Given the plethora of strike prices across the variety of expiration months, option traders face a bevy of choices when structuring a position.  The options market is a world of tradeoffs lacking a single solution for all participants.  Risk and reward exist on a correlated scale where a rise in one invariably results in lifting the other.  With this backdrop in mind let’s tackle a recent reader question regarding bull put spreads.

I’ve noticed that there are times when a weekly spread can be the same price as a monthly spread or a front month spread can be the same as second month spread. I feel sure that there is a trade there somewhere but I’m not sure..any thoughts? – Baruch

Rather than being a rare phenomenon the situation in question arises on a daily basis in virtually all optionable securities.  If, of course, the bull put spread is structured with strike prices close to the current stock price (at-the-money in other words).  Here’s an example on AAPL currently trading at $675.

Sep 675-670 put spread @ $2.42

Oct 675-670 put spread @ $2.42

Nov 675-670 put spread @ $2.50

Dec 675-670 put spread @ $2.50

As you can see the price of each put vertical spread is clustered around $2.45 regardless of the amount of time to expiration.  The essence of the question raised by Baruch is not just why the pricing is so consistent, but also what opportunities, if any, arise from such a situation.

The underlying reason behind the linked pricing of the aforementioned at-the-money vertical spreads has to do with probability.  In order to capture the maximum profit on the 670-675 bull put spreads outlined previously, AAPL has to sit above $675 by expiration.  With AAPL currently residing above $675 it’s fair to say there is a 50-50 chance it could sit above or below $675 at any point in the future.  Because the Sep spread has just as good of a probability of producing a profit as the Dec spread they are priced with a similar risk-reward proposition.

Now, if we were comparing the price of out-of-the-money bull put spreads, the pricing from one month to the next would differ substantially.  The addition of each month of time would increase the amount of reward available in the spread like so:

Sep 645-640 @ $.92

Oct 645-640 @ $1.52

Nov 645-640 @ $1.87

Dec 645-640 @ $1.97

With the spreads positioned out-of-the-money, time is now a decisive factor influencing the probability of profit.  With AAPL currently trading at $675 there is a much higher probability of it remaining above $645 for the next two weeks than for the next three months.  Since the Sep put spread boasts a higher probability of profit it delivers a smaller reward.

The key takeaway here is that risk, reward, and probability are all inextricably linked in the options arena.  A change in one of the variables will undoubtedly change the others.

Stay tuned…  Next time I’ll take a look at the tradeoff being selling the front month at-the-money bull put spread over a back month.

On a day when normalcy rules the roost, the broad market indexes exhibit a strong positive correlation.  Like slaves tethered together by chains the S&P 500 Index, Dow Jones Industrial Average, Nasdaq Composite, and Russell 2000 Index tend to move tit for tat.  While one Index may deviate mildly from the rest in the short-run, it eventually drags the rest along with it on its new path or is pulled back in line by the combined weight of the others.

Without a doubt the interesting development from Tuesday’s trading session was the stark outperformance of the Russell 2000 Index.  While its brethren closed lower on the day, the small-cap laden index surged 1.24% on high volume to boot.  Indeed, small caps marched to the beat of their own drum – a bullish one that was struck incessantly for the last four hours of the trading session.   The rally propelled the ISHARES Russell 2000 Index Fund (IWM) just north of multi-month resistance at the $82 level.

Conventionally relative strength in small caps is viewed as a positive for the market, a sign that risk appetite is on the rise as investors are piling into more volatile stocks that could produce quicker profits.  Some may conclude yesterday’s Russell rally was a sign of things to come, a peek at what the bulls have in store.  On the other hand, the utter lack of participation in the bullish festivities by the other indexes is a tad concerning.  Could it turn out to be a mere one-day aberration void of significance?  Sure.  Of course, it may also indicate something more ominous is afoot. Perhaps the Russell is about to be yanked back in-line to follow the more neutral path currently being trod by its bigger brethren.

Along with other chartists I’ll be watching for the inevitable resolution to yesterday’s divergence.

[Source:  MachTrader]

The relentless bullish vortex known as Apple Inc. achieved an impressive benchmark on Monday by finally climbing atop the totem pole of valuation.  With yesterday’s rally its market cap lifted over $661 billion thereby overcoming the previous record holder Microsoft, which traded at a $618.9 billion valuation in 1999.

But, before all you Apple zealots don your party hats and pull out the pom-poms, keep in mind this is a record that deserves a large asterisk since the comparison doesn’t consider inflation.  As reported by Tech Crunch, with inflation adjusted numbers Microsoft is actually the king of the hill with its value rising to $856 billion in 1999.

Valuation aside, Apple’s implied volatility was also on the move in yesterday’s historic session.  The Apple VIX (VXAPL) was up over 30% at its intraday high revealing a strong surge in demand for option contracts.  The action in the derivatives market reveals two lessons of note.

1.  Implied volatility doesn’t always have a negative correlation to a stock’s price.

Typically a fall in a stock’s price will be accompanied by a rise in implied volatility as worried traders willingly bid-up option prices.  The widespread belief that volatility and stock price are inversely correlated is perpetuated by everyone’s fixation with the CBOE Volatility Index (VIX).  Anyone who has watched the VIX for longer than a nanosecond will attest that it tends to zig when the market zags.

Yet, yesterday’s liftoff in the Apple VIX came on the heels of a rise in the stock price.  Such a curious phenomenon isn’t so curious when you realize implied volatility is merely driven by supply and demand.  If traders perceive Apple is about to get “jiggy wit it” to the upside they’ll happily bid-up options to exploit the expected increase in realized volatility.

2.  Buying implied volatility when the AAPL VIX falls into the low 20s continues to be a profitable idea.

Option traders know the whole “buy low, sell high” mantra not only applies to a stock price, but also implied volatility.  Given its mean reverting tendencies implied volatility is easiest to predict at extremes.  Since its launch in 2010, VXAPL has oscillated between the low 20s and high 40s.  The fact that we’ve rallied so strongly off of the lower end of the range proves once again that buying volatility in some fashion when VXAPL falls to the low 20s can be a lucrative proposition.

[Source:  MachTrader]

The so-called “risk on” trade has ruled the roost in recent days.  A return of risk appetite to Wall Street has resulted in a mass exodus from safe havens like US treasury bonds and the US dollar as well as defensive sectors like utilities and consumer staples.  To the delight of the bulls this flood of money has found a new home in offensive sectors – who tend to outperform during healthier markets -  like technology, basic materials, and financials.  Not to be outdone, small cap stocks have also changed their stripes from a laggard to a leader over the past week.  All told, this shift in performance serves as a compelling piece of evidence supporting a more bullish backdrop to the US equities market.

This change in character is captured nicely in the following graphic comparing risk-on related areas like oil, financials, and consumer discretionary to risk-off related areas like bonds, the U.S. dollar, and utilities.  The chart covers the past week’s performance relative to the S&P 500 Index.

While one week does not a trend make, this change in character undermines the argument that the US equities market is unhealthy because safe havens are leading.  Provided this favorable turn of events persists bullish setups should not only multiply but also have a higher chance of success.  With dips being bought and rallies running long in the tooth, bull retracements and breakouts should perform well.

How long this resurgence in risk appetite lasts remains to be seen.  But, hey, while it’s here why not unleash your inner bull and start taking advantage of the quality bullish plays which have been and will continue to come across your path.

The day-by-day demise of Facebook (FB) continues to be a thorn in the side for shareholders of the social media behemoth.  Indeed, with FB falling to new lows today we can officially say that everyone who ever purchased the toxic stock is underwater.

Yet, hidden within the epic failure are a few vital trading lessons which should be imprinted in the minds of both those who have the misfortune of holding shares of FB in their portfolio as well as curious spectators viewing the debacle from afar.  Let’s review my top two:

1.  Financial ruin beckons traders lacking an exit strategy.

Those who venture into the stock market without an exit strategy in tow have climbed aboard a train speeding toward a single destination – the financial graveyard.  This final resting place boasts an innumerable host of has-been traders with a stubborn disposition and a friend called “hope” who accompanied them all the way to their death beds.  Facebook loyalists unwilling to part ways with their shares are realizing the once promising social titan is engaged in a cut throat game of limbo.  To the spectators chanting, “How low can you go?” FB continues to surprise with its ability to reach new depths.

Traders in possession of an exit strategy who bailed early when FB ran amiss have lived to fight another day.  Those still participating in the death spiral are witnessing firsthand the mercilessness of buy and hope.

2.  The IPO playground disallows the use of technical analysis.

One of the weapons of choice for short-term traders is technical analysis.  By analyzing past price action technicians contend they can better forecast the future.  Technical analysis can also be a very effective risk management tool.  Traders are able to use key support or resistance levels to assess the potential risk and reward involved in a trading opportunity.  The trouble with IPOs, of course, is their utter lack of prior price action.  Without an existing trend or price levels to trade off of, determining risk-reward degenerates to a guessing game and the purchase of an IPO becomes a mere roll of the dice.

This explains why many veteran traders opt to wait for the IPO frenzy to die down and allow the stock to establish a trend along with important support and resistance levels to serve as reference points for future trading opportunities.

If Facebook has extracted more than its fair share of greenbacks from your war chest, chalk it up as a learning experience.  Take the two aforementioned lessons to heart and modify your trading accordingly.

The IPath S&P 500 VIX Short-term Futures ETN (VXX) burst onto the volatility scene at a cool $100 (split-adjusted) on January 30^th, 2009. With the equities market grappling with a hangover from the 2008 malaise the VXX was able to withstand the beckoning of lower prices for a little over two months.  Then the epic slide commenced.

Fast forward 1 year, 9 months, and 10 days and with poor old VXX staring single digits in the face, Barclays implemented a 1 for 4 reverse split on November 9, 2010 to lift the beleaguered ETN back above $45.  Interestingly, the announcement of the reverse split was issued a few weeks prior when VXX was trading around $12.68.

And hey, VXX has survived another 1 year, 8 months, and 8 days without another reverse split being needed. Given that this go around VXX started dropping from $45 instead of $100, it’s fair to say its post-split performance has been notably better than its pre-split performance.  But with VXX dropping intraday to $12.86 it is eerily close to the threshold it reached just before its reverse split of 2009.  Though Barclay’s white horse of reverse split salvation has yet to appear on the volatility horizon, that doesn’t mean it’s not getting prepped in the stables.

Of course, a reverse split would be a welcome development for the everyday option trader.  Particularly for those employing spread strategies.  Anytime a stock approaches the single digits it becomes increasingly difficult to structure worthwhile spread positions due to the following two reasons:

1.  Even with $1 dollar wide strike prices, a move from one strike to the next represents a 10+% move.  This severely limits the amount of option strikes that have enough premium to be considered “in-play” thereby increasing the difficulty of structuring a position that’s worthwhile.

2.  Given the cheapness of options on low priced stocks traders may be forced to initiate positions with a large amount of contracts which increases commission costs.  For example, with VXX at $50 I may be able to initiate one $5 vertical spread for $300.  If VXX is at $11 I may have to initiate upwards of five $2 vertical spreads for the same $300.  That’s a 10 contract trade versus a 2 contract trade.  Depending on your broker that could make a huge difference in transaction costs.

So here’s to hoping Barclay’s sallies forth from their citadel to save VXX yet again from entering the underworld of single digits.

[Source:  MachTrader]

For related posts, readers can check out:
VXX Reverse Split
Reflections on VXX
Learn the Quirks

With the market down six days in a row one might think fear would be permeating Wall Street.  But, curious enough, fear – at least as measured by the CBOE Volatility Index (VIX) – has been notably absent during the recent selling bonanza. While the S&P 500 Index is down 2.8% since last Thursday’s open, the VIX is only up 4% – a pittance compared to its performance during other comparable market corrections.

Worse yet, the IPath S&P 500 VIX Short-Term Futures ETN (VXX), is up a mere 1% no doubt disappointing any short-term traders who snatched up shares last week in hopes of cashing in on the recent market weakness.

So believe what you will about the current six day losing streak, but it certainly is not causing a mad dash into the options mart in search of protection.  Of course the apparent lack of concern can be interpreted a few different ways.  From a bullish perspective we might make the case that the volatility markets are acting as a leading indicator.  The unwillingness of option players to bid-up implied volatility may be signaling the sell-off is either close to termination or will continue to be fairly benign.

On the other hand, cynics might say option traders are asleep at the switch and in for a rude awakening if the selloff persists.  Such a sour turn of events may eventually lead to a rapid lift in the VIX as traders come to terms with a more volatile reality.

Perhaps the strongest argument for the sleepy VIX can be made by putting recent market movements in proper context. Interestingly, actual market volatility as measured by 21 day historical volatility has been falling during the six-day market slide, not rising.  While the correction may be characterized as persistent it may not be characterized as all that volatile.  Over the past week 21 day HV has fallen from 18% to 16%.  Since June 29^th it’s actually dropped from 20% to 16%. I suspect this explains in large part the aforementioned unwillingness of option traders to bid option prices any higher.

VXX’s poor performance has been further exacerbated by the term structure of VIX futures remaining firmly entrenched in contango territory.  If VXX is unable to get off the floor during a market selloff you can imagine how it will behave when the bulls return to lift the market from current levels.

For related posts, readers can check out:
The Fear Fest Resolution
VIX Trading Resource Guide
The VIX and Numbing News

Monitoring Apple’s price action of late has been like watching a possum play dead.  Bulls and bears have congregated about the rodent poking with sharp sticks in an attempt to illicit some type of reaction.  Yet there it sits, reacting not a whit. “Move!” they bellow in a collective chorus.  Perhaps they’ve stumbled upon the rare breed of deaf possums.  It appears what was thought to be an imminent breakout morphed into a looming breakout which morphed yet again into a breakout which may or may not transpire at some point, or at no point, in the future.

Of course, my sarcasm is bleeding through, but the point is valid.  Anticipating a bottom in implied volatility coupled with a surge in realized volatility is often easier said then done, especially if your instrument of choice is a long straddle.  Think of the straddle as a race between time decay and sufficient price movement.  In the event you purchase the straddle you’re betting price movement will come out the victor.  In other words, the long options will accumulate enough intrinsic value to offset the time decay that is plaguing the position day-by-day.

Unfortunately the recent race in Apple has been a one-sided slaughter with time decay winning virtually every single day.  Need a numerical example?

Let’s say on June 14 with AAPL trading at $573 you purchased the July 570-575 strangle for $37.30.  At trade entry your position delta was effectively zero (neutral) while your theta was -52.  Given that your position is hemorrhaging $52 a day the hope is that you acquire greater than $52 per day due to the straddle gaining intrinsic value, implied volatility lifting, or a combination of the two.  Sadly, such has not been the case.  While theta has engaged in its daily acts of thievery, the inability of AAPL to venture more than a stone’s throw away from the $573 level as well as implied volatility’s reticence to lift much from trade entry levels has thus far spelled disaster for straddle buyers.  As of Friday’s close the 570-575 strangle was trading for a paltry $24.40, down $1290 from trade entry.

Might the quarterly pre-earnings ramp in price and volatility swoop in to save the trade?  Perhaps.  One thing is for sure, those who acted early with long straddles/strangles on the opportunity spelled out in my prior post have been punished.  An adjustment worth consideration for long straddle advocates might be to wait for an uptick in realized volatility (via a price breakout) before acquiring their positions. Or perhaps simply monitor the value of the straddle in question and wait for it to begin to pick up in value before pulling the trigger.  In the AAPL case study mentioned above I’m pretty sure the straddle dropped in value virtually every day.

The wittier headline would have been The Case for Apple Strudels Straddles but yours truly couldn’t figure out how to do strike-through text in my heading.

The life of a straddle buyer could properly be characterized as perpetual disappointment punctuated by the occasional flash of brilliance.  Over time the long straddle produces many losers and few winners.  Chalk this fact up to the so-called volatility risk premium which exists when the implied volatility built into an option’s price is higher than the subsequent volatility realized by the underlying asset throughout the life of the option.  In simple terms options are persistently overpriced.  And since the long straddle involves purchasing both a call and a put option it’s a tough trade to consistently make money with.

While many tout the long straddle as a bi-directional trade, let’s not forget it is at its heart a long volatility play.  To say the purchase of a straddle is a bet that a stock will move up or down is a bit misleading.  In reality it is a bet that the stock will move not just up or down, but up or down MORE than expected.  You’re effectively betting the option market has it wrong, that it is underpricing the volatility soon to be realized by the underlying asset.

The successful implementation of long straddles then is a byproduct of impeccable timing.  It requires identifying environments of opportunity where a volatility explosion is imminent and option premiums are on the cheap.  Such a setup is often revealed through the compression of Bollinger Bands, the formation of a symmetrical triangle, or other such signals of a coming volatility surge.  Yet, the identification of such a setup is merely half the battle.  One must also assess a volatility chart to ascertain the relative cheapness of option prices.  In the event implied volatility is low enough, long straddles may indeed prove fruitful.

Technology rock star Apple Inc (AAPL) currently provides a compelling case study for the long straddle.  From a chart perspective is has been basing for over a month in the $570-$580 area.  In volatility terms we’d say the stock is coiling or experiencing a compression in volatility as reflected by the Bollinger Bands which have narrowed in recent days to their tightest levels in over six months.  If you subscribe to the notion that volatility regimes alternate between periods of expansion and compression then you’re likely in the camp that contends a volatility expansion is looming.

[Source:  MachTrader]

At the same time implied volatility (VXAPL) is approaching the lower level of its multi-year range making options appear somewhat cheap relative to where they usually trade.  In addition Apple’s Q2 earnings are set to be released in July so one would expect the typical pre-earnings volatility bid-up heading into the event.

So this is a long way of saying straddle buys make more sense now in AAPL than they have in awhile.  And if you count yourselves among the ranks of those who shudder at the thought of buying a straddle, then by all means do something else.  All I’m saying is buying volatility here looks more appealing than selling it.

For related posts readers can check out:
Options and the Volatility Risk Premium
The Notoriously Difficult Straddle Play
Low Volatility, A Siren Song?

My new daddy duties of the past two weeks have been punctuated by readings of Hank Haney’s illuminating book on his 6-year coaching regime of Tiger Woods.  I discovered more than a few trading parallels of note in The Big Miss.  Here’s perhaps the most revealing one:

There are very few perfect shots hit in golf, even by experts.  It’s above all a game of managing misses.

Tiger’s perpetual fine tuning of his swing and marathon practice sessions were performed with the intent of minimizing the chances of big misses.  The type of duck hooks or mega pushes that yield double bogeys or worse thereby taking him out of contention.  It wasn’t the eradication of misses that was the goal, but rather the controlling of said misses.  The concoction of a formula that effectively banished big misses led Woods to be in the running for “the big W” in tournament after tournament.

No doubt we could say the same of trading.  It is above all a game of managing misses.  Avoiding the big loss at all costs.  The essence of this is captured by the popular trading adage espoused by the everyday trading educator:

Maximize your gains and minimize your losses.

Of particular import in the dual mandate is that of minimizing losses.  While one may get away with failing to maximize gains, the inability to cut losses inevitably brings a swift end to one’s trading career.  The successful avoidance of “the big loss” is a byproduct of a number of trading techniques: possessing a trading plan, implementation of risk measures, usage of stop losses or hedging, and time diversification.

While each successful trader blazed their own trail in the world of the financial markets, the one common thread tying them all together was their ability to master the art of managing misses.