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Thursday, April 21, 2011

Sheridan Options Mentoring Blog

Sheridan Options Mentoring Blog

Link to Sheridan Options Mentoring Blog

Option Pricing: How does it work?

Posted: 20 Apr 2011 11:20 PM PDT

Option Pricing MazeA friend of mine thought Google stock (GOOG) was going down after their earnings announcement. He knew he wanted to buy puts to take advantage of the anticipated downward movement in the stock price. He picked an option strike well below the current price of the stock. Google did move down after the announcement but not far enough. His puts expired worthless the next day. My friend didn't understand how options are priced and how to use that information to pick a more appropriate strike for his put.

Let's discuss the two components of an option's price and the primary factors that influence them.

1. Intrinsic Value or real value
2. Extrinsic Value or time value
3. Factors that change Extrinsic Value

Intrinsic Value or real value

Intrinsic value of an option is the amount of real value the option has if it were exercised. This is the amount the option is in-the-money. For calls, it is the strike price minus the stock price. For puts, it is the stock price minus the strike price. The number is always positive. If an option is out-of-the money, the intrinsic value is always zero.

For example, if you have a stock trading at $100 and your Call strike is $105, the option has a real value of $105 – $100 = $5. If there is any time left before the option expires, the option will be priced higher than this difference in strike prices.

Extrinsic Value or time value

An option with any time left before it expires will have a higher price than its intrinsic value. The difference between the option price and the intrinsic value is called extrinsic value. Other names for extrinsic value are time value, time premium or fluff. This premium is what the option seller hopes to keep for his profit. The option buyer will slowly lose this time premium as the option gets closer to expiration. All options at expiration have zero extrinsic value. An option at expiration is either worth something or it expires worthless. Because traders prefer out-of-the money options, more options expire worthless each expiration cycle than options that expire with real (intrinsic) value.

Factors that change Extrinsic Value

The option pricing model includes variables for time to expiration, volatility, dividends and interest. Because we usually are only in the market a few weeks, we can assume interest and dividends don't play a large role in the option prices we trade. That leaves two primary factors that influence option prices:

1. Time to expiration
2. Volatility

The more time there is to expiration, the more time premium an option has. Options with more time premium are more sensitive to volatility changes. Any time spread should consider the effects of volatility changing. This is especially true for long term options, or LEAPS.

The volatility of an option is calculated from the option pricing model. All of the other factors are known, including price. Volatility is calculated and displayed as implied volatility. The price of the option implies a specific volatility. Option analytic software does this calculation for you for each option. Don't try to calculate it by hand. You will notice that different software arrives at slightly different implied volatility values. These differences are due to different assumptions and using different inputs into different option pricing models. Stick with the same software so you are consistent.

Isn't knowing the factors that effect extrinsic value a waste of time?

Not really. You know that options lose value as they get closer to expiration and that volatility affects the price of options. My friend who bought Google puts should have purchased puts with more time to expiration. Google releases earnings data after the market closes, the day before option expiration. I think they do it on purpose. Because options lose all time premium the following day, my friend would have been much better off purchasing an option with 30 days until expiration.

Volatility has more influence on longer term options. If you want to buy longer term options, make sure you buy them while volatility is low so you don't pay for too much time premium.

Understanding option pricing isn't difficult

Intrinsic value of an option is a simple difference between the strike price and stock price. Extrinsic value has many ingredients that go into it. If you are trading long term options, interest and dividends are more important. Implied volatility and time to expiration are the most important variables. Be aware of the factors that influence time premium when you trade.

Here's your homework

Look at an option chain and calculate the amount of time premium for each at-the-money call and put for each of the next four to six expiration cycles. Compare the difference in time premium and notice how slowly it decays at first and then accelerates as you get close to expiration. For extra credit, look at options several strikes in and out-of-the-money and compare the decay to the at-the-money option.

Delta/Gamma: The Most Important Option Relationship

Posted: 20 Apr 2011 09:53 AM PDT


In the late 80's. My morning train ritual was pretty much the same. The first half of the ride, I read the sports section and had my coffee. The second half of the ride involved a crucial phone call that would be a big determinant of my happiness for the day.

It was the call to my clerk

It went something like this: "Hey Todd, how are the overseas markets doing and how are my stocks looking pre-opening?" Todd might reply something like this, "Europe is down pretty good and IBM is projected down $2.00 at the opening".

My pleasant train ride was suddenly getting a bit stressful

I nervously asked the key question that would make me happy or nauseated, " Todd, what are my deltas and gammas?" Waiting for his response, panic started to set in. "Dan, your deltas are 2000 long and your gamma is short 5000."

Not good!

This meant that if IBM opened $2.00 lower as projected, my deltas would be about 12,000 long. When you are short gamma, if the stock goes down $1.00, you pick up more long deltas equal to the amount of the gamma. In English, the stock is down $2.00 and I'm the equivalent of 12,000 shares of stock long. The first dollar down my deltas go from 2000 to 7000 long, the second dollar down, they go from 7000 to 12,000 long. Bottom line, I'm down good coin at the beginning of the day. When the first buddy I run into at the CBOE says the morning salutation " How you doing?" , how should I respond? I'm Long!!

Why is this relationship so important?

Gamma and delta refer to price risk. Most strategies like calendars, credit spreads, butterflies, and diagonals have 2 main risks. They are implied volatility and price. `Implied Volatility is very important, but I would give the nod to price as my main nemesis in the spreads I do. Managing my deltas was my most important task as a risk manager. When you let your deltas get out of whack, your P and L will usually get whacked. Controlling deltas takes planning , discipline, and plain hard work. I encourage you to spend time understanding deltas and gammas and how gamma can change deltas quickly, especially near expiration.

Wednesday, April 20, 2011

Sheridan Options Mentoring Blog

Sheridan Options Mentoring Blog

Link to Sheridan Options Mentoring Blog

Delta: The Most Important Greek

Posted: 19 Apr 2011 05:53 PM PDT

Dan is presenting a webinar at OptionsXPress on Wed, April 20th at 11:00 AM Central (Chicago) Time.  The webinar is titled:

Delta: The Most Important Greek

To Join the webinar, please visit the OptionsXPress site at

http://oxps.webex.com/oxps/onstage/g.php?t=a&d=926179859

 

Download the presentation slides

 

Delta: The Most Important Greek


Thursday, April 14, 2011

Sheridan Options Mentoring Blog

Sheridan Options Mentoring Blog

Link to Sheridan Options Mentoring Blog

Trade Execution Like the Pros – Part 3

Posted: 13 Apr 2011 01:12 PM PDT

Dan Sheridan is having another follow-up webinar on Saturday, April 16th at 9:00 AM Central (Chicago) Time. This will be the 3rd webinar on trade execution.

Trade Execution Like the Pros – Part 3

Sign up for this free webinar here.

How Do Market Makers Hedge or Adjust Trades?

Posted: 13 Apr 2011 11:22 AM PDT

Trading ScreenThe world of adjustments for a retail trader can be very daunting . The arsenal of upside adjustments can include an array of possibilities: long calls, call debit spreads, put credit spreads, bullish calendars or butterflies, and long diagonals, just to name a few. On top of that, you have the fun task of deciding which adjustment to use and when to use it. To make matters worse, each adjustment affects the Greeks and margin and the ultimate choice has to be tied into your trading plan. Good luck!

This process takes a lot of time and practice
I was a Specialist, which is a Market-Maker with much more responsibility. When Goldman Sachs or other brokers came in our pit, they came to the specialist. He was the one they would hold responsible if they didn't get what they want.

How did it work?
Mr. Goldman might buy 1000 at-the-money calls from me. As the specialist, I could take up to 40% of the order, the market makers would split the rest. My take of the 1000 calls would have been 400 contracts. At-the-money deltas generally would be around 50, so if I sold 400 contracts, I just got short 20,000 deltas! If you’re wrestling with the concept of deltas, just pretend you are short 20,000 shares of stock. Get the idea?

How did we hedge our trade?
Could I buy calls from traders in my pit? No way, everyone sold Goldman calls, we were all in the same boat! The only logical and quick choice was to call our stock clerks and have them buy stock at the appropriate exchange. We could hedge our deltas and most importantly, take a deep breath because we were closer to delta neutral. That is a concept that sounds very comforting but in reality doesn't address the risk of a position. It just means at that second, at the current price, you are hedged.

Conclusion
As a professional trader, I would hedge my trade or adjust my deltas first by buying stock. After that, I might spend a few days or hours massaging my Greeks to get them where I want to be, based on my price and volatility expectations. The difference between myself in the pits and retail traders is choice!

You can trade when you want to. We had to trade, whether we wanted to or not
As a retail trader, buying stock as an adjustment or hedge would be painfully expensive. In a portfolio margin account, it would be much more palatable. In a retail account, instead of buying stock, you could buy deep in-the-money calls with deltas 70 or higher. The more in the money you buy the calls or puts, the less affect you will have on your position gamma, vega and theta. Neutralizing your position with stock or in-the money options is only a good first step. Once the position is stabilized, then you must massage the risk of the position if you aren't comfortable.

Lastly, in a fast moving market, adjusting or hedging with single options instead of spreads can sometimes be easier to get executed at a reasonable price.

Saturday, April 9, 2011

Sheridan Options Mentoring Blog

Sheridan Options Mentoring Blog

Link to Sheridan Options Mentoring Blog

What Options Broker do You Use?

Posted: 08 Apr 2011 10:10 PM PDT

We have a one question survey to see what the most popular options broker is.

Please take this short survey:

What Option Broker Do you Use? Survey

We’ll post the the results here and in our public forums here:

http://forums.sheridanmentoring.com/f9/what-option-broker-do-you-use-27/

Forest, Hauptstuhl, Germany

Tuesday, April 5, 2011

Sheridan Options Mentoring Blog

Sheridan Options Mentoring Blog

Link to Sheridan Options Mentoring Blog

Trade Execution Like the Pros – Part 2

Posted: 05 Apr 2011 05:40 AM PDT

Dan Sheridan is having a follow-up webinar on Saturday, April 9th at 9:00 AM Central (Chicago) Time.

Trade Execution Like the Pros – Part 2

The event is open to everyone and will be at http://sheridanmentoring.webex.com/

To sign up for this event, please visit:

http://www.sheridanmentoring.com/index/method/c.eventSignup.html

Our WebEx meeting room can only hold 200 people.  The room will be open at least 30 minutes prior to the event so you can grab a seat before they are gone.

We’ll post a video of the webinar here in case you miss it.

 

Monday, April 4, 2011

Sheridan Options Mentoring Blog

Sheridan Options Mentoring Blog

Link to Sheridan Options Mentoring Blog

How Retail Traders can get Execution Like the Pros

Posted: 03 Apr 2011 09:16 AM PDT

Dan Sheridan presented a webinar yesterday:

How Retail Traders can get Execution Like the Pros

Here’s one of the slides in Dan’s presentation:

How Market Makers would trade as retail traders
- Step #1 Find a few good vehicles to trade (very liquid)
- Step #2 Based on implied volatility levels and recent price movement, pick an income spread
- Step #3 Determine fair value of spread (implied volatility – take skews out of formula)
- Step #4 Test the market in small size to see where the fish will bite, start better than mid prices

 

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