I realize that most “Investors” are not all that interested in trading Options – in which case you can just skip this post and move on to the next. However, from an educational point of view they can be very informative and provide a leveraged way to play in the markets with controlled risk. In the past, I have written a few posts on simple (text-book) “strategies” that are used by many investors/traders to “insure” their portfolios and/or to generate additional “income”. However, in this post I want to approach things a little differently and to take a look at options from a wider perspective rather than to focus on specific “strategies”.
I have chosen to write this post now because I have been looking for a way to “insure” my investment portfolios for some months – but, currently, “insurance” is expensive and it is difficult to find “cheap” hedges. I will therefore attempt to build a “position” in Options. The “position” will, eventually, look very complicated and will have no “strategy” name per se – although it will be possible to break it down into more common/popular “text-book strategies”. So, try to follow along with some of my “simple” thinking.
First of all, a quick word on allocations. I would never suggest that anyone should just trade/invest only in Options. Personally, my maximum allocation to Option trades is 20% of available funds – and my actual use is usually less than 10%. I hope that puts things in some sort of perspective from the start – and I am not suggesting that this is necessarily the appropriate allocation for all investors/traders – it’s just where I am comfortable.
On the surface, Options are very simple/straight forward. There are only two (2) categories of Options – Call Options and Put Options. And there are only two (2) things that we can do with these Options – Buy them or Sell them. So what can be so difficult?
A single Option Contract is a “contract” between a buyer and seller to Buy or Sell 100 shares of an underlying asset at a specified price within a specified time frame.
A single Call Option entitles the buyer to purchase 100 shares in the underlying asset at a specified price (the “strike” price) at any time before the expiration (“expiry”) date of the Option.
A single Put Option entitles the buyer to sell 100 shares in the underlying asset at a specified price (the “strike” price) at any time before the expiration (“expiry”) date of the Option.
The buyer always has the right to exercise an Option and controls the actions to be taken. The seller is obligated to deliver on the contact if the buyer chooses to exercise his/her rights. Of course, Options do not have to be held until expiration and can be bought/sold to other investors/traders on the same contractual basis (but at different prices). Thus, no underlying assets may ever change hands if buyers and sellers cancel out. The ease/ability to buy/sell Options will depend on market liquidity that is reflected in “Open Interest” and Bid/Ask “Spread”. More on this later.
Perhaps the easiest way to understand Options is to consider an investor who buys a Put Option at $10. This gives the buyer the right to Sell 100 shares of the underlying asset at the specified “strike” price and it will cost the buyer $1,000 to buy the contract. Option prices are quoted on a per share basis but each contract is for 100 shares – therefore cost is $10 x 100 shares. This might be insurance (a hedge) against a long-only portfolio or speculation that prices are going to decline and is similar to paying $1,000 for home or auto insurance where the rights of the insured will only be exercised if the home is damaged in a fire (and is decreased in value) or if the car is involved in an accident. In the case of the financial Option, it will only be exercised (by the buyer) if the market crashes and the price of the underlying asset drops below the “strike” price of the Option.
For a Call Option, the analogy might be a house contract whereby the buyer might have an Option to buy a home at a specified price within a specified period of time. If, within this time period, the value of the home increased above the contract price, the buyer would exercise their right to buy the home – otherwise he/she would let the contract expire and forfeit the contract price (because they could buy the house for less “at market”).
At this point, let’s take a look at a typical “Option Chain”:
The above Option Chain is for SPY, the ETF that tracks the S&P 500 Index. This is also the first ETF that came to market and is the most heavily traded Optionable ETF – hence the asset with the largest number of different available Options. In the left-hand column we see the expiry dates of available options and, in the second column from the left the number of days to expiration. Originally, Options had only monthly expirations (third Friday of every month) but, due to the increased interest in Options, many assets now have weekly Options that expire on the Friday of every week. SPY is unique in that it has “weekly” options that expire on Mondays, Wednesdays and Fridays – hence the exceptionally large number of choices. If this is your first look at an Option Chain this is probably scary – but don’t quit on me yet – this is an extreme example – I just wanted to give you an idea of the number of available Options that might be available since this will be important for some of the positions that I will be creating.
Each expiration date has Options available at different strike prices. In the above figure I have just opened one of these expiry dates (18 Sep 2020 – 25 days to expiry) and I’m showing just 14 different strikes between $335 and $348 (center column). There are actually over 100 strikes listed at this single expiry – so probably over 1,000 available Options contracts throughout the complete “chain”.
In the above window, Call Options are listed on the left and Put Options are listed on the right. Just to the right/left of center are the Bid/Ask prices of the Options. As for normal stock quotes, these bid/ask spreads are important because they reflect on liquidity and, eventually, “slippage” costs.
More information/data can be shown in other columns and I have chosen to show just a few of the more important. “Open Interest” shows the number of contracts that are currently “open” – or where buyers and sellers are balanced. This is different from “Volume” that shows the daily transaction volume. This (volume) may or may not add/subtract to “open interest” depending on whether traders are buying/selling contracts that already exist or whether new contracts need to be created to balance supply/demand. Options are a zero sum product – there must always be an equal number of buyers and sellers but (unlike shares of stock) there is never a fixed number of contracts (shares) available. For high liquidity (and better pricing) we look for high Open Interest and tight Bid/Ask spreads. High volume is also desirable but usually goes along with the other two factors.
Now we move on to some of the more technical stuff and I don’t want to spend a lot of time on this – I will leave it to readers to ask specific questions that they feel may help them understand things better – I just need to provide a little information to make understanding a little easier going forward, but I don’t plan on getting into the (heavy) math – just trust me 😊.
Options can be either In-The-Money (ITM), At-The-Money (ATM) or Out-of-The Money (OTM). The “Money” is a reference to the strike price of the Option relative to the market price of the underlying asset. In the above figure, the price of the underlying asset is $341.78 and, if we are holding (long) a $340 Call Option the $340 Call Option is said to be $1.78 In-The-Money (ITM), and will be priced with $1.78 worth of intrinsic (real) value. The difference between the quoted Option price ($6.92 in the above figure) and this $1.78 of real (intrinsic) value is the premium (or extrinsic price value) that we pay to buy the Option. In the example, the ‘Extrinsic” value is $5.14 (third column of white-on-black figures).
Call Options at prices higher than the market price of the underlying asset are said to be Out-of-The-Money (OTM) and the Option price is all “extrinsic” (or premium) value – the Option has no intrinsic (real) value and will expire worthless if the price of the underlying asset does not move.
If the price of the underlying were exactly at the strike price of the Option the Option would be At-The-Money (ATM). This is highly unlikely, so the ATM Option is usually identified as the Option whose strike price is the closest to the market price of the underlying asset.
The opposite definitions are used for Put Options – i.e a Put Option with a strike price above the price of the underlying asset is ITM (priced with intrinsic plus extrinsic value) and Put Options with strike prices below the price of the underlying asset is OTM (with purely extrinsic value).
I don’t want to get into the details of Options pricing but take a look at the “extrinsic” values in the above figure. You will note that, for both Calls and Puts, the maximum extrinsic value is in the ATM ($342) Options and drops off on both sides (ITM and OTM). The distribution is (approximately) gaussian in nature (bell-curve). The significance of this is that the most “expensive” Options to buy are the ATM Options. This does not mean that they cost the most money ($’s) – deeper ITM Options (either Calls or Puts) will cost more to buy since they include intrinsic value – but, if the price of the underlying does not change, the loss due to “premium decay” will be less for Options further ITM or OTM.
On the other side of the coin, if we are selling Options (acting as the insurance company on the other side of the contract) then we can bring in the maximum premium be selling ATM Options.
While we are focusing on the ATM strike price let’s move on to the columns labelled “Delta”. There are a number of ways to use Delta but, technically it defines the change in price of the Option with a $1 change in the price of the underlying. For example, note that the “Delta” of the $342 ATM Call is ~0.50 (actual 0.49 in the above example) – this means that, for a $1 move in the price of the underlying, the option will change by $0.50. If the price moves up $1.00 the 342 Calls will increase by $0.50 – from ~$5.65 to ~$6.15 – likewise if price moves down $1.00. the Option price will drop $0.50 to ~ $5.15. The Opposite applies to Put Options, if price moves up $1, the Put Option will decrease ~$0.50 from $6.60 to $6.10 and if the underlying price moves down $1 the Option will increase ~$0.50 from $6.60 to $7.10. Note that the Delta values for Puts are negative. Deltas range from 0 to +1 for Calls and 0 to -1 for Puts.
Looked at from a slightly different perspective, if we buy an ATM Call Option (controlling 100 shares of the underlying), with a Delta of 0.50, this is equivalent of holding (being long) 50 shares of the underlying. This is applicable to all Options i.e. Options with Delta’s of 0.30 or 0.70 will be equivalent to holding 30 or 70 shares of the underlying asset respectively.
Bottom line from looking at Deltas – positive Deltas are bullish, negative Deltas are bearish. In an Option “position” with multiple legs (different Options) Deltas are additive and the net Delta value tells us whether the “position” is bullish or bearish. ITM Options have higher Delta values than OTM Options – i.e. they are more sensitive to movement of the underlying asset. This relates directly to directional risk. Delta is not static – as the price of the underlying moves, the Delta of the Options will change – as will the directional risk. Delta is one of the “instrument gauges” used to manage complex Option positions.
As a final note, before we move on, Delta can be used as an estimate that an Option will end up ITM at expiration. This is not a perfect measure of probability – but it is very close, so, If you were to look at a trading platform that did not include rigorous probability calculations, using the Deltas is plenty good enough as a practical estimate. As an obvious example, we noted above that ATM Options (Calls and Puts) have a 0.50 Delta. Used as a probability estimator this also means that the Options have a 50%/50% chance of closing ITM at expiration – intuitively correct, either the Call or the Put will end up ITM – the other will close OTM. The same holds for a 0.70 Delta Option – it will have a 70% chance of closing (somewhere) ITM.
The final parameter in the above figure is the Implied Volatility. This is probably the most important parameter in the establishment of Option prices. The reason for this is that other parameters (e.g. strike price and time to expiration) are known and can be managed/controlled. However, Implied volatility is not and is set by “market makers” based on supply/demand and uncertainty in the markets. Implied Volatility is not the same as historical (or statistical) volatility that we use in the Kipling workbook (that is calculated from the standard deviation of returns from historical data) – it is set by market sentiment and is an indication of expected future price movement. Implied volatility is “backed out” of current market Option prices using an Option pricing model. Thus, Implied volatility is important since it provides us with a measurement of probable future prices.
Note that Implied Volatility (IV) is not a constant – it is not annualized and varies from expiration date to expiration date and even between strikes at a specific expiration date (“skew”). In the above example IV varies between an average of 15.9% for the 31 Aug (7-day) short-term options to 29.8% for the longer-term 31 Dec (129-day) Options and between 18.9% for the 335 strike and 15.4% for the 348 strike in the same expiration 18 Sep series of Options. I’m sure that all this information is making your head spin a little – but don’t worry too much about the details – my point here is that Option prices give us a “real world” measurement of where prices might be going in the future, not where they have been in the past (Historical Volatility). Although there is usually a high correlation between historical and implied volatility they are not the same and IV tends to lead HV.
Of course, volatility does not give us an idea of which direction price might move – just an indication of how much movement, or risk, we might expect.
Before moving on to build an Option position let me address two common criticisms of Option trading:
- Options Are Too Risky – so stay away from them
Rather than being too risky I would argue that Options are less risky than buying/selling stock – if used sensibly. They may be more volatile (relative to money at risk) but the risk can be controlled. This is why funds allocated to Options should not be excessive – Options are a leveraged product, so less money is required to “control” a given level of investment in underlying assets.
If I buy a Call Option (with an expectation that prices will move higher) I cannot lose more than the cost of the Option that I buy, even if the price of the underlying asset moves to zero – so my risk is absolutely defined. On the negative side, if I am right, but price only moves up slightly, I might not show a profit – price will need to move up far enough to cover the cost of the “premium” that I pay to own the Option. This is the “break-even” point.
If I Sell a Call Option, this is where I can get in trouble – since risk is unlimited – if price moves up higher I am contractually obliged to sell shares of the underlying asset to the Call buyer at a price that is below current market value – therefore I must buy high and sell low. So, simply put, don’t sell “naked” Options. As we shall see, this risk can be controlled by buying a Call Option at a higher price (creating a vertical, or diagonal, “spread”).
- (Something like) 80% of Options Expire Worthless – so stay away from them
This statement may be true – assuming Options are held to expiration – but this is not a contractual obligation, so Options can be sold prior to expiration either for a profit or small (acceptable) loss. Options are commonly used to “hedge” or “insure” portfolios – so, as with home or auto insurance, the expectation will be that contracts bought with this intent will expire worthless.
If this is true (that 80% of contracts expire worthless), then maybe we should be the seller of Options rather than the buyer? i.e. we can choose to be the “insurer”.
So, Options aren’t necessarily too risky – it’s a matter of how we choose to use them.
Now I’ll move on to creating an Option “position”. I will build this position in SPY Options and my objectives in creating this position will be to be a NET seller of time “premium” and to generate a “hedge” against downside price movement. Because I have no control of where or when prices will move I will try to spread my risk over both price and time.
I will place my first “trade” as an “Iron Condor” position. I won’t go into an explanation/discussion of “Iron Condor” strategies since this isn’t particularly important if we look at it from the simpler perspective of the individual “legs” – and the final “position” will morph into something different anyway.
My first action therefore is to Sell a Call Option at the 375 strike and a Put Option at the 305 strike. As described above, this labels me as the “insurer” and I will collect “premium” as a credit. However, at this point, I have unlimited risk. So, I will Buy a Call Option at the 380 strike and a Put Option at the 300 strike. This will cost me money but reduces my risk and limits it to something less than $400 should price move above $380 or below $300 at expiration. My net credit on this trade is 1.16 ($116). All these Options have an expiry date of 20 Nov 2020. Note that price cannot be in two places at one time, so at least one side of this trade must make money – ideally if price were to close between 305 and 375 at the Nov expiry date (if all Options were to be held to expiration) all Options would expire worthless and both sides would make money enabling me to keep the $116 credit. Note that 100% of the Options might expire worthless (criticism 2 above) but I would show a profit ($116 with $384 risk – ~30% return in ~3 months). Probability is ~65% (based on implied volatility and expected move as described above). Do you like those odds? Note that my risk/reward is absolutely defined and my probability of profit is clearly estimated.
After getting filled on the first trade (above) I move to the Options expiring one month earlier on 16 October:
and I place a similar trade with Option strikes at $310, $315 (Puts), $365 and $370 (Calls). I was filled on this trade at a net credit of 0.96 ($96) – again with a maximum risk of ~$400. So far we have $220 in credits with ~$800 maximum risk. The total Delta on the 2 trades is -3.63 (by adding the Deltas shown in the above figure) – or slightly bearish (one of the objectives) but no significant downside bias. At this point I have sacrificed directional risk at the expense of premium gain (time decay).
So, to add a little more bearish bias I will add a Put “calendar” spread:
And I will do this by selling a 320 strike Put Option expiring on 16 Sep and buying a Put at the same $320 strike price but expiring one month later on 16 October. Note, again, that the purchase of the Oct Put mitigates the unlimited risk on the Sep Put that is sold. As you can see from the above figure, this adds an additional negative 7.62 deltas to my “position”. However, this portion of the “position” is placed for a debit of 2.70 ($270) – thus using the credit generated from the first two portions of the “position”. However, at expiration of the Sep Options I will be left with a long Put Option that will add significant negative delta to the “position”.
I realize that all this might be a little mind blowing for readers not familiar with Options, with Option “legs” spread out all over the place at different prices and with different expirations. But this is done deliberately in an attempt to cover price movement in any direction and at any time. However, the profit/loss of the total “position”, over the next 27 days looks like this:
Thus, I have some degree of a downside hedge – at least to $320 in the next 27 days – and this ” just happens” to be the “expected move” as determined from the implied volatility of the Options.
This is the beginning of an even more complex “position” and I will be adding to, or adjusting, the position as we move forward in time and we get price movement. I will re-evaluate the “position” with every ~$10 in price movement – so the next review will be when SPY hits ~$330 or ~$350. However, the philosophy is to “diversify” in terms of price and time.
The reason that I have chosen to go into so much detail on this is because I expect a lot to happen over the next 3 months as we lead up to and through the upcoming elections – and I would like to be prepared to handle anything that the markets throw at us. It is an attempt to be proactive rather than reactive. My expectation is that we will see increased volatility (due to uncertainty) going into the elections – and this will hurt a portion of the “position” – with a sharp drop in volatility when the election is over (and uncertainty is reduced). On top of this we still have the economic and emotional impact of coronavirus to deal with, potential flare-up of trade wars, Fed actions ….. etc to layer on top of the election uncertainty.
I currently don’t have a significant downside hedge in this trade – and I want to increase this protection – but I would like to be able to finance this protection through the sale of Option premiums. I’m not suggesting that anyone should try to copy this position – just follow along for fun and the educational benefits that it might provide. At the very least, going forward, I will try to keep readers updated on what the Options markets are telling us about risk through the implied volatility factored into Option prices.
In case anyone would like to keep a copy of this post (or see the figures more clearly) a pdf file is available here: https://www.dropbox.com/s/2duu2fcc0n148ps/OPTIONS%20CORNER.pdf?dl=0