Trading Equity Options Week 3

Disclosure All investments involve risk and are not suitable for all investors. The past performance of a security, industry, sector, or market of a financial product does not guarantee future results or returns. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker or the Options Clearing Corporation at 1-888-OPTIONS or visit www.888options.com. Any strategies discussed here, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. The author of this presentation, and the content of the website www.tastytrader.net are in no way approved, endorsed, supported, or affiliated with tastytrade. We are a third party with interest in the tastytrade content, and the purpose of the information presented here is for education only. The ideas presented here are solely the views of the author, and are meant to enhance the ability of the individual investor in managing personal investments using the strategies and ideas set forth by tastytrade. 2

Discussion Questions from Week 2 What POP and ROC would we like to see? How about theta? When trading options on margin, do you pay margin interest to the broker? What option greek(s) would you tend to watch the most, the least? With short premium (short puts and calls) do we want IV to move or? Given stock XYZ at $50, position delta = -$30, how much does the position move up or down in price with a $2 increase in price of XYZ stock? Explain in words what a delta neutral position would be. Is it better to trade a debit or a credit spread? Why would we trade an undefined risk spread if we can define our risk? If you sold 10 put contracts with a theta =.08, how much would your position value increase or decrease in 1 day assuming no other changes? Why is IV Rank a more useful measurement of volatility than IV? 3

Option Skew The VIX VIX Relationship to SPX The Vertical Spreads The Iron Condor Spread Topic Summary 4

Option Skew Options have individual IV s at each strike. Skew refers generally to differences in relative volatility of ATM options versus OOM options. The volatility smile describes the relative shape of IV skew (OOM options have > IV, light green line). When there is fear in the market, traders buy puts in the indices to protect portfolios, so the put prices are bid higher, and will generally have more premium than the calls. Therefore, we say that the puts trade richer than calls (as in blue line). This is called normal skew. For individual stocks, skew can be relatively forward, flat or inverted. We look at skew when we open new option trades to take advantage of it. Generally, liquidity is better in OOM options vs. ITM options (bigger volume). 5

Trading Volatility: The VIX VIX is a weighted estimate of Implied Volatility of the S&P 500 (SPX) options based on option prices with a net duration of 30 days. ATM options are weighted more heavily vs. OTM, as are puts vs. calls. Computed from a weighted blend of prices of near-the money SPX options with between 23 and 37 days to expiry (approximates a 30 day forward vol). VIX is often called the fear gauge because it spikes during a market selloff when there is fear and traders are buying put protection for their portfolios. The VIX is mean reverting. It hovers around an average (18 to 19 range). When the SPX is making a big move down, the VIX is usually spiking. The VIX itself is not tradable. VIX futures are tradable, and VIX options are tradable, but they are based on VIX futures prices, not the VIX index itself. There are some ETF s that you can trade which follow the VIX; VXX, UVXY. 6

VIX Relationship to SPX VIX Spikes SPX Falls 7

Normal VIX Contango 8

Implied Vol vs. Realized Vol If Implied Vol is overstated compared to Realized Vol, then options sellers have an edge over buyers. 9

Getting Edge by Selling Volatility 10

Is the 1-Month Expected Move in SPX Overstated? Data source: Market Measures, 2/6/15, Implied vs Actual IVs Different Timespans 11

Results of selling strangles in the 4 major indices The theoretical % profitable trades selling 1 SD strangles is 68%. Every index over-performed the theoretical expected number when selling premium at 1SD. 12

Vertical Spreads A vertical spread uses either puts or calls (not both), in the same expiry. One option is bought, and the other is sold. If the sold option is closer to the money than the bought option, it is a vertical CREDIT spread, and if the sold option is further out of the money than the bought option, it is a vertical DEBIT spread. Another way to state this: If you collect more from the short option than you paid for the long option, it is put on for a credit, otherwise it is a debit. The vertical spread is always risk defined; you can calculate easily what your max profit and max loss is on the trade before you enter it. These calculations are also done for you automatically when you place the trade. 13

Vertical Spreads Bullish and Bearish If you sell a vertical call spread for a credit, you are bearish (short delta). If you buy a vertical call spread for a debit, you are bullish (long delta). If you sell a vertical put spread for a credit, you are bullish (long delta). If you buy a vertical put spread for a debit, you are bearish (short delta). Outlook Vertical Put Spreads Vertical Call Spreads Delta Bullish Sell for Credit Buy for Debit Positive Bearish Buy for Debit Sell for Credit Negative 14

Example of a Call Credit Spread An example of a vertical call credit spread would be to sell the Jan 202 call for $4.20 and buy the Jan 205 call for $2.68. The spread price would be a net credit of about $1.52, or a credit of $152 per contract. BE: $203.52 Max Profit: $152 Max Loss: $148 15

Example of a Put Debit Spread (same strikes) An example of a vertical put debit spread would be to buy the Jan 205 put for $7.06 and sell the Jan 202 put for $5.58. The spread price would be a net debit of about $1.48, or a debit of $148 per contract. BE: $203.52 Max Profit: $152 Max Loss: $148 Is this identical to call credit spread? WHY? 16

Profit and Loss on the Vertical Spread A vertical spread is always directional; it is either bullish or bearish. For a credit spread, the max profit is the credit received, and the max loss is the width between strikes less the credit received. Example: Sell 116 call for $4.15, buy 117 call for $3.80; credit is $.35, or $35 per contract and max loss is $65 per contract ($100-$35). For a debit spread, max loss is the amount you paid to place the trade, and max profit is the width between strikes less the debit paid. Example: Buy 114 call for $5.35, sell 116 call for $4.15. Your debit is $1.20 or $120. The max loss is $120 per contract and the max profit is $80 per contract ($200-$120). Buying a debit spread has many advantages over just buying a long option. By selling the OOM option, you reduce the cost of the trade (lowers risk). 17

P/L Graph Vertical Call Debit Spread Vertical Call Debit Spread Bullish Trade Best with Low IV Long Call ITM Short Call OTM POP around 50% Underlying Price at Trade Entry Short Call Strike Long Call Strike 18

P/L Graph Vertical Call Credit Spread Vertical Call Credit Spread Bearish Trade Best with High IV Short Call OTM Long Call Further OTM POP around 60-80% Short Call Strike Underlying Price at Trade Entry Long Call Strike 19

P/L Graph Vertical Put Debit Spread Vertical Put Debit Spread Bearish Trade Best with Low IV Long Put ITM Short Put OTM POP around 50% Short Put Strike Underlying Price at Trade Entry Long Put Strike 20

P/L Graph Vertical Put Credit Spread Vertical Put Debit Spread Bullish Trade Best with High IV Short Put OTM Long Put Further OTM POP around 60-80% Short Put Strike Short Put Strike Long Put Strike Long Put Strike Underlying Price at Trade Entry 21

P/L Graph Iron Condor The Iron Condor is a neutral trade; You want the underlying to move within a range. Uses a Vertical Put Credit Spread and a Vertical Call Credit Spread together as one trade. Max Profit is achieved if the underlying stays between the short strikes at expiration. Trade is entered for a credit (selling the Iron Condor). Roughly center the Iron Condor around the current underlying price (you can move it around to lean bullish or bearish). This is a 4-legged spread. Best used with high IV. Upper BE = Short Call Strike + Net Credit Received Lower BE = Strike Put Strike Net Credit Received Entered as a single trade: Sell an OOM Put Buy a further OOM Put Sell an OOM Call Buy a further OOM Call Underlying Price at Trade Entry Short Strikes 22

Watch these episodes: Homework Week 3 Strategies for Your IRA 6/18/13 Cost Basis Reduction Market Measures 10/23/14 Premium Why Selling it Works Market Measures 2/6/15 Implied vs Actual IVs Different Timespans Tasty Bites 9/30/15 Credit and Debit Vertical Spreads Market Measures 12/1/15 Drawbacks of Buying Options Know Your Options 8/15/14 In Depth Iron Condor Market Measures 8/26/14 Iron Clad Adjustments OTHER HOMEWORK: 1. Think about the discussion questions for next session (next slide). 2. Do the doughjo section 8 and do ALL the quizzes. An outline is posted at www.tastytrader.net in the downloads section. 23

Discussion: Questions to Think About When do you use a vertical debit spread vs. vertical credit spread and why? Which type of spread (credit or debit) has higher POP and why? Where does your risk lie when you sell an Iron Condor? Why would we expect Iron Condors to be best entered with high IV rank? How do Iron Condors make money if price stays stagnant? If you make the short strikes very far apart on the iron condor, do you get more or less credit? Have a better POP? What about your ROC? Do Iron Condors get more or less credit at trade entry w/wide short strikes? A variation of an Iron Condor is just a Condor. It is exactly the same trade using all puts or all calls. One of the verticals becomes a credit spread and one becomes a debit spread. Model this in TOS. Would you expect it to perform the same as an Iron Condor? Which is the better choice? Why? 24