you the right to purchase the asset for the strike price selected on or before expiration. For example, if you buy a call on XYZ at the $50 strike price, you have the right to buy XYZ for $50 no matter what the actual price may be.

If you buy a put it gives you the right to sell the asset for the strike price selected on or before expiration. For example, if you buy a put on XYZ at the $50 strike price, you have the right to sell XYZ for $50 even if the actual price goes to zero.

The option GREEKS remain a mystery to many traders but they are pretty straightforward. They simply tell you how the option is expected to behave. If you want to be a good option trader then you need to learn the Greeks.

Delta is the ratio of the value of the option compared to the value of the asset. The delta of an ATM (at the money) call should be very close to +.50. This means that if the asset price increases by one dollar the option value will increase by fifty cents.

The delta of an ATM put should be very close to -.50. This means that for each dollar the asset decreases in value, your put option will increase in value by fifty cents. The opposite is true for an adverse price movement. Since DELTA is one of the GREEKS in option trading, I will discuss my view of the Greeks.

Delta is the most important aspect of option trading. An ATM call option may have a delta of +.5 which means for each $1 the price of the asset increases, the value of the option will increase by fifty cents. An ATM put option may have a delta of -.5 which means for each $1 the price of the asset decreases, the value of the option increases fifty cents.

GAMMA is the reason delta neutral trading works. Gamma is the rate of change of delta. Gamma is greatest at or near the money and is lesser deep in or out of the money. It is this increase or decrease in delta that make delta neutral trading work.

When you buy a stock you are making a linear trade. If the price of the stock goes up one dollar then you make one dollar. Option trades are non-linear. You can make more if the trade goes in your favor. You can lose less if the trade goes against you. This is the effect of Gamma.

THETA is the rate of change of the value of an option due to time decay. This tells you how much money you will lose (if buying) or make (if selling) each day due to time decay. VEGA is sensitivity to volatility which is very important. An increase in volatility can increase the value of your option. RHO is rate of change due to interest rates. It is a factor in option pricing.

When I am setting up a trade, DELTA is pretty much the only Greek I am interested in. I don't need the other values because I always GRAPH my trade and count up or down the chain ladder. I also do a quick VOLATILITY study. That's all I need (along with my technical analysis) to make a trade. I'm in the TMI camp. TOO MUCH INFORMATION! There is a lot to be said for keeping it simple.

Once you grasp the fundamental concepts of option trading, the other information can be added if necessary. Complex trades can be developed and simple trades will become second nature.Before trading options please read the publication "Characteristics and risks of standardized options", available from your broker.

Sunday, November 18, 2012

Three Tips For Penny Stock Trading

There are very few steps to start trading in penny stocks. Here are three important tips to get you going in the right direction by being smart with your money.

The money you will use to invest in penny stocks is money that you can afford to lose. Yes, money can be lost investing in penny stocks! Do not use the money that you pay your bills or need on an everyday basis. Penny stocks can be extremely unpredictable and although you might make a great deal of money it is also true that may lose everything. After you have built up a profit, you can re-invest your profits from past trades which will snowball your earnings.

The next tip is to make sure you get some knowledge about investing. This is without a doubt the single most important factor in determining whether your budding career as a penny stocks investor will be a spectacular triumph or a dismal failure. If you are a newcomer to investing of any kind there are various guides you can buy so get them and read every word. Do not spend any money until you have read these guides! These guides will help you get smarter with investing. They will not help you with specific decisions such as whether to buy a particular penny stock, or when to sell, but they will give you a good background on how it all works and are invaluable in building a good knowledge base.

The final tip is to not rush 'helter-skelter' into penny stocks without a plan! I repeat 'do not rush' head first into buying stocks. Before you invest any money, make an investment plan and stick like glue to your plan. This will give you discipline and will also help you organize your time and investments. Keeping things simple will result in less stress. Your plan should consist of the investments you are going to make, why and how much you are investing. Make sure you include your exit point which is the price you will sell your investment to take a profit or to prevent a big loss. How much time will you spend working with your investments each day.

Now that you have all the major elements in place you are set for the ride of your life; that is the world of investing in penny stocks. Remember that knowledge is the most powerful tool you have to make your penny stocks successful so start learning today. Take care of your money, and plan your investing.