Copyright 2018 Craig E. Forman All Rights Reserved. Trading Equity Options Week 2

Copyright 2018 Craig E. Forman All Rights Reserved www.tastytrader.net Trading Equity Options Week 2

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 Why Trade Options What is your theoretical probability of profit (POP) when buying stock? Is there any way to increase your POP when buying stock? How can you make money in a neutral or down market buying stock? What sort of Return on Capital would you like to see from your portfolio? Is it better to be a passive or active investor? How will a typical 401K plan perform in an up market, a down market? If you own mutual funds, how have they performed relative to the S&P 500? 3

Discussion: Questions for Next Session If it IV an input to the options pricing model, why don t we know what it is? If we say that a stock has an implied volatility of 10%, what does that mean (in English)? What are the chances of a stock closing outside the 2SD expected move? What are the chances of a stock closing above the 1 SD expected move? What is the difference between historic and implied volatility? If volatility rises, will it help or hurt our options position? Is it better to be a buyer or seller of options? Can volume of options traded be greater than open interest? If HV is 10% greater than IV, would you tend to want to buy or sell options? What probability of profit would you like to see in your trading? 4

Topic Summary IV Rank and IV Percentile Key measurement parameters; POP, BPR, ROC, EXT, and P50 Margin The Option Chain The Option Greeks Delta, Gamma, Theta, Vega, and Rho Synthetics Option Spreads Credit and Debit Spreads Defined Risk vs. Undefined Risk Spreads Naked Puts and Calls Covered Calls and Covered Puts 5

IV Rank IV tends to be at different levels for different underlings. So when we compare two underlyings, we need at way to look at RELATIVE IV. IV Rank (IVR) is the relative position of the current IV as compared to the low-high IV range from the past year (or other interval) FOR THAT UNDERLYING. It compares current IV to historical IV Does not use IV data for expiries less than 8 DTE due to upcoming earnings. An IV centered between the 52 week low IV and 52 week high IV is Rank 50. IVR = Current IV 52-week Low IV (Expressed as 0 to 100) 52 Week High IV 52-Week Low IV The problem with IV Rank is that an outlier IV move will skew the data for a whole year. Every time the IV makes a new 1-year high or low, the denominator of the equation gets larger, so it tends to push IVR lower. 6

IV Percentile IV Percentile (IVP) attempts to correct the effect of large outliers in IV. IV Percentile tells you the % of days from the period of interest (i.e. 1 year) that the current IV is above rather than below. Varies from 0 to 100% If current IV is trading above the last 126 out of 252 trading days (1 year), we say that the IV percentile over the past year is 50%. We can look at IVP for any length, like 6 months, 1 year, etc. IVP is not calculated for you on TOS, but you can get it by downloading and installing a custom study called a THINKSCRIPT study (see advanced homework at end of this slideset). 7

IV Rank vs. IV Percentile Consider the following IV plot for 1 year: Do you think IV is relatively low, middle, or high now? IV Rank (IVR) for the past year is 47. IV Percentile (IVP) for the past year is 98. Which is the more useful number, IV Rank or IV percentile? You can use whatever you want, but BE CONSISTENT! 8

Key Measures: POP, BPR, ROC, EXT, and P50 POP = Probability of Profit An estimate of the probability that the trade will be profitable (at least 1 cent) at expiration. We generally look for high probability trades. BPR = Buying Power Reduction This is the amount of capital that the broker reserves in your account to cover the potential risk on a trade (both for you and your broker). ROC = Return on Capital (used for defined risk trades) Maximum possible profit / BPR. EXT = Extrinsic value in trade. This is the amount in dollars of extrinsic value in the options position at entry. If net long, we will be paying this at entry, if net short, we will collect it at entry. This will decay over time. P50 (tastyworks only)=prob of reaching 50% of either max profit or debit paid at some point before expiry. Calculated through a Monte Carlo simulation. 9

Margin and Buying Power Reduction Margin and BPR are similar terms, but margin is historically associated with stock and BPR is used with options. Both refer to use of leverage; you can take on more risk than your Net Liq. All trades with risk reduce your buying power because the brokerage firm must set aside some of your account equity in case your positions move against you. All option traders must be approved for margin trading. This is necessary because short option positions can lose more than the initial investment. Buying stock w/margin typically uses 50% of value in BPR; balance can be borrowed Reg-T Margin Used for most option traders with small to medium sized accounts. Portfolio Margin Used for larger accounts and more experienced traders. Much more liberal than Reg-T margin. You have to have a minimum acct value and pass a test to get it (ask me if you need help in prep or want some sample tests). SPAN Margin Used for futures accounts, similar to Portfolio Margin, very liberal. You can ask TOS to set up your paper money account as a PM account. 10

The Option Chain An Option Chain is a way of presenting the various options that can be traded on an underlying. Calls on the left, Puts on the right. Weekly expirations are marked in Yellow, others are Monthlys (3 rd Friday) Implied Volatility and Expected Move for each expiry is on the far right. 11

Reading the Option Chain The option chain shows you the bid-ask spread on each option. There are expirations monthly (3rd Friday) + Weekly expirations. The bid is the price at which you could sell the option contract, and the ask is the price at which you could buy the option contract. The difference is the bid-ask spread and is a measure of liquidity. When you are trying to trade an option contract or spread, you usually try to buy or sell it somewhere near the midpoint of the bid-ask. Since each option contract controls 100 shares, you have to multiply the price shown in the chain by 100 to get the price of 1 contract. The options chain always shows you the bid and ask prices. The other columns can be configured to show you additional information such as mark price, volume, open interest, IV, Greeks, etc. 12

The Option Greeks Δ, ϴ, ѵ, Γ, ρ The option greeks are Delta, Theta, Vega, Gamma, and Rho Understanding the option greeks can help you set expectations for option positions based on your assumptions Allows you to place trades that minimize risk based on your assumptions. Delta Δ = Impact of underlying price change on option price. Theta ϴ = Impact of time on option price; we generally want positive theta. Vega ѵ = Impact of implied volatility change on option price. Gamma Γ = Impact of price change on Delta; the first derivative of Delta with respect to price. This is like the accelerator for Delta. Rho ρ = Impact of interest rate change on option price Negligible at this time due to extremely low interest rates. 13

Delta Δ Delta tells how sensitive the position is to price. Tells you how much $ the option or position will move with a $1 up move in the underlying. Sign tells you if position is net short or long; magnitude represents directional risk. Option Delta has a range of -1 to +1 Options with positive delta will positively correlate with underlying (you want underlying to move higher). Options with negative delta negatively correlate to underlying (you want underlying to move lower). The closer the option delta is to 1 or -1, the more it correlates with movement in the underlying ATM options have a +.50 or -.50 delta, OTM calls have < +.50 delta, ITM calls have > +.50 delta Delta is also a proxy for how much the option acts like stock (a.75 delta call acts like 75 shares of stock) The absolute values of the call and put deltas at a single strike add up to 1.0 Thus a strike with a call delta of.70 has a put delta of -.30 100 shares long stock = +100 delta; short 100 shares stock = -100 delta. Delta is approximately equal to the probability of the option expiring ITM. 14

Delta as seen in the Options Chain Note for each line, sum of the put and call deltas (not including sign) is 1.0. Note that for each line, the Prob ITM (probability of expiring ITM) is approximately equal to Delta. Calls Here Puts Here Expiry Strike Price Prob ITM Deltas add to 1.0 on each line (disregarding the sign) 15

ATM Call Delta as a Function of DTE (Days to Expiry) 16

Gamma Γ Gamma tells us how delta changes as the underlying price changes. It is the first derivative of delta. It is like an accelerator for delta. Gamma is the change in delta for a $1 up move in the underlying. A positive gamma will cause delta to rise as the underlying rallies and fall as the underlying moves lower (it moves WITH the underlying). A negative gamma will cause delta to rise as the underlying moves lower, and fall as the underlying rallies (it moves OPPOSITE of the underlying). ATM options have the most gamma, ITM and OTM options have less. The further time until expiration, the smaller the gamma. As gamma approaches expiration, it explodes for options that are ATM, so holding short options near the money into expiry is risky. 17

Gamma Risk approaching expiration 18

Theta ϴ Theta tells us how sensitive the position is to the passage of time. Theta is the dollar amount by which an option or position s price changes each day due to the passage of time. A positive theta position benefits with the passage of time (MAKES $$). A negative theta position is hurt by the passage of time (LOSES $$). Long options have negative theta, short options have positive theta. Theta is the PROFIT ENGINE for short premium trades (selling options). ATM options have the most theta; ITM and OTM options have less theta. 19

Time Decay for Options Note: Time value is much higher for ATM options, and accelerates its decay approaching expiry. For OTM options, time value is lower, but decay slows as expiry is approached. This is why selling ATM options brings in so more premium, and why closing short OTM options early makes sense. ATM Options Days to Expiry 20

Time Decay for Teeny Options Teeny options are options that are far out of the money and sell for very low price (like $.20 or less). If you sell these options, you have to wait until expiry to squeeze the last few cents out of the option. So if you think you can sell $.10 options and make money, you probably can, but you will have to wait until expiry to make most of your profit while there is always risk that the underlying price will move against you and your short option that you collected $10 per contract for is going to cost you like $500 to buy back, so risk/reward is lousy. When options get to a low price like $.10 or $.05, you should be closing them to take the risk off the table. Many trading firms will even give you free commissions to close a cheap short option. Teeny Options Decay slows down when option price gets very low 21

Vega ѵ Vega tells us how sensitive the position is to a change in Implied Volatility. IV is the volatility that the market is PREDICITING that volatility will be, based on the options prices. Vega tells us for every 1% up change in implied volatility, how much the option price or position price will change, in dollars. A positive (+) Vega position benefits from increase in IV. A negative (-) Vega position benefits from decrease in IV. Long options have positive Vega, short options have negative Vega. ATM options have the most Vega, ITM and OTM options have less Vega. The further the time to expiration, the more Vega an option will have, and the more sensitive it is to volatility changes. 22

Vega ѵ 23

Put Call Parity and Synthetics Puts & Calls are related. This allows us to create synthetic positions. Synthetic positions allow you to get long or short using far less capital. Stock(S) Strike Price(x) + Carry Cost = Call Put or S = C P + x To replicate long stock, buy the ATM Call and sell the ATM Put (S = C P+x) To replicate short stock sell the ATM Call and buy the ATM Put (-S=P-C+x) You can use this to price a stock by just looking at option prices. You can get synthetically short or long a stock using just options! Note: 120 call - 120 put = 2.685 1.760 =.925 120 +.925 = 120.925 Stock Price = 120.92 24

Option Spreads When we trade options, we often trade option spreads, which may have 2, 3, or 4 legs. Over time, if we add to the position we can have many legs. Option spread trades can be entered as a single order on your trading platform. This can save on commissions and are easier to execute. Spreads can contain puts, calls, or both puts and calls. Spreads can be bullish, bearish or neutral. When trading an option spread, the puts and calls are all options on a single underlying. The option legs may have the same expiry or different expiries. Option spreads have names such as vertical, calendar, butterfly, iron condor, ratio spread, etc. We can easily analyze our overall options position by looking at the Greeks. 25

Credit and Debit Spreads Spreads are either put on for a credit or a debit. A credit means you collect $$ for placing the trade because you are taking on risk. A debit means you are paying $$ to put on the trade because you are paying someone else to take on risk. Credit and Debit spreads have nothing to do with profit and loss. You will start to see profit and/or loss on a trade only after it is placed. When the trade is closed, you have a realized profit or loss. Credit and Debit spreads can be identical in risk profile. But as a practical matter, we usually pick one over the other depending on volatility and our mechanical trading rules. Many traders like to put on trades for a credit. 26

Defined Risk vs. Undefined Risk Positions A single short option is a naked position; risk is large. For a short call, theoretical risk is unlimited to the upside and for a short put, theoretical risk is strike price minus credit to the downside. A single long option has defined risk limited to the amount you paid. Option spreads can be either risk defined or risk undefined. A defined risk spread means you know the max loss upon entry. An undefined risk spread means you have very large risk up or down. Your buying power reduction is much larger with undefined risk trades. Some undefined risk trades cannot be placed in an IRA. You can always change an undefined risk trade into a defined risk trade by buying cheap options as protection (but it will cost some $). 27

Short Options Naked Put and Call If you sell an option without an offsetting option it is called selling naked. You are then said to be short the option contract. Naked short options are ALWAYS directional and use a lot of buying power Naked short puts may be done in an IRA, but naked calls cannot. Naked short puts are BULLISH and naked short calls are BEARISH. Outlook Put Options Assignment Risk Call Options Assignment Risk Bullish Sell (short) Obligated to Buy Stock Buy (long) No Obligation Cannot get assigned Bearish Buy (long) No Obligation Cannot get assigned Sell (short) Obligated to Sell Stock 28

P/L Graph Buying and Selling Stock P/L Graph shows how your P/L changes with underlying price change. These graphs generally show the P/L at expiration. 29

P/L Graphs Buying and Selling Naked Options 30

P/L Graphs Morph into Expiration Graphs as Expiry Approaches 31

Covered Calls - Bullish If you own stock, you can reduce cost basis by selling calls against it. Covered calls are ALWAYS bullish positions. Covered calls give you a little protection to the downside. You give up the unlimited upside of owning naked stock. Typically, you might look to sell calls slightly OOM, 30 to 60 days out. Max profit occurs if stock is at or above strike price at expiration. If calls expire ITM, your stock is called away and you book a profit. If calls expire OTM, you keep the premium, and can sell calls in next cycle. If you are near expiration, and you are near call strike price, you can buy back your short calls and roll them out to extend duration. You can do covered calls ATM, OOM, or ITM. All will increase POP! 32

Covered Puts - Bearish If you are short stock, you can reduce cost basis by selling puts against it. Short stock with short puts are ALWAYS bearish positions. Covered puts give you a little protection to the upside. You give up the unlimited upside of being short naked stock. Typically, you might look to sell puts slightly OOM, 30 to 60 days out. Max profit occurs if stock is at or below strike price at expiration. If puts expire ITM, your short stock is assigned ; you buy it back at a profit. If puts expire OTM, you keep the premium, and can sell puts in next cycle. If you are near expiration, and you are near put strike price, you can buy back your short puts and roll them out to extend duration. You can do covered puts ATM, OOM, or ITM. All will increase POP! 33

P/L Graphs Buying and Selling Covered Stock Covered Call COVERED CALL COVERED PUT Covered Put Note the same P/L Graphs Note the same P/L Graphs Short Put Short Call 34

Covered Stock vs. Short Naked Options A covered call has the same P/L graph as a short put. A covered put has the same P/L graph as a short call. Why would you choose one over the other? How do dividends affect your position in the covered call, the naked put? What happens if you are short stock and a dividend is paid? What happens when the short option expires? Demo - Look at covered call vs short put on TOS, using a cash secured (IRA) acct, and a Reg-T Margin account. What is Max Profit, Max Loss, POP, BPR, ROC for each? Which is the better way to trade, covered stock or short puts? 35

Covered Call vs. Short Naked Put Example Using QQQ ETF, Covered Call (1SD OOM) vs. same strike Short Put Current QQQ Price: Strike Selected: days, Strike Price: Covered Call Strategy: Buy 100 shares QQQ, sell 1 Call 1SD OOM, DTE = 30-45 Stock Price Covered Call Price BreakEven = Cost Basis POP (from tastyworks) Max Profit (if called) Max Loss Cash Acct BPR Cash Acct ROC (if called) Reg-T Acct BPR Reg-T Acct ROC (if called) Selling Put Strategy: Sell one QQQ Put using same strike as above Sold Put Price Net Credit BreakEven = Strike Credit POP (from tastyworks) Max Profit if Put expires OTM Max Loss Cash Acct BPR Cash Acct ROC if Put expires OTM Reg-T Acct BPR Reg-T Acct ROC if Put expires OTM 36

Homework Week 2 Answer the options chain questions on the next slide. Think about discussion questions on the last slide. Watch these segments: The Skinny on Options Data Science 11/12/15 IV Rank and IV Percentile (w/thinkscript) Advanced: There is a thinkscript link in this segment that allows you to add the IVR and IVP as chart labels. If you want to try this, follow the instructions in the link. Best Practices 2/2/15 Key Metrics POP & ROC Best Practices 1/26/15 Buying Power Reduction Market Measures 8/27/12 Margin vs. Portfolio Margin Best Practices What Else Ya Got 10/16/17 Ways to Make Money Trading Options 10/21/14 Theta Decay A Visual Explanation Best Practices 4/3/17 Comparing Long Stock to Short Puts Options Jive 8/1/17 Covered Call Mechanics Market Measures 4/8/13 Covered Call vs. Short Put 37

Homework: Option Chain Questions Which Dec 15 call would you buy if you wanted it to act like 100 shares long stock? How much would it cost and how much long stock would it be equivalent to? Which Dec 15 put would you sell if you wanted it to act like 100 shares of long stock? How much would it cost and how much long stock would it be equivalent to? 38

Discussion: Questions to Think About What theta would you like to see in your trades (positive or negative)? 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 and in which direction does your P/L move 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? You sold 10 put contracts, each option has theta = -.08. How much did your P/L move and in which direction after 2 days assuming no other changes? Why are IVR and IVP more useful measurements of volatility than IV? 39