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Investing with Credit Spreads for Higher Winning Percentages

As with all investments, the name of the game is “risk versus return.”  How much bang for the buck can you achieve for a given level of risk?  For many option-buying strategies, higher risk takes the form of lower winning percentages.  In fact, winning on fewer than half of your trades is quite normal.  The payoff, of
course, comes from the much higher profits you can achieve with these strategies, often in excess of 100%.

With credit spreads, the risk/reward paradigm is reversed.  You can reach winning percentages of 80% or higher using out-of-the-money options.  However,
the return per winning trade will be much lower, most often within the range of 10% to 25%.

A credit spread involves the simultaneous purchase and sale of puts (or calls) that expire at the same time, but have different strike prices.  Puts are used if you are bullish on the underlying stock or index, while calls are used for a bearish outlook.  For out-of-the-money credit spreads, the strike price of the sold (or written) option is closer to the underlying stock’s market price than the purchased option, and therefore carries a higher premium – resulting in a net credit.  The goal of a credit spread is for both options to expire worthless, allowing you to retain this entire net credit.

You may wonder why you would use puts for a bullish position and calls for a bearish position.  This is because you want the spread to finish out of the money, so you can achieve your maximum potential profit on the play.  Logically, then, puts will expire worthless on a bullish move, while calls will expire worthless on a bearish move.

Credit spreads offer two primary advantages over straight put or call purchases.  First, by using out-of-the-money options, you can profit from a wide range of outcomes, including the underlying stock moving somewhat against your expectations.  If you initiate a bearish credit spread with the sold call option 2% out of the money, you will keep the entire premium if the underlying security moves down, stays flat, or goes up 2%.  Only when the sold option slips into the money is your position at risk of losing value.  In addition, losses are generally capped at the difference between the strike prices of the options, minus the net credit collected upon initiation.

The second advantage is that no commission costs are incurred to exit your most successful trades, since the best-case scenario involves both options expiring worthless.  This feature increases your net return on a winning credit spread trade.  Moreover, unlike option purchases, credit spreads actually benefit from time decay, since neither option has any intrinsic value (as long as they stay out of the money), and the sold option will lose time value at a faster pace than the purchased option.

This is just one reason why we prefer to use front-month options for credit spreads.  In addition to providing the greatest exposure to time decay, these shorter-term options allow less time for the underlying equity to move substantially against you.  Such a move has a far more negative impact on a credit-spread position than the benefits of the underlying stock making a move in your favor.

Option Basics – What Vega Means to the Covered Write

Vega measures the sensitivity of the price of an option to changes in volatility. Vega is the estimate of the change in theoretical value of an option for the 1% increase in implied volatility. A higher volatility means higher option prices while a lower volatility means lower option prices. Vega is the measure of changing volatility on option prices. A higher volatility means an expected higher price swings in the stock.

An increase in volatility will increase the price of options on the stock while a decrease in volatility will cause all options on the stock to decrease. The vega of a long call or put option is always positive while the short calls and puts are negative. At-the-money (ATM) options have the highest vega so they are most sensitive to volatility changes. The further an option goes ITM or OTM, the smaller its vega will be. As volatility decreases for ITM and OTM options, vega is unchanged for ATM options. Vega decreases when time elapses similar to call premium decay. This causes vega to be higher for long dated options than short dated options. Of course, LEAPs have a high vega so an increase in volatility will raise the time value of the option.

For example, a stock that is trading at $35 with a high volatility of .75 with a vega of 30%. The stock option will lose $.30 for every 1% decrease in volatility and gain $.30 for every 1% increase in volatility. If volatility decreases by 20 points, then the stock option will decrease by $6.00. This suggests that you do not want to buy any call or put with a high volatility. Vega can cause option prices to change even if the stock price does not change.

Typically, I do not use vega in covered call trades as I tend to only sell options on stocks below 40% volatility and usually in the current option month. However, vega is important if you use LEAPs as a replacement for stock in a covered call trade.

Options Basics – How to Use Volatility in Covered Call Trades

There are two types of volatility used in security analysis: historical volatility measures the past price movements and implied volatility that indicates the potential level of future volatility a security is implying.

Historical volatility (HV) is the price changes of a security over a period of time so it is really a standard deviation calculation.  This means it is how much a stock price has moved over time usually expressed as a 10-day or 30-day volatility.  For example, a stock with a volatility of 70% is high and should be considered quite volatile.  This is not the type of stock to write a covered call on.  In contrast, a stock with a volatility of 20% is a low volatility stock and selectable for a covered call.

The stock’s volatility can help us forecast short-term price ranges and the relative value for an option price.  The option premiums of highly volatile stocks will have a high value while a low volatility stock will have a much lower premium.  An options premium will be influenced by the probability the stock price will move above or below the various strike prices.  Of course, the excitement of high premiums leads to some investors falling into the premium trap by chasing highly volatile stocks that impose a significant risk to loss of capital.

Another thing to keep in mind is the stock volatility as a confirmation of the stock chart.  Suppose you are looking at a stock chart that seems to be in a trading price range that is stable.  The 30-day historical volatility is 72%.  Is this a good stock candidate for a covered write?  The correct answer is no if you are seeking a conservative covered call investment.  Compare the 72% volatility to a stock with a 30 day HV of 25% which is lower than the S&P 500 at the same time.  I would select the stock with a 25% 30 day volatility for a more conservative covered call investment.

The bottom line is that adding volatiliy to your covered call selection process will increase your chances of morw winning trades and a more consistant income stream.  There will be several more posts about volatility in covered call investing in the coming days.

Option Basics: Risk and Diversification

The winners in option trading are those who manage the risk within their portfolio.  You must always monitor and protect your capital as if you lose your capital you will be out of the game.  Proper risk management starts with trading diversification and discipline to stick with your trading plan.  

There are generally two types of portfolio risk: systematic and unsystematic.

Systematic Risk, also called non-diversifiable risk, is risk that cannot be eliminated.  It arises from factors which cause the whole market to move up or down, and can not be eliminated by diversification because it affects all securities. Examples of systematic risk are political or sociological changes that affect all securities.  Some of the most common forms of systematic risk are changes in interest rates or inflation.

Unsystematic Risk, also called diversifiable risk can be reduced or eliminated by diversifying your portfolio.  Unsystematic risk is risk that is unique to a certain industry, firm, or company.  Examples of unsystematic risk include: a company’s financial structure, weather and natural disasters, labor strife and a shortage of raw materials.  Since unsystematic risk affects a single company or industry, it can be mitigated by investing in many companies across a broad range of industries.

Option positions should be diversified.  A major advantage of option purchases is ‘truncated risk’, whereby your loss is limited to your initial investment yet your profit is virtually unlimited.  Option sells have a limited profit but should be diversified across several investments.  Diversification will allow you to use truncated risk to its maximum advantage.  While some of your positions will inevitably be  unprofitable, each profitable trade can offset several unprofitable trades. Option positions should be established among many underlying stocks and indexes in unrelated industries. This gives you diversification, which can help mitigate sector weakness.

In order to trade options, your broker must first approve your account for option trading. There are various levels of option trading and each level has financial requirements that differ from broker to broker:

Level 1: Covered call writing
Level 2: Call and put purchases and covered put writing
Level 3: Spreads (requires margin)
Level 4: Uncovered call and put writing (requires margin)
Level 5: Index option writing (requires margin)

Be sure to ask your broker about their requirements for the level of options you plan to trade. Lastly, before you trade options, regulations require that you read Characteristics and Risks of Standardized Options prepared by the Options Clearing Corporation (OCC) and available from your broker.

Characteristics and Risks of Standardized Options prepared by the Options Clearing Corporation (OCC) and available from your broker.

Options Basics – Making Money With Delta

The most popular Greek is Delta which measures how much an option’s price moves as a result of a $1.00 price change in the underlying stock.  Call option values rise with the underlying stock while put prices move inversely with the underlying stock price.  Therefore, the deltas of calls and puts must be expressed differently.  If the option price moves exactly the same (dollar-for-dollar) as the stock price, then the call will have a delta of 1.0 while the put will have a delta of -1.0.  If the option only moves 0.4 for a dollar move in the stock price, the delta is 0.4 for a call and -0.4 for the put.

Delta is typically expressed as a fraction or percentage.  A 0.4 delta can be expressed as 45% meaning that the option will change value of 45% for every dollar move in stock price. Delta is useful for options at different strike prices.  For example:

Under Armour stock is trading at $67.14 – (a $3 increase in stock price equals);
the current month $67.50 call has a delta of .478 – ($1.43 change in option);
the $65 call has a delta of .666 – ($2.00 increase);
the $70 call has a delta of .289 – ($0.87 increase);
the $67.50 put has a delta of -.521 – (-$1.56 decrease);
he $65 put has a delta of -.329 – (-$0.99 decrease);
the $70 put has a delta of -.726 – (-$2.18 decrease).

As you can see, delta calculations are not difficult but it gives you information for making investing decisions.  Compare the option price change between a call and put at the same strike price.  At the $67.50 ATM call strike price, a $3 increase in Under Armour caused the call to increase $1.43 while the put decreased -$1.56 because of the different deltas.

Also (not shown in example), as a call moves more into the money, some time value is converted to intrinsic value. This time value conversion is not the result of delta.  This will work for both calls and puts as the underlying stock price changes.  

In general, the more in-the-money the option, the higher its delta.  Only deep ITM options will have a delta of 1.0 although many ITM options will have a delta close to 1.0 near expiration.  Options OTM will have a delta of less than .30 as seen by the $70 Under Armour call above.

Delta matters as it can lose value fast.  For example, if you sold the $70 Under Armour call when the stock was at $67 then the call delta was 0.289.  Then the stock drops which makes the $70 call further out of the money.  Delta is also dropping with stock price decrease.  By the time the stock drops below $65 the delta could be at or below 0.20.  If you decide to buy the call to close, it would be more expensive to purchase because as delta falls the call loses value at a progressively slower and slower rate.

Clearly, the options delta changes to the underlying stock price dependent on whether the option is:

  • OTM (option not winning so delta is low)
  • ATM (option very close to winning so has a high delta)
  • ITM (option is winning so it has a very high delta)

This dynamic is truest for the current and next month options.  When options get further out in time, the delta dynamics begin to change.  The greater the time to expiration means more opportunity for losing options to win and for winning options to lose.  In general, the ITM option will have a higher delta for a LEAP compared to current delta while the OTM LEAP option will have a lower delta than the current delta.


Strategies for Selling Options

It is widely known in the stock market to buy low and sell high.  Options are really no different than stocks as you should buy cheap options and sell expensive options.  The entire strategy of selling covered calls is selling overpriced options to generate more income.  
 
Call values move in the same direction as the stock price while puts move inversely to the stock price.  The amount of change in the option will be determined by the option’s delta.  If you think a stock price will rise then you would buy a call and if you think the stock price will decline you would buy a put.  

Traders sell options primarily to generate income.  The strategy used will be determined by what you decide the stock price will do in the future:

  1. Bullish/neutral – sell covered calls to create income
  2. Bearish – sell naked puts to generate income as the stock declines
  3. Bullish/neutral – sell OTM puts to create premium income while reducing assignment risk
  4. Bullish – sell ATM puts to acquire the stock at a discount price while keeping the premium income

It is important for the call writer to understand time value.  For the option writer, time value is the major source of income but the option holder sees time value as a negative because option value decreases as time decays.  In general, time is the option writers friend and the option buyers enemy.

In covered call trades, returns are generated by the time value of the option premium.  Assume that we bought the stock for $55 and we sell the $50 call for $7.00.  This is a nice premium but you are obligated to sell the stock at $50.  The time value of this option is $2.00 ($7.00 – $5.00).  If the stock is assigned at $50, then your total profit will be $2.00 or the time value of the option.


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Factors Affecting Option Prices

While there are many factors that determine option prices, stock option premiums move in unison with the underlying stock price.  The most popular method for determining option value is the Black-Scholes Model.  There are six factors in this model:

  1. Stock price is the most important factor in an options price as changes in stock price affect the price of options on the stock;
  2. Strike price has an affect on option price through intrinsic value, time value, delta and other factors;
  3. Time to expiration is the time remaining before an option expires.  Due to time decay, option values can decrease at a faster rate when the option is closer to expiration;
  4. Stock volatility is the standard deviation of a stocks price variations over a fixed period of time.  The more volatile the stock, the more likely its price will move and the option price will increase with high volatility;
  5. Interest rates have little affect on option prices but they are part of the Black-Scholes model;
  6. Stock dividends also have little affect on option prices since they are already included in the stocks price by market forces.

There are other forces that can affect the price of options that are not included in the Black-Sholes model such as:

Option Basics – Option Premium

The premium is the price paid or received for an option.  Options are traded much like stocks with the bid and ask prices as shown:

  • Seller receives the bid price;
  • Buyer receives the ask price;
  • The marker marker keeps the spread between bid and ask prices.

The premium refers to the total amount received for selling the option contract not the option price.  The premium means the option’s contract price on a per share basis.  For example, if the option contract price is shown as $1.25, this means you receive $1.25 per share or $125.00 per contract ($1.25 * 100 shares).  

The premium can be intrinsic and time value.  Intrinsic value is the portion of premium that is in-the-money.   Time value is the portion of premium that is not in-the-money which is also known as “extrinsic value.”  Time value is the amount upon which the return is calculated in covered call writing.  The equation is:

Total Premium = Intrinsic Value + Time Value

Calculating time value and intrinsic value is simple.  You calculate the intrinsic value portion of the option premium, then the remainder is time value.  The entire premium of an ATM or OTM call option will to 100% time value.  The real value of option premium for sellers is the time value portion of premium.  The profit in covered call returns lies solely in time value.  

Parity simply means that the option is trading at intrinsic value which occurs to ITM options.  Options seldom trade at a few pennies below parity.  ITM options then to trade at parity when they are close to expiration or there is no expected volatility in the underlying stock.

Time decay means that the time value portion of the option premium will decay or shrink as time runs out.  The intrinsic value never decays due to the passing of time.  Time decay increases as the option nears expiration as time decay accelerates in the last 30 days of the options life.  people who write covered calls in the current expiration month are seeking income from time decay.  Remember, time value is on the side of the option seller not the buyer as time destroys the option premium of the buyers investment.

Theta is the expected change in an option premium for a single day’s passage of time.  If all other factors are the same, then option premium will be lower the next trading day by the theta value of the option.  Theta expresses time decay as an options time value.

Option Basics – Option Strike Prices

Stock option strike prices are the price stated on each call or put option.  The strike prices can be classified according to their relationship with the current stock price.  There are three categories:

  • In the money (ITM) defined as calls with strike prices below stock prices and puts with strike prices above stock prices;
  • At the money (ATM) defined as the call and put strike price at or near the stock price;
  • Out of the money (OTM) defined as calls with strike prices above the stock price and puts with strike prices below the stock price.

As you know, an option will move from category to category based on its relationship with the actual stock price movement.  For example, when a stock is trading at $50 the the $50 strike prices will be at the money.  When the stock price moves above $50, calls will be ITM while puts will be OTM.  Likewise, when the stock price falls below $50, then calls will be OTM and puts will be ITM.  Therefore, the category is totally dependent on the current stock price.

OTM options expired worthless while ITM will always be exercised by the holder because they still have a value at or near the expiration date.  When a stock option is exercised, the call holder buys the stock and the put holder sells the stock.  When options are exercised, the OCC decides to which brokerage firm the option will be assigned and the brokerage decides which customer will get the assignment. When you are assigned an exercise, those shares are said to have been called away or called out.

When stock options are American style, you can be assigned an exercise anytime the option is ITM.  Of course, early exercise is affected by the time value remaining on the option.  As time value begins to decline more rapidly as expiration nears, the holder is more likely to assign an ITM option.  In general, 10% of options are exercised, 60% are traded out and 30% expire worthless.  
  

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