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Monitoring Implied Volatility is Critical for Option Traders

One of the hallmarks of an options trader is the ability to reach into his trading tool bag and pull out different trading vehicles in order to accommodate the current market situation.

With few exceptions, a major component of any strategy our trader would select includes selling option premium. Premium sales usually are selected in out-of-the-money strikes where the time (extrinsic) premium constitutes 100% of the price received.

Examples of pure premium sales would include being short naked puts or calls. Another version of option premium sales would include credit spreads and iron condors wherein premium sales are combined with selling options.

It is important to remember that the time, or extrinsic premium of an option is directly related to time to expiration and implied volatility in the current 0% interest rate environment.

This current week of the options cycle is particularly difficult for two reasons. The first reason is the result of the fact that the September monthly expiration is one of four annual five week monthly options cycles. Remember that there are twelve monthly option expiration cycles, a clearly obvious fact for those possessing a calendar. What is not immediately obvious is that since there are 52 weeks in a year, four monthly cycles must contain five instead of four weeks.

Now remember from our previous discussions that the time decay of option premium is not linear. As illustrated below, time premium decay accelerates relentlessly into the closing bell at an ever accelerating pace.

Implied Volatility Option Trading

Implied Volatility Option Trading

From a practical level, the extra week of time in our five week cycle gives us an extra week of relatively sluggish decay before the accelerating decay begins to erode time premium significantly. Each week of the option cycle has particular characteristics; living in the fifth week of a five week cycle is like watching paint dry for traders depending on theta decay to benefit their positions.

The next factor that exists in our current cycle is the unusually low implied volatility that is routinely encountered across a wide variety of underlying assets. Let us look at the measure of implied volatility of the Russell 2000 index, the RVX. This measure is similar to the more frequently encountered measure of volatility for the SPX, the VIX.

As can be seen in the weekly candle chart of this volatility measure, implied volatility is at multi-year lows.

Option Trader Newsletter

Option Trader Newsletter

I consider the implied volatility to be the “stealth” component of options trading. It has impacts far greater than expected for traders and for this reason must be carefully analyzed in both a historic and current time frame for each trade considered.

In order to provide a practical example of the impact of the variable of implied volatility, let us consider how it affects a common “bread and butter” trade for most option traders. The trade is a “high probability” iron condor and consists of the combination of an out-of-the-money call credit spread and an out-of-the-money put credit spread.

The trade under discussion will be opened today and has fifty seven days to expiration. The high probability of its success derives from selecting the short options for the spread having a current delta below 10. This essentially means that these short options have a greater than 90% probability of expiring out-of-the-money. The trade therefore has a probability of being profitable in excess of 80%.

For purposes of illustration, I want to allow the magic of trade modeling to look at this trade under two different implied volatility scenarios. Displayed below is the comparison between the actual available trade today and the trade that would be possible if the volatility of the calls alone were at recent historic mean levels. I have purposely not used extreme values for the implied volatility in order to emphasize the impact of this routinely underestimated factor.

 

Implied Volatility P&L Graph

Implied Volatility P&L Graph

The curves above represent the expiration P&L graphs of the same trade taken at more normal volatility levels (the higher curve) and current volatility levels (the lower curve). The benchmark for comparison I have used is the annualized yield. The seemingly small modification of increasing implied volatility of the calls alone doubles the annualized trade yield from 80% to 160%!

I am a realist and understand that if we wish to trade, we must live in the world we are presented. The point of today’s missive is to call attention to the fact that what seem to be minor factors of trivial impact can have huge results on overall trading results.

Happy Trading!

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JW Jones

This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.

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Using Iron Condors to Create Profits Trading SPX

This recent rally has many market pundits believing the market will continue higher, fueled by slightly improved economic data points. The bulls realize that the all important S&P 1130 level is not that far overhead; if they can push the SPX through that level with strong volume, a rally could play out. The charts below are using the S&P E-Mini contract for analysis purposes.

In contrast, the bears look at the S&P noting the ever present head and shoulders pattern as well as the potential triple top formation should the S&P 1130 resistance level hold. While the S&P 1130 level is critical for the bulls, the bears view it as the final stand. The bears realize that if they cannot hold the 1130 level, their party will end and the bulls will happily rub it in their face.

So what is a trader to do? The first advice worth offering is to utilize patience. Let others do battle and wait for the market to confirm a specific direction. Professional traders always have a plan before they enter a trade and they consistently utilize stops to define their risk. The very best of traders do not allow their opinions or the opinions of others to cloud their judgment; professional traders will abruptly change their trading plans in order to adapt to changing market conditions.

Trading is all about perception and leveraging probability. Regardless of whether a trader utilizes technical analysis, fundamental analysis, or the newspaper-dart method the very best traders realize that consistently taking money out of the market is more about managing emotions and probability than anything else.

The market always leaves clues behind, but if a trader is too biased in one direction or the other he/she becomes blind to clues that do not fit his/her directional bias. The current state of affairs in the S&P 500 offers another quality setup, regardless of which bias a trader has. With option expiration looming, a new option cycle presents itself with expiration at the end of September (Quarterly’s). My most recent missive focused on option butterflies, however the situation we have currently on the S&P calls for a wider trading range. We now find ourselves in condor season.

Condors and iron condors have similar setups, but they have slightly different constructions. Theta (time decay) is the primary profit engine just like traditional butterflies; the only difference is that condors and iron condors offer potentially wider profit zones than a traditional butterfly. Similar to butterflies, condors are susceptible to volatility shocks, expanding implied volatility on the underlying, and gamma risk can also present itself and negatively impact a trade’s overall performance.

The most important thing to remember about option trading is that as one progresses in his/her overall option knowledge, options allow a trader to modify their position to reduce risk and allow positions to become profitable.

While both types of condors are susceptible to the same risks, their primary functional difference is based around their construction. Both condors and iron condors have 4 separate and specific legs. A traditional condor utilizes 4 option contracts of the same type; 4 calls or 4 puts. Iron condors utilize a mixture of calls and puts; 2 calls and 2 puts. Another primary difference is that condors are a debit trade, while iron condors are a credit trade.

In this week’s example we will use an iron condor strategy to set up a trade. The trade will not have a directional bias, instead we will simply use the passage of time as our profit engine. We will use the S&P 1130 level as our midpoint, and build the wings of the iron condor equidistant from that level. Trading the cash settled SPX index options or trading options on the S&P 500 futures requires more capital and the acceptance of greater risk.

A trader with less capital could utilize the SPY in the same manner, with less capital at risk and tighter bid/ask spreads. For accounts exposed to the ravages of the tax system, it is important to remember there is preferential tax treatment of the cash settled index options and futures options that are not present in the SPY.

The iron condor is set up using 4 separate option contracts – 2 calls and 2 puts. The iron condor has the following construction ratio: Long 1 Put/Short 1 put/Short 1 Call/Long 1 Call. Each of these two vertical spreads is constructed as a credit spread. In our case, we are going to use the following strike prices for our example. Keep in mind, a trader willing to take more risk could use strikes which are closer for the potential of higher returns (more risk). On the other hand, those who are more risk averse could move the short strikes further apart for a lower return (less risk).

The chart below represents the profitability of an SPX iron condor using the following trade construction: Long 1 Sept (Quarterly) SPX 1050 Put/Short 1 Sept. (Quarterly) 1060 Put/Short 1 Sept. (Quarterly)1165 Call/Long 1 Sept. (Quarterly) 1170 Call. For further detailed information, prices used to produce this iron condor were based on the Thursday close and the midpoints of the bid/ask spread on all contracts. The profitability reflected below is based on a 1/1/1/1 setup. Obviously if a trader decided to add more contracts the max profit and loss would increase. Keep in mind, this example is for educational purposes only and is not reflective of intraday market prices.

The red line represents profit/loss at expiration. The white line represents profit today. As you can tell, the potential profit for today is essentially zero unless a substantial deterioration of implied volatility was to occur. The key to this entire trade is the passage of time. If the SPX stays within SPX 1060 and SPX 1165 price at expiration on September 30th the trade will realize the maximum of profit of $160. The total risk taken by this trade would be $840.

The beauty as always with options is that risk is crisply defined. The absolute most you could lose on this trade regardless of what happens is $840 per side. As a side note, the probability of SPX’s price remaining between the 1060-1165 price range over the next two weeks is around 70% based on a log normal (Gaussian) distribution of prices.

Additionally, iron condors can be manipulated throughout their lifespan to defend profits. The ability to make slight changes to the construction by purchasing slightly out of the money puts/calls can also help protect profits if price gets near the edge of the profitability window. A myriad of strategies exist once this trade is placed to adapt to ever changing market conditions.

As an example, let us assume that price goes higher to around SPX 1150 in one week. At that price point, we could close the put portion of the condor for the maximum gain and then restructure our condor to protect the call side with a slightly out of the money call purchase and/or another put credit spread at a higher strike point taking in more premium and further reducing our risk.

After a trader becomes proficient with the various option trading strategies, he/she can constantly adapt positions to prevent further losses. After all, options were designed primarily as a means to hedge equity positions and reduce risk.

In closing, the iron condor strategy can be profitable regardless of which direction an underlying’s price goes. There is no guesswork or fake outs, as long as the inevitable passage of time continues and price stays within the contracts that were sold to open the position, a near 19% return is possible based on capital at risk.

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Learning How Theta Can Be Utilized to Trade Gold

In the previous article, “Learning How to Profit from Theta When Trading SPX Options,” I discussed the basics of the famed option Greek, Theta. A fundamental knowledge of Theta is imperative in order to understand the mechanics and construction of option strategies. In many cases, Theta is either the profit engine or the means by which experienced option traders reduce the cost of opening a new position. Theta can even take an ETF that pays no dividend and create a monthly income stream utilizing a technique known as a covered call write.

The most exciting thing about options is their versatility. You can trade them in so many different ways. A trader can define a positions’ risk with unbelievable precision. When traded properly utilizing hard stops, options offer traders opportunities that stocks and futures simply cannot provide. Theta allows option traders to write spreads which generally offer nice returns with very limited risk.

Theta is the fundamental reason behind the slow and relentless deterioration of option values over time. As a series of options gets closer to expiration, Theta becomes a very powerful force. As stated in the previous article, the final two weeks of option expiration put Theta into overdrive. Courtesy of Optionsuniversity, the two charts listed below illustrate the rapid decay of Theta.

These charts illustrate effectively that option contracts which are out of the money and consist entirely of time premium decline rapidly in value on their way to 0 potentially. While Theta must be respected, it is Theta’s relationship with implied volatility that really makes it a force that must be monitored closely.

While I will not discuss implied volatility in this article, in future articles it will gain considerable attention. Implied volatility is paramount in every decision that an option trader makes. Ignoring implied volatility and Theta is a recipe for disaster, the kind of disaster where an entire trading account is wiped out in less than 30 days. In most of the trades that I place, Theta is regularly a profit engine. I never purchase options naked, in every option trade that I construct I am utilizing some form of a spread in order to mitigate the ever present wasting away of time premium. In many cases, Theta is the driving force behind my profitability.

In any other case, Theta decreases the cost for me to purchase options allowing me to minimize my risk to an acceptable level. Vertical spreads come in two variations: debit spreads and credit spreads. A vertical spread is a multi-legged option trade which involves more than one strike price. As an example, we will assume that GLD is trading around $119/share. If I were to have placed a call credit spread trade at the close on Thursday I could have sold the GLD August 120 call strike and purchased the GLD August 121 call strike, thus receiving a credit in my account.

At current prices as I type, the August 120 call strike would have resulted in a credit to my trading account of $53 dollars while the August 121 call strike would have resulted in a debit in my account of $29 dollars with a one lot position size. If I were to place this trade, I would have a strong feeling that the price of GLD was going to decline. The reason this trade is called a vertical credit spread is because the total trade results in a credit to my account of $24 dollars less commissions. The vertical aspect of the trade is based on the arrangement of the positions on the options board, also called an option chain.

When an option trader places a credit spread, they are relying on time decay, Theta, to provide them with profits. In many cases, option traders will utilize vertical spreads to play a directional bias. In the example above, the bias on GLD would be to the downside. However, the maximum amount I can lose is limited because I purchased the 121 call. The most I can lose is $100 dollars minus the credit of $24 dollars. Thus, the worst case scenario for this call credit spread would be a loss of $76 dollars for every contract I had put on. If I had put on 5 contracts, my loss would have been limited to $380 dollars plus commissions.

A call debit spread is constructed exactly the opposite direction. If I believed that gold was going to increase in value I could buy 1 August 120 GLD call for $53 dollars and sell 1 August GLD 121 call for $29 dollars. Notice that the sale of the GLD 121 call reduces the cost of the GLD 120 call. By selling the GLD 121 call, I reduce the cost of this spread down to $26 dollars. However, my maximum gain is limited to $74 dollars minus commissions. The point of this illustration is more to focus on the way Theta helps option traders in practical situations.

When an option trader utilizes a credit spread, Theta operates as the profit engine. When an option trader does the exact opposite by placing a debit spread, Theta acts to reduce the overall cost of the spread reducing the overall risk exposure. As one can see, understanding Theta is crucial when trading options. While vertical spreads are very basic, they can provide nice returns while having the unique ability to control risk with an extremely tight leash.

In future articles, we will dissect the various option trading strategies which option traders can utilize in different situations, at different points within the option expiration cycle. While this article will conclude the basic overview of Theta, future articles will discuss intimately the key relationship that Theta and implied volatility share. In closing, I will leave you with the famous muse of Benjamin Franklin, “Time is money.”

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Chris Vermeulen – Gold Analyst/Trader
J.W Jones – Independent Options Trader

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Learning How to Profit from Theta When Trading SPX Options

J.W. Jones
As discussed in the first article, “The Hidden Potential of Learning How to Trade SPX and Gold Options” I pointed out that there are several fundamental principles that must be mastered before profits can be attained when trading options. Novice traders typically skip the discussion about “The Greeks” and skim over volatility only to watch their precious trading capital disappear.

As promised, this article and future articles are going to discuss the Greeks as they relate to options trading in a way that hopefully everyone reading this can understand. While there are more than ten Greek symbols that directly relate to option pricing, an option trader must be able to clearly articulate and understand 4 of the ancient Greek symbols and one English invention. (Vega is not a true Greek symbol-Look it up!)

The five core Greek symbols which are critical in order to understand are as follows, in no particular order: Delta, Theta, Vega, Gamma, & Rho. Most veteran option traders have a sound understanding of Delta, Theta, Vega, & Gamma. Rho is not nearly as well known, but anyone who has ever studied econometrics, option pricing models, or has studied applied finance know all too well the importance of Rho. For inquiring minds, Rho measures sensitivity to current interest rates.

Today’s article is going to focus on the Greek symbol Theta. By now many readers may wonder why I continually capitalize the Greek symbols, and the reason is because they are that critical. The technical definition of Theta derived directly from Wikipedia when applied to options is as follows:

THETA – T, measures the sensitivity of the value of the derivative to the passage of time: the “time decay.”

Time decay (Theta decay) is of critical importance when an option trader is attempting to quantify and/or mitigate risk. There are two parts factored into the price of an option contract: extrinsic value (a major component of extrinsic value is Theta; the other is implied volatility) and intrinsic value which would be the amount of money a trader would gain if they exercised an option right away. A great many authors who opine about options get caught up using terminology like intrinsic and extrinsic value which only serves to confuse most novice option traders even more. I refuse to use those words in my writing as I find them to be cumbersome and option trading can be made much more difficult than it needs to be.

Theta and time decay are synonyms when discussing options. An easy way to remember their congruence is that the word time starts with a “T” as does Theta. If a trader owns calls or puts outside of any type of spread, they are totally exposed to time decay (Theta) and as an option contract gets closer to expiration, the time value of the contract diminishes. This accompanied with failure to account for implied volatility (to be discussed in the future) are the fundamental reasons why so many people lose money when trading options.

Just as theta can be an option trader’s worst enemy, it can also be used as a profit engine. If an option trader sells an option contract to open the position, that option trader is using theta as a method to profit or as a way to reduce the cost of a spread. While this article will not spend a ton of time discussing various option spread techniques, in the future we will discuss them in detail. At this point, we are only attempting to understand that Theta represents the time decay priced into an option.

It is also critical to understand that Theta (time decay) is not linear in the time course of the life of an option and accelerates rapidly the final two weeks before an option expires. The rapid time decay the final two weeks before expiration presents a multitude of ways to drive profitability, but it also can represent unparalleled risk. While this article is just an introduction to Theta, the next article later this week will continue the time decay discussion.

Since we are discussing Theta, I thought it would make sense to discuss a trade I took last week which utilized Theta as the profit engine. Recently a variety of underlying indices, stocks, and ETF’s have options that expire weekly. Weekly expiration expedites Theta and gives option traders additional vehicles to produce profits.

While most equity or futures traders might shy away from a chart like this, an option trader has the unique ability to place a high probability trade. I believed that the market would stall around the SPX 1130 area so I looked for a trade which would utilize the SPX weekly options. The SPX weeklies expire based on the Friday SPX open. With the SPX trading around 1124, I put on a call credit spread which used time decay as the primary profit engine.

The setup I used involved selling an 1150 SPX call and buying an 1175 SPX call, which is also known as a vertical credit spread. I received $100 (1.00) for the 1150 SPX call and purchased the 1175 call for $20 (0.20). The $80 dollar profit represents the maximum gain per contract sold. As an example, if I placed this trade utilizing five contracts per side I would have a maximum gain of $400 dollars. The probability of success at the time when I placed this trade was around 78% based on a log normal distribution of the price of the underlying.

Immediately after placing the trade I utilized a contingent stop order that would close my trade entirely if the SPX reached the 1135.17 area. Essentially, my maximum loss not including commissions was limited to around $60 dollars per contract with a maximum gain of around $80 per contract assuming we did not get a big gap open.

Essentially, if the SPX stayed below 1135.17 for two days and opened on Friday below the 1150 level my trade would reach maximum profitability. This is a trade I actually placed on Tuesday afternoon, however I exited the position before the close on Thursday due to the impending jobs report which was set to come out Friday morning. I was able to collect over 60% of the premium sold per contract ($80) which came to about $45-50 per side. At $1,000 dollars risked based on my stop level, the trade would have produced a net gain of around $750 dollars in less than 3 days.

Hopefully this basic example illustrates the potential profits options can produce if they are traded appropriately with risk clearly defined while having hard stops in place. This trade produced a nice profit, however it was susceptible to a gap open, thus I maintained a relatively small position to mitigate my overall risk profile. As always, a trader must see potential risks from all angles and utilize proper money management principles when determining how much capital to risk. In closing, I will leave you with the insightful muse of famed trader Jesse Livermore, “A loss never troubles me after I take it.”

If you would like to continue Learning about the Hidden Potential Pptions Trading Can Provide please join my FREE Newsletter: www.OptionsTradingSignals.com

J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J.W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized.

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The Hidden Potential of Learning How to Trade SPX & Gold Options

J.W. Jones
Market technicians believe they operate in a world that few people truly understand. It is as if they believe they are working in some sort of secretive financial construct that only a few lucky souls away from Wall Street can access. The truth is that technical analysis should only be used as one metric to help a trader navigate financial markets.

There are a variety of research methodologies which all shed light and offer clues where the market may be heading. Market internals, the volatility index, Fed speak, and even fundamental analysis can be helpful to traders. It would not make sense to ignore market information that provides greater insight and additional clues that can help give a trader an edge. After all, the edge is what all traders seek. The sweet spot in trading is having a trading system that gives you an edge and offers a variety of way to quantify, mitigate, and define risk.

The same traders that only look to use purely technical analysis in their trading also fail to recognize other investment vehicles which might offer advantageous returns. The best kept secrets are always kept in the open, right beneath the public’s proverbial nose. People will travel the world in search of secrets or to prove theories, but in many cases the Holy Grail is lying right beneath their noses.

The greatest secret financial markets offer are the unbelievable potential returns that options can offer. Options offer a variety of ways to profit in a multitude of market conditions. Options offer unique profit engines that are not available or even possible when trading stocks or bonds. Most traders overlook options or are simply unwilling to put in the time or effort to learn how to trade them appropriately. In doing so, they are walking away from huge opportunities.

Most novice traders are quick to spurn options as they consistently lose money when trading them. The most common reason novice option traders experience losses is that they do not do their homework beforehand. New option traders fail to recognize the importance of “The Greeks.” Option traders not only have to be cognizant of the volatility index, but they have to be proficient in the dynamic factors that impact option prices such as implied volatility. In the future, my articles will be focused with the intent to educate readers about “The Greeks” in a way that is easy to read and understand.

Traders that utilize a trading system or that look for low risk entries find themselves sitting idle when market conditions are not favorable for their trading system or when prudent entries have not presented themselves. The ability to trade options gives a trader another investment vehicle that can offer potential profits. In most situations, options can offer attractive returns while taking significantly less risk than trading stocks, ETF’s or bonds.

In order to illustrate a situation where options can present a better risk versus reward, we need to look no further than intraday market action in the S&P 500 on August 2nd. The market rallied from the previous close and was bumping up against significant resistance. Traders could have been looking to get long or short based on recent price action. The market had been consolidating, and a significant move was likely coming.

Clearly the market was at a crossroads and a breakout could be right around the corner, or the market could test recent highs only to turn down to retest recent support. Stock traders have to make a decision about direction or sit on the sidelines and let others do the heavy lifting. Option traders could put on positions that have a directional bias, or they could utilize time decay (theta) as a profit engine.

Through the use of spreads such as an iron condor or a butterfly spread, option traders can actually put on a position that has the ability to be profitable regardless of which direction SPY goes. In order for a spread to work, SPY’s price must stay within the confines of the spread which is also determined by the specific option strike prices selected by the option trader. Similar to the mechanism that drives asset pricing, the more risk an option trader takes the greater their return. If a spread is written that is extremely wide and thus less risky, potential returns diminish.

Ultimately, this is a recent example of how options can offer more than just leverage, but a totally different methodology that can produce outsized profits. In the future, we will dissect the various spreads and the profit engines that drive them. However, before we begin detailed discussion of various option strategies, option traders must have a sound understanding of various volatility principles as well as the impact that the Greek’s have in the world of options. In closing, I will leave you with the muse of George Orwell, “To see what is in front of one’s nose requires a constant struggle.”

If you would like to continue learning about the hidden potential options trading can provide please join my FREE Newsletter: www.OptionsTradingSignals.com

J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J.W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized.