Option Selection With Bill Corcoran

Presents Option Selection With Bill Corcoran

I am not a registered broker-dealer or investment adviser. I will mention that I consider certain securities or positions to be good candidates for the types of strategies we are discussing or illustrating. Because I consider the securities or positions appropriate to the discussion or for illustration purposes does not mean that I am telling you to trade the strategies or securities. Keep in mind that we are not providing you with recommendations or personalized advice about your trading activities. The information we are providing is not tailored to any particular individual. Any mention of a particular security is not a recommendation to buy, sell, or hold that or any other security or a suggestion that it is suitable for any specific person. Keep in mind that all trading involves a risk of loss, and this will always be the situation, regardless of whether we are discussing strategies that are intended to limit risk. I am not subject to trading restrictions. Myself and other instructors could have a position in a security or initiate a position in a security at any time.

A Few Questions First Have you ever lost money on an options trade when the stock went in the right direction? Have you ever felt like you should have made more on your option when the stock went in your favor?? Do you calculate expiration breakeven before every option trade? Is option price one of your primary considerations when selecting your options? Do you buy cheap options because you think they represent less risk?

BASIC OPTION PRICING

OPTION GREEKS

Sensitivity to Stock Price We can measure option sensitivity to price movement of the underlying stock with DELTA. DELTA helps determine how much an option price will move relative to the underlying stock price movement. The easy way to see this is: If the stock moves $1, the option price will move by the DELTA.

DELTA DELTA is affected by movement in the price of the underlying stock. DELTA is also affected by the time to expiration. DELTA can be affected by IMPLIED VOLATILITY. Call options have positive (+) DELTA Put Options have negative (-) DELTA Intrinsic Value always trades with a 1 DELTA As expiration approaches, the DELTA changes. ITM DELTA moves toward 1.00 (GAMMA increase) OTM DELTA moves toward 0.00 (GAMMA decrease)

DELTA Example Stock moves DELTA Option Moves $1 1.00 $1 $1.50 $.50 $1.25 $.25

DELTA Moves Too? DELTA is not constant, it will move: If the underlying stock price moves. If the stock price moves up, the DELTA on the call options tend to also move up, while the put option DELTA moves down. If the stock price moves down, the DELTA on the put options move up and the call option DELTA moves down. As Expiration approaches. DELTA moves up If Implied Volatility changes Higher Implied Volatility typically suppresses DELTA The rate of change of the DELTA is called the GAMMA

GAMMA GAMMA is displayed as the projected change in the DELTA given a $1 move in the underlying stock. GAMMA is also affected by time to expiration. The less time to expiration, the more pronounced the GAMMA

ATM GAMMA Example Stock Moves ATM Call DELTA ATM Put DELTA Moves Up Moves Down (Gamma.10) (Gamma.10).60.50 $1.50.40 *Numbers are examples only.

Time Time is a diminishing resource. As expiration approaches, there is less time left. The price of an option can include time value. The time value component of an option price is reduced as expiration approaches. This time value decay is represented by the THETA. THETA can be affected by the IMPLIED VOLATILITY.

THETA THETA is the measure of an options price sensitivity to diminishing time. THETA only affects the TIME VALUE portion of an options price. At expiration, there is no more time left, hence there is no TIME VALUE Because there is no TIME VALUE, all OTM options have expired worthless. THETA increases as expiration approaches.

Theta Curve Price Time Expiration

THETA THETA is represented as the amount that the TIME VALUE will decay in one day. THETA is highest for ATM options regardless of time to expiration. ITM options have lower THETA due to decreased TIME VALUE OTM options have lower THETA due to reduced cost of the option. THETA can be significantly different for calls and puts

THETA Example TIME PERIOD THETA Option Moves 1 -.15 - $.15 1 -.65 - $.65 * numbers are estimates ** numbers are based on no movement in stock price

Theta Profile Option buyers experience negative (-) THETA Option sellers experience positive (+) THETA THETA profile can potentially help balance risk Calculating THETA Calculate positive THETA (options that are sold to open) Calculate negative THETA (option that are bought to open)

Implied Volatility Implied Volatility is specific to the Option. Is an estimate of the stock s volatility as determined by the Option Market Maker Represents the risk premium priced in by the Market Maker. Determines the time value (extrinsic) portion of the option price. Can change dramatically as market conditions change.

Vega VEGA measures the option price sensitivity to a move in Implied Volatility. It represents how much the option price will change based on a 1% change in Implied Volatility. It can indicate an INCREASE in extrinsic value in an environment of increasing Implied Volatility. High Implied Volatility will suppress DELTA and GAMMA

VEGA Example Implied Vol. moves VEGA Option Moves 1%.1 $.10 1%.65 $.65 * numbers are estimates ** numbers are based on no movement in stock price

OPTION PRICE STRUCTURE

CALL OPTION STRIKE LOCATION 110 Strike 105 Strike OUT OF THE MONEY (OTM) AT THE MONEY Stock Price $100 100 Strike IN THE MONEY (ITM) 95 Strike How far ITM is the $95 strike? 90 Strike

WHAT IS INTRINSIC VALUE? Example: The stock is trading at $100, we are interested in the $95 strike call: Stock Price $100.00 Strike Price -$95.00 Intrinsic value = $5.00 INTRINSIC VALUE tells us how far the OPTION STRIKE PRICE is IN THE MONEY. INTRINSIC VALUE is the difference between the STOCK PRICE and the strike price. Notice that the INTRINSIC VALE will always move right with the stock price! The more Intrinsic value the more the option price tracks the stock price movement.

PUT OPTION STRIKE LOCATION 110 Strike 105 Strike IN THE MONEY (ITM) How far ITM is the $105 strike? AT THE MONEY Stock Price $100 100 Strike OUT OF THE MONEY (OTM) 95 Strike 90 Strike

THE PRICE FOR TRADING OPTIONS Our hypothetical 95 strike CALL option expiring next week is listed for $7 The stock is trading at $100 so we can quickly determine the intrinsic value: Stock Price $100.00 Strike Price -$95.00 Intrinsic value = $5.00 INTRINSIC VALUE is the difference between the STOCK PRICE and the strike price. It seems like this option should only be worth $5, right? Why is it $7? The OPTION price beyond the INTRINSIC VALUE is called EXTRINSIC VALUE or TIME VALUE.

WHAT IS TIME VALUE? Example: The stock is trading at $100, we are interested in the $95 strike call. That call option is listed at $7/share: Stock Price $100 Strike Price $95.00 Intrinsic value = $5.00 Option cost $7.00 Intrinsic value - $5.00 Time value = $2.00 We Know there is $5 of Intrinsic Value. By subtracting the IV from the option price we can easily determine how much Extrinsic (Time Value) there is in this option

TIME VALUE In the money (ITM) options will have some TIME VALUE and some INTRINSIC VALUE. At the money (ATM) and out of the money (OTM) options will be all TIME VALUE. The Market Maker can add or subtract TIME VALUE whenever he feels the need to. TIME VALUE IS THE Market Makers estimate of what the time left until expiration is worth.

THE MARKET MAKERS EDGE TIME VALUE is the Market Makers protection from you. Time value allows the Market Maker to hedge against paying you a profit. The amount of time value assigned to any given strike price is determined by IMPLIED VOLATILITY. Higher IMPLIED VOLATILITY means more time value. Guess who determines the Implied Volatility??

Out of The Money Option OTM and ATM Option is all Time Value OTM option has no Intrinsic Value The time value will erode to zero at expiration!

In The Money Option ITM Option has some Intrinsic Value The ITM Option also has some Time Value If the stock price does not change in our favor, the time value will erode.

Deep In The Money Option This ITM Option has a lot of Intrinsic Value.. And very little Time Value If the stock price moves at all, the option price will change at nearly the same rate!

A VIEW FROM THE OTHER SIDE

LET S PRETEND For this drill you are the Market Maker Your job is to create an orderly market. You get to set the price of any option but must keep the orders flowing. You get paid the spread so you have to protect yourself. Remember you must buy whatever the trader is selling or sell whatever they are buying at the market price. Ready?

105 put $5.50 x $5.70 102.5 put $3.50 x $3.70 Support at $102 100 put $2.50 x $2.70

WHICH ONE? Which strike price would you prefer to SELL to the trader? Remember the trader can choose whichever he wants to buy. If you get this wrong, YOU will lose the money on the spread. You could raise or lower the Implied Volatility. You could open the bid x ask spread What are you going to do?

105 put $5.50 x $5.70.80 delta 102.5 put $3.50 x $3.70.55 delta Support at $102 100 put $2.50 x $2.70.40 delta

SMART MOVE! The OTM strike offer the highest probability of you getting paid! It has a 60% probability of expiring OTM (worthless). You should be a market maker! Let s try another

107.5 call $1.50 x $1.70.35 delta Resistance at $107 105 call $2.50 x $2.70.50 delta 102.5 call $3.50 x $3.70.70 delta

SMART MOVE! The OTM strike offer the highest probability of you getting paid! It has a 65% probability of expiring OTM (worthless). You should be a market maker! Let s try another

WHY? As a MM, you d rather sell OTM options, right? This gives the Market Maker a huge advantage. Options that expire OTM pay the bills for the Market Maker. If that s the case, why would you ever BUY and OTM option?

THE UGLY TRUTH ABOUT BUYING OPTIONS

#TRUTH Bad news! You are on the wrong side of the trade. It is much harder to make money buying options. As soon as you buy an option, you start losing. You insist on making it worse by buying the exact options the market maker wants you to buy.

BREAKEVEN You MUST calculate the expiration breakeven on any option trade BEFORE you enter the trade. The cost of a CALL added to the STRIKE. The cost of a PUT subtracted from the STRIKE.

#MATH Breakeven Price? 106.20 BTO 105 call $1.00 x $1.20 Stock Price $102

#MATH Breakeven Price? 104.20 Stock Price $102 BTO 102.5 call $2.00 x $2.20

#MATH Breakeven Price? 103.20 Stock Price $102 BTO 100 call $3.00 x $3.20

RISK OTM options have a low probability of reaching breakeven. This creates a significant risk of LOSS of initial investment. ATM options only have marginally higher probability of reaching breakeven. This still creates unacceptable risk of LOSS or of underperforming profit.

RISK ITM options have a high probability of reaching breakeven. This significantly reduces the risk of LOSS of initial investment. The stock price must travel less in order to reach and exceed the breakeven point. The higher DELTA means the option will gain more value and have a rapidly increasing GAMMA resulting in very high performance.

Why are you trading? THINK ABOUT IT! Are you doing it to lose money? Are you doing it to make less profit? THAT is EXACTLY what will happen when you buy OTM options.

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