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Dear Dale....

The Options Hunter Blog — Mon, 26 Jul 2010 20:46:00 GMT

Dear Dale,

I just want to thank you.

Every day, I thank God I could buy your DVD a few months ago. I'm 55 and I feel my life (as an active guy) is changing quickly. I thank you for sharing your ideas and your way of thinking with others. Many would have taken these kind of ideas for themselves.

I thank you for your ideas about money, and how you consider it - "That's just something that would allow me to do what I want to do". That's just my way of thinking.

For a long time, I've been trying to set up a "trading plan" based on the same ideas ("jolt") but could not find the right way to do it.Your DVD was what I was waiting for, for a long time.

I only could follow your "webinars" the next or following day (because I'm in Europe), but whathever, the general ideas or the "phylosophy" of your sayings seemed to me as important (or more important) than the technical ones.

As you said, "Give a man a fish, he will eat one day, teach him how to fish, he will eat every day". I think I can leave now.

Once again, thank you for being what you are.

My Best Regards,

Earl

More Dale testimonials are available at http://theoptionshunter.com/testimonimals.html

Goldman Sachs [GS] daily divergence pans out well in July

The Options Hunter Blog — Mon, 19 Jul 2010 21:56:00 GMT

Goldman Sachs [GS] had a good daily MACD divergence at the beginning of July.

The weekly chart did not provide clarity for a longer term trade, but a lower time frame entry on the 60 minute on July 2nd in the afternoon for a shorter term trade yielded a good return on the July 135 calls.

New dates for August mentoring program

The Options Hunter Blog — Tue, 13 Jul 2010 15:53:00 GMT

Please note, that the new dates for the Options Hunter mentoring program in August are August 24 - 31, 2010. More details are available at http://theoptionshunter.com/2010_Mentoring_Program.htm

Risk & Return When Selling Puts

The Options Hunter Blog — Tue, 22 Jun 2010 12:45:00 GMT

The dominant consideration that a sold puts strategy hinges on is the consequence of being obligated to purchase the underlying stock after being exercised.

Ideally this writing strategy will be used when the greater probability is that the market is expected to stagnate and undergo a small retracement. In this event, the underlying will soften and enable a lower entry price for the buyer. The sold puts can be closed out in receipt of time decay, or may expire worthless. The premium received will offset the purchase price and so reducing risk, will find the strategy to be even more rewarding.

This risk averse strategy finds its motivation in the desire to own the stock initially, and so the worst result is that the stock is purchased at a higher price, and the writer of the put, loathed as they will be, will need to accept the full premium of the option to offset against the purchase price.

The more flamboyant participant may not intend to purchase the stock, but merely use the writing of put options to affect a bullish view of the market.

This of course will be a splendid result if that is indeed the case however; if this is incorrect it will find the writer at the risk of being put the stock which may be at a considerable premium to the market price prevailing at the time. This will occur after the writer has been exercised, and the fact of the premium received will be of little consolation.

American style options can be exercised at any time. Of course this is a privilege enjoyed by the buyer, the cost of which is defrayed through the pricing model. Rarely does life imitate art in the financial markets however, and so the risk of being put the stock needs to be investigated prior to executing this type of strategy.

The holder of both stock and puts effectively owns synthetic call options, and often the risk of being obliged to purchase the stock by investors who have purchased puts will come from internal forces such as dividend issues, with the most likely time a writer will be exercised being ex-dividend. When a stock holder has received the dividend, and the interest earned on sale proceeds from early exercise is greater than the cost of purchasing the corresponding call, in all probability the put is likely to be exercised.

Taking into account dividend declarations and issues, if the cost of the corresponding call option is less than the interest expense incurred in purchasing the stock, the risk of being exercised is greater than the annualized return for writing the put, and the strategy will be unsound. If forced to purchase the stock, it may well result in a fruitless adventure as the capital loss on a falling stock will far outweigh any premium received in an effort to outperform market performance indicators.

Ideally the benefit of low volatility in the market will support this strategy by way of time decay accruing to the writer who is obligated to purchase stock at an approximate market price. Of course, if uncertainty in the underlying exists, historical volatility can hardly be expected to remain low and the risk increases significantly.

The Difference Between a Buy Write Strategy and Selling Puts

The Options Hunter Blog — Thu, 17 Jun 2010 12:39:00 GMT

The buywrite strategy will typically be affected to maximize returns using the device of options. Through selling call options, a stock holder is effectively exchanging potential upside gain for the chance of creating a cashflow by accruing premium by writing calls. When executed to equal proportions, the cumulative exposure will result in synthetic sold puts.

In the alternative, naked sold puts can be implemented as a strategy if there is an intention to purchase the underlying at some time in the near future, or if the underlying is envisaged to trade within a range that is slightly higher than the market. In the former case, the premium will offset the eventual purchase price, and a worst case scenario will see the intended purchase of stock be contrived with an early exercise of the sold put options. In the latter case, there is no specific intention to own the stock and upon a downward move, the writer will effectively own the stock in a falling market if exercised. However, the sold puts may produce valuable income from time decay should the market trade within a band for an extended period.

As the option pricing model is so very pedantic, it assumes that possibilities extending from the bell curve in both directions are of equal probability. History reveals however, that while markets have an inherent tendency to rise over time, they fall with far more ferocity and momentum. To address this intriguing quality, the market will attribute more time value to the downside than the upside. This volatility skew will see options strike prices south of the market trade at volatilities that are higher than those above the market. This adapted progression needs some type of linear framework to refer to, and so often a skew will appear to be uniformly applied between strikes.

This being the case, when sold puts are adopted as a strategy as opposed to that of the buywrite, the volatility of out-of-the-money puts will be significantly higher than that of the out-of-the-money call. A higher premium and therefore a higher annualised return is now able to be enjoyed. When one considers the 10-15% p.a. appreciation that stock markets typically rejoice within over the long term, sold puts appear to be the most attractive statistical alternative overall.

However, in choosing sold puts over the buywrite, thought must be given to the dividends that may be forgone through not needing to own the physical stock. If the dividend return is greater than both the interest expense incurred in purchasing the stock, and also the annualised return of the sold puts, the buywrite may be a more prudent investment strategy.

Sold puts are high maintenance. They will need margins to be satisfied, and as with all sold options, the cost of possible contingencies will be elevated in favour of the clearing guarantee. The call options sold in the buywrite strategy however, will not need as high margin security, due to an offset being extended in lieu of the physical stock in hand.

The Search for Alpha

The Options Hunter Blog — Mon, 07 Jun 2010 05:25:00 GMT

The search for alpha necessarily entails performing in excess of the overall market performance index of a similar market. An alpha of 1 is achieved when a portfolio investment outperforms the indicative average market performance by 1%.

Competition in the market place is part of its inherent character; the very precept of the capitalistic philosophy lies in the free pursuit of financial independence within various markets lending themselves to investment and risk. The particular features and idiosyncrasies of a market will dictate the risk it demands and the return that it may provide however, as with any astute investment, it pays to dedicate resources to extensive analysis before committing to risk. In modern markets technology is an indispensible resource for investment analysis and risk assessment.

Options markets do indeed provide opportunities to add value to investments with an aim to outperform the industry benchmarks through supplementary returns. Apart from individual strategies such as the covered call, that have been historically proven to provide an investment with an Alpha in excess of 1, the very anomalies that exist between historical and implied volatility, those that arise as an incident of the pricing model needing to be reasonably adapted to market forces, and those that provide opportunities for complex combinations of derivatives, will all provide success in return if an objective, consistent and mathematical approach is applied.

One limitation of the pricing model is that it assumes that variables remain constant until expiry of the option and reversal of the risk. This of course can rarely be further from the truth, and so on any given day value may be seen in overpriced and underpriced options, which are all too willingly to offer an attractive return to those that learn to recognize them. To characterize these opportunities as ‘value’, a relative comparison needs to be made; it is the epitome of value judgments.

To this end it is suggested that option models be adapted to market conditions as far as possible. In a pragmatic sense, this will mean skewing volatility in order to accommodate a likely change in volatility subsequent to a move in the underlying, to accommodate the presence of specific interest in the market place, or to simply revise ones view of volatility in respect of broader market influences.

In effect, these modifications to the model are reshaping the bell curve and adjusting the gradients of probability, to ensure that the statistical benchmark used in relative comparison will only assume value is present when it is beyond all reasonable doubt; when risk and return are within reasonable proximity. If these opportunities present themselves, it is then that an investment is made and risk is adopted. When value is derived from a stringently adapted pricing model, and is also the motivation for every trade, profitability and return is merely a matter of time.

When Higher Volatility is Not Good for Trading

The Options Hunter Blog — Wed, 02 Jun 2010 14:22:00 GMT

Higher volatility will mean that higher premiums are demanded by options sellers. Any commodity trader does well to notice that regardless of a pricing model, or theoretical reasoning, an option is only ever worth what the market will bear. A model relies on inputs, and is not responsible for the market differing in its valuation of options.

Of course, the effect of higher volatility on an options price is similar to that of time. Where an increase in days to expiry will lead to higher premium value, there remains a quantified period of time for options to perform, while an increase in volatility does nothing to allow more opportunities; it merely increases the price.

It is for this reason that higher volatility will directly increase the time decay of options. This in turn demands a higher level of performance from options – regardless of its role as a hedge, an outright directional position or one based simply on value. Irrefutable proof of this contention is found in the common experience of a favourable move in the underlying, finding an exasperated trader still suffer a loss due to the higher premium that was paid.

In order to realize a profit or loss, one needs to be realistic about the exit points of the strategy. Particularly with the stock market, it is historically established that markets rise at a slower rate to that when they fall. For this reason, a bull market will routinely (but not exclusively) find a rising market consolidate at each breach of resistance, and volatility will fall. Conversely, when the market is infused with fear, the fall is dramatic and volatility is prone to escalate almost immediately. Quite simply the reason for this is the proposition alluded to earlier; the competing arguments of theory versus reality.

An options model not only bases its calculations on input, but it also assumes that those inputs will remain unchanged till expiry. This will often explain the discrepancy between implied volatility and historical volatility, as the market simply does not envisage the underlying madness (or lack thereof) to remain constant till expiry. A trader may contemplate an exit point, an options model does not.

To protect against these latent risks, every entry trade needs to take into account the most likely scenario at its exit point, and this will not only involve consideration of time decay, but anticipated volatility direction also. It also needs to be borne in mind that the pricing model does indeed have its relevance in moderating the passions of mankind, and that enormous value opportunities are available to a trader cognizant of this fact.

Another contingency that attaches to increased volatility is the cost of holding a position. Clearing houses to this end, are concerned with maintaining security in respect of the risk inherent in open positions. In the execution of this objective they charge a premium margin which will bear some relevance to the most recent market price of options, and therefore implied volatility, but will supplement this with a risk margin reflecting the contingencies of volatility moving up and also down.

Ideally this security will be reflective of the cost incurred in closing the position out, however this is rarely the case. Usually, open positions in their entirety will be considered and a series of offsets will be affected however, per option add-ons are not uncommon. Effectively a guarantor, a clearer will prefer to err on the side of caution and require a risk premium on the reversal cost of the position to compensate for the anomalies between the model and the market that was referred to above. Further still, clearers will also possess an element of subjective concern, which in climates of high volatility, will only increase the cost of trading, a contingency that needs some measure of forethought on the part of the trader.

Understanding Gamma

The Options Hunter Blog — Wed, 19 May 2010 21:26:00 GMT

Of course the Greek values used in the course of option pricing can all be statistically graphed; however none is more useful in graphical format than the gamma of an option.

The gamma is the rate of change of an options delta, and will increase as the market approaches the strike price, and decrease as it moves away from it.

Given that the delta is the rate of change of an options price to a corresponding increment in the underlying, an options gamma is then found to be ‘the rate of change, of the rate of change’ of the options price to a corresponding increment in the underlying. As much an exercise in the ludicrous as this may appear, it is absolutely accurate in its assertion.

At-the-money options have a delta of 50%, and it is just such options that have the greatest rate of change of delta; the greatest gamma. Other options have a delta that changes also, but it is the at-the-money option that does so to the greatest extent.

Particularly when the competing interests of time decay and underlying market direction are being considered, it is often the case that one needs more or less as the case may be, of the rate of change of the options price to the incremental move in the underlying.

This is only possible with acquiring more gamma and directing these options and their characteristics into the portfolio. It is with the use of at-the-money options that this is most efficiently achieved, however it is also possible to choose alternative strike prices, although significant volume changes will need to be affected in order to meet the same ends.

For example, the gamma of an out-of-the-money option may be 0.0025. This means that the delta changes by 0.0025% for an increment in the underlying. An option with a delta of 17%, for a one point increment would increase its delta to 17.25% or 0.1725. With a four point move it will experience a change of 1% in delta. By comparison, an at-the-money option will have a delta of 50% and a larger gamma than the previous example say, 0.0045. For a one point move in the underlying, the options delta will change from 50% to 50.45% or 0.5045. With a four point move, this options delta will then experience a 1.8 % change in delta.

If resort to the out-of-the-money option is had, it will need a little less than double the amount of at-the-money options to achieve the same exposure. When portfolios need cover with expediency, it is with judicious use of at-the-money-options that the most effective strategy is achieved.

Setting MACD exits using RTalerts

The Options Hunter Blog — Fri, 14 May 2010 15:07:00 GMT

You have a great setup, double top and MACD divergence in a higher timeframe, you see the entry in the lower timeframe, the MACD divergence. You have a goal for where the price should be going and you've bought your put appropriately. Of course this may be one of many option positions you have going. Monitoring these positions manually for an exit is just not feasible for many traders. Here's where using AIQ TradingExpert Pro RTalerts comes in.

Here's an example of a setup from yesterday.

Macys [M] in the first chart, shows a double top forming on the daily chart with an MACD downside divergence. The Monthly and weekly charts do not show the price and MACD diverging.

In this context a short term trade using lower timeframes (60 min) might be considered. The 60 min chart from 5/13/2010 shows MACD turning down.

So say you bought the May 24 puts on 5/13/2010. You're about a week from expiration. What's a good exit? Having entered on the downturn in the 60 min MACD, we could consider exiting when the 60 min MACD flattens out or turns back up. You could monitor this visually, maybe looking at even lower timeframes and waiting for the MACD to begin the process of flattening out. Better yet is to setup an alert. If you use AIQ TradingExpert Pro, RTalerts is the place to do this.

From the AIQ Main Menu, launch Alerts. use Tickers, Add, from the menu in Rtalerts to add the underlying tickers. Set the timeframe button to 60 min. Now we need to add the alert. We are looking for the 60 min MACD line to flatten or turn up. To do this we go to File, Alert Properties, Edit alerts. In the Alert code screen, scroll down to an empty line at the bottom, and copy and paste in this alert

!MACD SELL MY PUTS
Sellmyputs if [MACD]>val([MACD],1) or [MACD]=val([MACD],1).

For call positions I'm looking for the opposite exit, MACD to flatten or turn down, copy and paste in this alert

!MACD SELL MY CALLS
Sellmycalls if [MACD]<val([MACD],1) or [MACD]=val([MACD],1).

Click OK. You are back in the Alert Properties screen. Scroll down and find the alert in the list. Right click on the alert and select Alert Enabled. You can also add a sound from the right click. Make sure there is a check mark in the Alerts Enabled box, and click OK.

The alert is now set.

Important Note: The alert will fire on any ticker in your list and is dependent and fires only on the timeframe you are viewing.

The Volatility Index (VIX)

The Options Hunter Blog — Thu, 13 May 2010 14:52:00 GMT

Volatility Index options are a refreshing innovation that allows an option trader a spectacular trading opportunities that are rarely present in other option markets.The index is based on the implied volatility present in 30 day S&P 500 options. In efficient markets this can reliably be seen as the markets expectation of near term volatility, and once the index is created traders are able to implement a view of volatility that is isolated from other variables that are common to option pricing such as underlying asset prices, dividends, and even days to expiry. With the VIX, volatility has been transformed into a commodity, and can be apprehended without the complexities of hedging an option in order to capture the extrinsic value, and then set about funding the position. The VIX allows a straight purchase or sale of volatility, which if anything, removes the skill of trading volatility; a prerequisite that has deterred so many traders to date.

The VIX shares an intriguing relationship with the S&P. Indeed, it is true of all equity markets that they rise at a far slower rate than they fall, and as such, the historical volatility of the S&P is found to be inverse to its price. Immediately it can be seen that the VIX is the perfect hedging device for equity markets, and moreover offers the classical economist the true diversification they so strongly advocate.

Marvelously, the VIX also trades within a strict range of between 10 and 45 (reflecting volatility as a percentage). Similar to a stock, the VIX is unable to contemplate low extremes toward zero due to the implication that implied volatility in the S& P will be zero and so remain unchanged. This unlikely event preserves the VIX as one of the only assets that can be relied upon to always carry a value. Every equity index will experience the usually humdrum of the trading day. This may continue into weeks and months, but out of the entire option delivery month there may be one day that volatility sky rockets to outrageous levels, and the market undergoes a significant move. Further, the implied volatility of index options will remain at comparatively high levels suggesting up to 25% with ease. Of course, when historical volatility rarely reaches such levels the advantage is clearly with the grantor of options. Still, that one day of mayhem where historical volatility reaches 50-60% will eradicate any profits made from the prior diligent selling of premium.

As to the VIX, it matters not that the correlation between the implied volatility of index options and that of the underlying index is not synchronized. The VIX relies on only one factor; the volatility implied by premiums traded in index option markets. The historical volatility of the index itself is of no import, but a perfected market will bring the two into line in the long term. Under these conditions, the IX is sure to offer value when it is absent in many other markets.

The Importance of Having an Underlying Stock View

The Options Hunter Blog — Mon, 10 May 2010 19:59:00 GMT

There was a breed of trader that in times gone by would trade options excluding any fundamentals or research, and based purely on the mathematical model and adaptation thereof. However, as options and stock markets became more competitive, and the spreads narrowed, the so called risk free options income was no more. In truth, this competition reflects the perfection of markets; all the more prevalent in markets reliant on technology for their research and implementation.

The tide has turned and the options trader intent on survival will do well to resort to undertaking research on their underlying stock instruments. Certainly opportunities will present themselves that are mathematical gifts, however by analogy, the same is true of the most common of two horse races and yet totalizator agencies are only too keen to these seemingly gratuitous prices. They do so due to the underlying realties in the real world that defy the pricing model. So it is with options and their underlying stock instruments.

When the collective knowledge of the stock market insists upon a premise, this may well suggest that fundamentals and research are responsible, and that art should imitate life instead; the model has failed. At any length, it is far more secure a seat to occupy when the underlying stock is well understood. It is only then that an options strategy can be executed with confidence, for all that is needed for success is the rational application of informed reason. Any system that is adopted will only perform for a certain period of time, and so it is research, and knowledge of the fundamentals that will serve as a hedge against ignorance, and a barrier to financial demise. This is most relevant with respect to the subjection of many, to a mindset of undivided attention, paid to annualized returns of available option strategies, with none paid to the workings beyond the corporate veil.

When an informed opinion on a stock is arrived at, and it lends itself to an options writing strategy, some circumspection ought to be applied to any reversion to an annualized return options strategy. For example, in order to exploit the acceleration of time decay, the choice of options strike to write will depend on a view of the underlying stock. If low volatility is expected, the greatest annualized return will be provided by at-the-money options, and under this objectivity, research, and authoritative view of the stock, one would not easily expect the threat of early exercise, and so the return can be calculated excluding the risk of being exercised.

Ideally, written options will be most effective at the point where the stock will reside in the future. Particularly when stock markets rise, they routinely do so at a slower rate to that when they fall, and so volatility invariably falls in a rally. Still, the market will incorporate this incident into its pricing and it will only be the knowledge of the underlying fundamentals that will give the trader any tangible edge on the competition. Similarly, when the underlying stock is expected to suffer a retracement, an educated view will enable a trader to write put options at exceptionally high volatility and still retain confidence that value has been captured.

“Scientia est potentia” – knowledge is power.

Puts & Calls - the basics but worth a refresher $$

The Options Hunter Blog — Wed, 28 Apr 2010 20:50:00 GMT

A put option is a right but not the obligation to sell an underlying asset. In that sense the holder of the option has the right to alienate the asset to another person; the right to put it away. Similarly, a call option is the right but not the obligation to buy an underlying asset. In that event the holder would be drawing the asset closer; they will call it toward themselves.

While puts and calls can be of different types, expiry dates, strikes prices, and upon quite different underlying assets, it is important that the grantor or the holder of an option is aware of the risks associated with the transaction, and their commensurate obligations. A useful manner in which to do this is through a rudimentary graphical depiction of the investment.

Put Options:

A simple put option is illustrated below. Note that this is a reflection of the holder’s investment position.

Asset Price

Here, as the asset price declines, the profit on the investment increases and the buyer’s potential for profit is defined. The buyer’s breakeven point of the investment is located by deducting the premium from the strike price. Where the asset price increases indefinitely, the loss remains constant and the buyer’s limited risk comes into play.

Next, the grantor’s investment in the same transaction is reflected below.

Asset Price

Here, as the asset price declines the grantor’s premium is a buffer against loss, but only serves such a function to a certain point, thereafter the seller of this option will experience loss that extends indefinitely. The grantor’s breakeven point is found by subtracting the premium from the strike price. As the asset price increases indefinitely, the seller retains the premium received. Note that this premium is a fixed amount and remains the total amount of any potential benefit to the seller.

Call Options:

A simple call option is depicted below, reflecting the position of the buyer.

Asset Price

It can be seen above that as the asset price increases, the potential for profit by the buyer increases in an unlimited linear fashion. The buyer’s break even is located by adding the premium to the strike price. Conversely, as the asset price declines, the limited nature of the buyer’s risk is reflected in the premium remaining the full extent of any loss that may be incurred.

Next, the grantor’s position in the same transaction is graphically represented.

Asset Price

It can be seen above that the grantor has unlimited risk as the asset price moves upward, and the premium received will only protect against a loss for a time. The seller’s breakeven point is found by adding the premium to the strike price. As the asset price moves downward, the premium will remain the entire benefit that will ever accrue to the grantor, regardless of how far downward asset prices retreat.

Taking Advantage of Higher Volatility When Trading Options

The Options Hunter Blog — Fri, 23 Apr 2010 19:11:00 GMT

When the time value of an option is increased, this will invariably lead to an increase in premium, but can only occur due to the effect of either an increase in the variables of days to expiry, or an increase in that of volatility. The effects of an increase in volatility are more clearly visible when regard is had to the dramatic differences in consequence that both of the above scenarios exhibit. When an increase in days to expiry is responsible for an increase in premium, time decay can be quantified with respect to a fixed number of days. In the case of an increase in price due to rising volatility, in addition to the time decay that would ordinarily be attributed to the option, the increase reflected in the price will also need to be defrayed over that amount of time remaining in that options life. It is for this very reason that time decay increases when volatility increases.

The validity of these propositions are put to the test when a move in the underlying instrument, is compared with time decay. For the seller of options, it is hoped that the latter will prevail against the former. This compromise between interim loss and interim gain is the centre piece of an intriguing and profitable strategy.

An option model makes a numerous assumptions, the most outrageous of which is that all the variables will remain constant till expiry. This necessarily includes volatility, and the assertion that volatility is continually susceptible to change is unlikely to be challenged.

Implied volatility may rise for a number of reasons, not the least of which is the movement of the underlying at that particular point in time however; this does in no way commit the market to replicate that behavior continually until expiry.

In this regard, it is possible to capture enormous theoretical edge when volatility rises, by selling options not only to accrue a higher rate of time decay, but also to capture mathematical value. The strength of this strategy lies in the correlation between the inanimate pricing model and the emotive underlying market. Markets are over bought and oversold every day; indeed the premise that the majority of orders in a market are stop loss orders, suggests that this is precisely where market volume derives its rhythmic existence.

Indeed, if a seller of options enjoys a theoretical edge in their favour each time they sell, any one particular trade may not present a profit, but there is no doubt that a series of theoretical edges will result in sustained profitability. Certainly, reality may outperform theories and texts, and for a time put them to scrutiny however, when reasonably adapted to a dynamic marketplace, a quantitative benchmark is able to bring objectivity and discipline to the fore. Armed with probability analysis and a sensibly adjusted model, the only issue to be yet resolved is the inherent arbitrariness of the term ‘high volatility’. This term of course, like many curiosities is relative to its user. What is high volatility in one economic climate will not be so in another, and it is with just such cooperation with external forces that the rigidity of the mathematical model needs to be tempered.

Exercise & Assignment of Index Options - Part Two

The Options Hunter Blog — Tue, 20 Apr 2010 21:48:00 GMT

Options allow the creation of synthetic positions, a feature lacking in underlying asset markets. The creation of a synthetic position can be executed in numerous ways, but invariably the cost of funding the identical position will dictate the manner in which the investment ought to be driven.

The underlying asset itself can be purchased in the outright market or it can be synthesized through the purchase of a call and the sale of a put of the same strike price. If this can be accomplished at a net receipt of extrinsic value, the synthetic alternative will prevail as it achieves a stock price of lower than available in the market. Certainly a profit can be realized immediately, but for the intents and purposes of investment, the return will be higher due to the lower cost of the investment.

Certainly it is arguable that all equity ownership, just as option purchase, is limited in its risk due to the purchase price representing all that can be lost. In the case of equities, the sum is considerably larger than that of an option premium.

If a call option is exercised, and the underlying asset is then held, unlimited risk is exchanged for limited risk. Still, the call option can be resurrected by purchasing the equivalent number of put options of the same strike. In this event, the extrinsic value of the call is forever lost, and the cost of funding the underlying asset ownership will also be imposed. Still, dividends on stock may accrue to offset against expenses.

If however, the put of the same strike is also able to be purchased at a level that results in an overall saving, the time value will again be retained, but an additional funding cost will be incurred for the value of the put, and risk will again be limited to the value of an option premium.

Essentially, it is the size of a dividend that may support the entry into this synthetic strategy. If the dividend offsets the cost of funding to such an extent that the proposition is viable, the synthetic call will be preferred to the literal call.

In the case of a synthetic put, it too will be executed in careful consideration of dividends, but will involve interest income from sale proceeds being balanced against the paying of a dividend to the holder of the underlying stock, and further outlay for call options of the same strike.

When a synthetic call is held however, the investor has the convenience of exercising the put option and delivering the stock directly. This will cause a realization of profits or losses and effectively close out the position. If however, the call option is sold, the extrinsic value of the call is received as additional income, and yet the strategy results in a conversion; a synthetic underlying asset that offsets a physical underlying asset. If the extrinsic value received is able to generate a profit that is greater than that derived from exercising the put and receiving income on the proceeds, the conversion will be the astute strategy to follow.

In all option trades it is advisable to consider funding costs as that including the funding of margin requirements in addition to that merely for capital outlay for assets. If this method is adopted, there will be no unexpected erosion of returns due to the cost of funding margins when an option is exercised.

Exercise & Assignment of Index Options – Part One

The Options Hunter Blog — Fri, 16 Apr 2010 18:09:00 GMT

A holder will exercise an option when they seek to avail themselves of the right to a bought position, or the right to a sold position in the underlying asset, whether it is a call or a put respectively. The grantor of the option vis a vis the holder will then be obligated to assign the underlying asset to the holder in the case of a call being exercised, or to accept assignment of the underlying asset in that of a put. Of course along with assignment of the asset, the strike price is exchanged as consideration for the agreement.

Holder can exercise an American option at will but are only able to exercise European options within specific periods leading up to expiry. Consequently, writers of American options are burdened by the uncertainty of exercise and so command a higher premium for the equivalent probability in European option markets. Often American and European option markets will automatically exercise in-the-money options, but the various methods of settlement can differ somewhat. For stock settlement, options that are exercised are settled with the provision of a position in the underlying asset, whereas for cash settlement, exercise will lead to the pecuniary difference in value of the underlying asset and the strike price of the exercised option being credited to the holder account. A commensurate debit will be reflected in the grantor’s account.

The exercise of an option becomes a strategic methodology when the incidence of funding costs and dividend yield are introduced. If the cost of funding the underlying asset is lower than any parallel disadvantage suffered by the option position, then exercise is naturally determinative of the issue. Prior to a dividend issue, if calls are exercised, the dividend is enjoyed. After the ex-dividend date the stock price will suffer pressure to the extent of the dividend and so the call price will also decline. If the calls are exercised, the dividend is obtained and will set of the cost of funding the share purchase, and thus affect the return as opposed to the return based on merely purchasing call options at a lower capital outlay. It is this facet of efficient market theory that causes the stock price to decline in compensation of dividend issues; the market will seek to purchase the stock, receive the dividend and then reverse the stock position for an overall profit.

Similarly, a put that is exercise will generate capital in the form of a sale price for underlying assets that is a product of the strike price of the option. Interest will be earned on this capital, which will be maximized if the exercise is affected straight after the ex-dividend date of a stock in anticipation of the imminent decline in the stock price that will reflect the dividend. At this point the dividend issue will increase the intrinsic value of the put, without imposing any dividend payment obligation on the resulting sold position. The point at which the interest earned on the sale proceeds exceeds the return provided by the investment and reversal of the put option at a profit, will provide guidance on whether exercise of the put is the judicious path to take.

Understanding Time Decay

The Options Hunter Blog — Tue, 13 Apr 2010 15:35:00 GMT

Options are such a wonderfully flexible instrument, offering the trader a plethora of alternative opportunities and crossing the dimensional hum-drum that many financial pursuits suffer from. The incidence of time decay is the one feature that will succinctly characterise options, and the attraction they hold for a global financial community that has thrived on their activity for almost 30 years.

Primarily it is time decay that differentiates options from the making of a forward agreement or futures contract, the underlying purchase agreement of the ownership of stock, or an agreement to borrow or lend money. Time value represents a premium, to which is attached the privilege (not the obligation) of choosing whether or not to exercise the option and receive an exposure to the underlying, or to forgo the premium which has succumbed to time decay. In this sense it is similar to an insurance contract, which will only be claimed upon in the event of it being lucrative to do so. Otherwise it is considered prudent to continue paying a premium in return for the protection it offers. Both the seller and the buyer have different motivations, but both of them bargain for performance of a specific type.

Still, the premiums involved are not gratuitous, and depend on numerous input variables not the least of which are days to expiry and volatility. Long dated options of varying strike and maturity will be less and less distinguishable with the extension of time. This is due to the analogous difficulty there lies in differentiating between two distant and unidentifiable objects. When expiry is approaching however, the differences between options are as plain as day. Predominantly due to far more clarity shed on their short path to expiry, time decay begins to accelerate, as the pricing model has no need to shroud their price with the trappings of uncertainty.

Given the propensity that options have in lending themselves to the art of minimalism, while the sun is still high in the sky as it were, the decay of an options time value will be modest but yet realistic; time waits for no one. When the option is in its twilight; as expiry appears nigh, despite the fact that markets tend to display some level of spontaneity at expiry, an options price will decay more rapidly at an accelerated rate. Primarily this is due to the binomial pricing model (most suited to American options), having iterated through the multitude of possible prices, uses a pricing tree to identify all possibilities. As expiry approaches, this tree that set in a matrix of occurrences, grows considerably smaller, to the extent that the slim possibilities are almost non-existent. The proposition illustrating tossing a coin to result in two hundred consecutive heads, while entirely possible, is growing more and more unlikely with each head that is tossed.

As expiry approaches therefore, particularly in the last 30 days, time decay will accelerate until expiry. Curiously, the last day of trading will still find some residual time decay. Typically the time value of the at-the-money option will be 8 points and will expire immediately at zero if out-of-the-money.

Part Two - The Similarities and Differences between Options and Stocks

The Options Hunter Blog — Tue, 06 Apr 2010 19:55:00 GMT

Just as stock prices contain an element of net asset worth and also prospective growth, options carry with them two components within their premium; intrinsic value and extrinsic value. Intrinsic value will reflect the absolute unrealized value of the option, whereas extrinsic value will reflect the possibilities held by the future. Options however, are derived from the underlying asset, which in this case is the stock. Here, the direction of the underlying, regardless of the source of its influence will dictate the value and activity of the option market. In a simplified sense, if the underlying stock is rising, call options on the stock will increase in value, while put options will decrease. If the stock is falling, put options will increase in value but call option will devalue.

Still, the fact that options are a synthetic instrument imbued with a predetermined lifetime carries with it the notion of probability. The presence of probability means that chance and risk are involved in the pricing of options, that have an existence governed by strictly predetermine conditions, whereas the underlying stock is tangible, physical and in existence as an asset available to all in the present and indefinitely into the future; it is ownership in the corporation.

While options are reliant on the movement of the underlying asset, which itself is susceptible to a large number of macroeconomic and microeconomic influences, the element of probability can only be confined to a mathematical jurisdiction. Expressions of possibilities and probabilities in the mathematical world are accomplished through a volatility variable. It is volatility; the predisposition to reflect the momentum of the past into the future, that will largely dictate the premium above its intrinsic value. This premium above absolute value is found to be very similar to the transformation that a stock price will undergo when investors consider it will experience growth into the future. As mentioned above, these stocks will experience a capital gain far beyond their present asset values; moreover, their prices will reflect the present value of future profits.

Options are the right but not the obligation to either purchase or sell the underlying stock, whereas the stock is an asset in the very hands of the investor that may be retained or sold in the market place. With stock ownership too, certain rights are enjoyed by the owner, and also certain obligations, but rarely are they both connected to the investment; a shareholder has not the freedom to waive ownership by default, for the shares must be actively sold to another individual. Options will however, simply expire in the fullness of time. In some instances they will be automatically exercised if expiring in-the-money, or with an intrinsic value. In these instances the option will provide income to the holder if a marked-to-market settlement is used, but in the event of cash settlement, an exercise will result in an ongoing responsibility being imposed upon the parties. If the option held was a call, the seller will assign the underlying asset to the holder at the strike price, who will then own full title of it. If a put was exercised, it will be the holder that needs to assign the underlying, at the strike price. Here, the option position has metamorphisized into that of the underlying.

Part One - The Similarities and Differences between Options and Stocks

The Options Hunter Blog — Tue, 30 Mar 2010 21:50:00 GMT

Stock market investment has been an institutional influence not only in investment but one that has permeated our society ever since the industrial revolution. Not only has it provided a means to finance innovation and expansion, it has also been a cradle that has carried within it public sentiment, and issued from it signals pertaining to the prosperity of the community. It is through this tacit codependence that the juncture of labor and capital is found in the stock market.

Corporations that list their shares on the stock market do so in order to raise capital to fund their operations, to invest in research and innovation, and to expand their activities. In return for providing financial support, the shareholder receives part ownership of the corporation. If the corporation is successful and its profits increase, it may choose to repay the investment made by the shareholder with a bonus to reflect the risk taken, it may choose to reward the investor with a dividend share in profits, or it may choose to reward the investor with additional shares in the corporation.

Ownership of options will rarely carry with it voting rights that share ownership is imbued with, but similarly to options investment, stock investment also is heavily reliant on risk and reward. All of these incidents will result in shares of the corporation becoming more sought after; they will be attributed a greater value. As such, market participants comprised of other investors will be prepared to invest more capital for the same share in the company. It is this reaction to corporate prosperity that provides a capital gain on share investment.

Indeed, some corporations will elect not to pay dividends and reinvest profits into their operations. If management is perceived by the market to be sound, the share price will still experience a capital gain. This invariably occurs when investors are of the opinion that the corporation will experience solid growth into the future.

A stocks value will usually reflect the value of the corporation, but particularly in developed stock markets, will often reflect an element of hypothesis as to the future prosperity and growth of the company and its profits. Indeed, whether or not a stock pays dividends, or if it is subject to the markets projection of its worth, anticipated cash flow in the form of either dividend or capital gain will necessarily have a present day value also. Discounting this cash flow to identify its present value will often play a large part in the price attributed to the stock by the collective market at any one time.

Of course, negative influences will also have a commensurate dampening effect on share prices. While both stocks and options markets are susceptible to the forces of demand and supply, stock investments are also subject to numerous external influences. Economic, managerial, political and social influences will also play a large part in shaping the market environment. These will of course have an indirect effect on options prices as they too experience pressures resulting from the same circumstances.

Put Call Parity within the Context of Underlying Asset Pricing Structure

The Options Hunter Blog — Fri, 26 Mar 2010 21:19:00 GMT

Options are financial products, the premiums of which reflect the likelihood of that option expiring in-the-money at expiry. While this is at best a mathematical deduction, the sheer magnitude of premium will reveal the risk and reward adopted.

Despite the assistance of mathematical models, a trader ought to always understand the basis upon which the model operates and the probabilities associated with each option relative to one another. If for instance an at-the-money call option is priced at approximately 40 points, intuitively, an in-the-money call options will be worth greater than 40 points, and an out-of the-money call will be worth less than 40 points. Pure premium awareness, along with the parallel delta value of each option ought to become a second nature arrow in the quiver of every productive option trader. When puts and calls are both able to be recognized for what they actually represent; probability and chance, a trader is in command of their environment.

If this is indeed within the grasp of an option trader, whenever they are confronted with an asset, it will not be difficult to immediately recognize anomalies in its derivative option pricing. Indeed the first confirmation that will be made is with the parameters of the underlying assets own pricing. If the asset is one that has the practical effect of having unlimited scope to experience priced movement in both directions, one can safely assume that out-of-the-money puts and out-of-the-money calls that are equidistant from where the market is at present, will reflect the same probability, and therefore the same delta, and of course the same premium. If not an opportunity exists to exact a theoretical edge by buying the cheaper option, or selling the more expensive one. This scenario will most likely be played out in debt security option markets that have an inverse price quotation for the underlying asset price which will invariably be reflecting an interest rate at which to borrow and lend.

If however, the asset is a stock price, the ramifications of the above instance are quite different. A stock price by definition cannot have an unlimited range of motion in both directions, for its downside is limited to zero. This will necessarily place a restriction on the probability of out-of the-money puts as the possibility of a stock price reaching zero or thereabouts certainly exists, by the very nature of asset worth, it is envisaged that an asset will usually be worth something. For this reason puts and calls will be imbued with a distinct skew in price.

In addition to this curiosity, interest rates will play a large part in the fabrication of a stock price call option. While a call option on a stock is available, the comparison will continue to be made between call ownership and outright stock ownership. If the call can be purchased instead of the stock, an upward and favorable move will be experienced by both investments. Often an outright long position in the stock can be replicated precisely in the option market, and it is then that the cost of funding becomes relevant. When the option can be purchased and exercised once it is in-the-money to take advantage of an imminent dividend declaration, an arbitrage would exist if the cost of funding the transaction afforded any advantage to the option investment. Arbitrage opportunities it will be found are quickly exploited and anomalous prices are brought back into line.

All about VIX options - derivatives of a derived index based on derivatives

The Options Hunter Blog — Mon, 22 Mar 2010 22:58:00 GMT

While the VIX is a novel market derived from options that are themselves derivatives of derivatives, the proposition becomes even more interesting when options on this asset are introduced. VIX options will of course resemble the construction of all options and so maintain a volatility variable in their own pricing. Due to the filtered effects of a sporadic third derivative equity market such as the S&P, with the proverbial mayhem that may admittedly, seldom occur, the VIX exhibits high volatility itself of up to 80%. This type of market is littered with trading opportunity.

Indeed, rarely do other option markets exhibit such high implied volatility, and options on the VIX are an even better suggestion therefore, than the underlying VIX. When the VIX is at the bottom of its range, VIX calls offer a perfect hedge for any equity portfolio that will be protected against a significant collapse in the stock market. When the VIX is high, unprecedented returns can be achieved by selling VIX calls. Here not only will there be a capital gain in the share investment, but the fact that equity markets rise at a slower rate will mean that volatility will fall and so profits are realized on the VIX calls also. In a world of competitive fund management, strategies such as this are invaluable.

Of course, high volatility in the VIX will bring with it large premium. Large premium will bring with it large time decay and also large vega. It is these characteristics of the VIX options market that will ensure that risk profiles within the VIX option market shift quickly, and so thorough monitoring of a position and its associated derivative markets is needed in order to retain control over the investment.

By its very nature, the VIX options market will in the fullness of time become imbued with a definite skew. When volatility is high, pressure will be upon calls rather than puts, and so great theoretical value will be had in executing a collar. Similarly, when volatility is low there will be great upward pressure on puts. Many equity option markets reflect similar skews due to the character of markets falling more quickly than they rise however, the skew apparent in the VIX option market will have a dynamic quality about it; it will be accentuated when the VIX itself is on its lows (approximately 10%) and then disappear when in mid-range. Then as the VIX approaches 50% the skew will re-emerge. The initiation of the skew by either calls or puts, depending on where the underlying VIX is placed, will lead implied volatility to be revised up or down as the case may be.