Tuesday, April 12, 2011

Options Strength is Their Flexibility

tdp2664
InvestorPlace
The knowledgeable options trading investor can structure trades using one or more of the three fundamental aspects of options – time to expiration, implied volatility, and price of the underlying. If these variables are considered in the initial construction of a trade, the options trader can increase his probability of success. Even more remarkable is the ability to modify the physiology of an existing trade as a result of changing market dynamics. Let's examine a trade in which I have had to use several of these factors in order (perhaps) to avoid a loss. In discussing this trade — which is still open – we can begin to understand some of the fundamental concepts which guide an option trader's decisions. On March 29, I saw a pattern in US Steel (NYSE: X ) which I considered to be modestly bullish. X is very liquid and this is accompanied by actively traded options. In considering how to structure this position, I chose to focus on what has been the defining characteristic of the market during early 2011 — the low volatility environment. Most traders are familiar with the CBOE Volatility Index (CBOE: VIX ) being reflective of general market implied volatility (IV), but when considering trade structure it is important to realize there is an implied volatility history for each underlying for which options are traded. Here's a graphic display: US Steel (NYSE: X) It is clear that X is currently in its lower range of implied volatility. I want to put as much wind at my back as possible so I looked at a group of trades that benefit from stable or rising volatility. The core knowledge is that IV is mean reverting and in this case reversion to the mean would result in a rising implied volatility. One of the best trade structures in a low volatility environment is the calendar trade. In the vernacular of an options trader, it is a "positive vega trade". In plain talk, this means the trade benefits from increasing volatility. A calendar trade is constructed by selling a shorter dated option and buying a longer dated option. These options are of the same type; either puts or calls, and is established at the same strike price. The profit curve typically shows a variably broad zone of profitability that reaches its maximum at expiration when the underlying is at the chosen strike price. Because maximum profit occurs at the strike price selected, a directional bias can be established by choosing the appropriate strike. Risk factors in this trade are two: 1. Price movement beyond the bounds of profitability. 2. Collapse of implied volatility in the long options leg of the structure. In this case, I chose to establish the calendar at the X 57.50 strike when the stock was trading at around 56.50. I put the wind at my back a bit by selling the weekly call at a price of 70 cents and a volatility of 38.5% and buying the monthly call at 1.63 and a volatility of 36.6%. This volatility skew served to reduce my exposure to volatility collapse in the long leg and broaden the range of profitability a bit. The initial P&L graph for the trade is presented below: US Steel Trade P&L Unfortunately, within 48 hours, the price of X had fallen significantly as a result of a negative analyst recommendation. The short option I had sold was now trading at 3 cents. I bought these back for a net credit of 67 cents and remained long the original calls I purchased. When options you are short trade at less than 10% of the original price at which they were sold, only bad things can happen if you keep them open. Such options MUST be closed regardless of other adjustments you may choose to make. I closed the options, and sold the next week's option at the same strike short for a net credit of 24 cents. On April 5, the price had continued to go down; my adjustment was to buy back these calls for 13 cents, booking an additional credit of 11 cents. I then chose to convert the trade to a butterfly structure in order to improve the odds of success. My current trade structure is displayed in the graph below. I do not know if this trade will be economically successful, but it represents an exercise in using the dynamic potential of options to accommodate the current "real world" situation. US Steel Butterfly Spread This trade may or may not work out economically, but it represents a characteristic example of the ability of dynamic use of options to mitigate losses from what turns out to be an initially incorrect hypothesis regarding future price movement. Stay tuned for the outcome; I will be monitoring it closely. Find more analysis & opinions of J.W Jones at Free Trade Setups: http://www.optionstradingsignals.com/profitable-options-solutions.php



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