One of the true benefits of understanding the complexities of the options market is the ability to construct strategies that help meet any number of trading and investment objectives. Often times novice option enthusiasts are intimidated by multi-leg combinations because of the number of “moving parts”. For those of you that are not sure what I mean by “multi-leg” this term simply refers to a strategy that is constructed of the purchase and or sale of different option contracts.
In order to understand any multi-leg strategy, we first need to have a solid grasp of the rights and obligations associated with being an option buyer versus an option writer. There are a number of videos at M-X.TV that can help you with this; however a review of the Introduction to Options trading video should cover all the details necessary.
For the purpose of this blog post, I want to look at constructing a 4-legged strategy known as a Directional Condor. It is important to realize that any complex strategy is simply a combination of multiple “simpler” strategies. By dissecting the components, the novice option trader can begin understand why a certain advanced combination may be appropriate. In addition, by understanding the rights and obligations associated with the various components any limitations to the strategy can be identified and the trader can manage performance expectations accordingly.
A Directional Condor may be applied when the trader has an expectation that a stock is going to move in a particular direction, but is not likely to exceed a certain price range within a specified period of time. The Directional Condor is simply a combination of a Debit Spread and a Credit Spread. Check out these videos for a more detailed description of the strategies and examples of how they may be applied independent of one another. Bullish Spread Strategies and Bearish Spread Strategies and further to these, Defining Option Spreads
The Debit Spread is used to trade the directional bias. The trader incurs a cost but may want to further offset this cost. By selling a Credit Spread further out of the money, but with the same expiration date, a credit is received and the net cost of the position is reduced. This lowers the break-even point of the trade and increases the percentage rate of return should the investor be correct in their forecast. The “trade-off” is that in order to achieve maximum profitability, the stock needs to be trading between the written strikes of the Debit Spread and the Credit Spread on expiration.
Take a look at the daily chart on Blackberry Lmt (TSE:BB) below as an example:
4 Legs, 2 Strategies
As I mentioned, the more complex strategy is simply a combination of two, less complex strategies. By breaking it down this way, it becomes easier to understand the logistics if the trade, and more importantly how to execute it within you brokerage platform.
For the purpose of this example, we will use options expiring in January 2015. As of November 12th, 2014 the prices of the option contracts were as follows
January, 13 strike Call - $1.10 Buy
January, 14 strike Call - $0.70 Sell
January, 15 strike Call - $0.50 Sell
January, 16 strike Call - $0.30 Buy
The net cost of the Condor is $0.20/per share. This represents the maximum risk of the trade regardless of what happens with the stock.
The Maximum profit is the difference between the 13 and 14 strikes which is $1.00 minus the cost of the trade which is $0.20. This results in a profit potential of $0.80.
There are 2 break even points on expiration because of the combination of Debit and Credit Spreads
Break even #1 is the 13 strike purchased plus the cost which equals $13.20
Break even #2 is the 16 strike purchased minus the cost which equals $15.80
Maximum profit is achieved when the stock is trading between $14.00 and $15.00 on expiration. This would represent a 400% return on risk. Remember that you can close the position in its entirety or “Leg Out” which means off set a portion of the combination at any point before expiration to lock in profits or manage risk.
While the Condor has a limited profit potential, the multi-legged combination offers a very attractive risk/reward opportunity if the trader feels that the stock is not likely to trade beyond a certain range within a specified time frame.
- Posted by Patrick Ceresna on October 29, 2014 filed in Options Market, Trading Strategies
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First off I wanted to say thank you to all the Toronto Options Education Day attendees for a warm welcome, it was a pleasure to meet all of you. Recently the stock markets have increasingly become volatile as almost all Canadian sectors have gone through a healthy profit taking cycle. This gives us the opportunity to reference back to our prior blogs where we demonstrated the use of puts as protection.
For those who are new to put options - every 1 put option purchased on a stock represents a contractual right to be able to sell 100 shares of a stock at a specific price over a specific period of time. When used as protection for investors owning stocks, it offers the ability to create certainties in an ambiguous market.
Looking back to August 29th. I wrote a blog titled “Is there any Fuel Left in the Energy Sector Bull Advance?” In that blog we referenced the substantial divergence between the price of crude oil (and natural gas) in relation to the material advance in energy stocks. I felt this created an increasing vulnerability to owning the shares and presented an example using Imperial Oil(TSX:IMO).
We could not have been more right. The time of the blog marked the highest price Imperial Oil traded before a substantial decline of over 15% (close to $10.00 a share). In that example we purchased an October $56.00 put option (secured the guaranteed sale price of $56.00 for the shares). I wanted to demonstrate the value the insured investor received vs. the traditional buy and hold investor.
Investor 1 - Buy and Hold
In this example the investor owned 1000 shares at an average cost of $45.00. At the time of the blog the stock closed at $57.50 which saw the investor up 28% in paper profits. On October 17th the stock closed at $51.45 which saw the investor lose half the profit down to 14%.
Investor 2 - Bought the October $56.00 put as protection
In this example the investor owned 1000 shares at an average cost of $45.00. The investor was also up 28% in paper profits on August 29th but that investor spent the $0.75 to buy the October $56.00 put protection. On the October 17th options expiration the put option was $4.55 in-the-money ($56.00-$51.45). This allowed the investor to close the put at a net $3.80 gain ($4.55 - $0.75 cost). The gain on the put allows the investor to have a new adjusted average cost on the shares of $41.20 ($45.00 - $3.80). This means that at the $51.45 closing price and a $41.20 new average cost, the investor is still up 25% on the stock, in spite of a violent $10.00 decline from top to bottom in the 2 months of the trade.
The key take away is the investor protected themselves, managed risk, locked in gains and substantially reduced the volatility of their portfolio. Who says options are risky now?
In my opinion, investors taking the time to educate themselves on options as an investment tool is one the single most important things one can do to improve the chances of long term success.
I’ll be traveling to Winnipeg today on behalf of the Exchange to facilitate a workshop for aspiring, active investors. I have had the opportunity to present to this group on several occasions and despite the anticipated cold weather, I know the crowd is always warm, very interactive and hungry to learn.
That said, one of the topics I will be focusing on will be options trading mistakes to avoid. I always think that this is a great topic, because regardless of how well you understand the basic trading principles of using options, it’s good to be reminded of some of the pitfalls that stand between you and trading and investing with options successfully.
While there are many common mistakes (I cover 10 in my presentation) I want to focus on one that proved to be an expensive misunderstanding for me when I first started options trading. In fact, if you are interested in the entire breakdown of the the most common mistakes, check out this video found at M-X.TV
Avoid The 10 Most Common Option Trading Mistakes
There tends to be a misconception that buying cheap options is the best way to leverage capital and a surefire way to guarantee a home run on a stock that is expected to make a substantial move.
While it is true that options offer a trader the ability to substantially leverage their capital with a limited and identifiable risk, it is important to understand that options are cheap for a reason. Often time’s novice traders overestimate their probabilities of being correct and underestimate their risk.
It’s all about the probabilities
I am going to assume that readers already have a basic understanding of terms such as strike price and expiration date as they relate to the options market. If not, here is a link to an Introduction To Option Trading video.
In order to truly understand the importance of probabilities, aspiring option traders must recognize that options are priced based on the expectation of whether a stock has the potential to trade beyond the selected options strike price within a specified time frame.
For example, let’s take a look at call options on Blackberry Limited (TSX:BB) Currently the shares are trading at $11.70.
To look at it from the perspective of time:
Note that the more time allocated for the stock to move towards and beyond $12.00, the more expensive the option contract. This is because the market is pricing in the stock’s average Historical Volatility.
Historical Volatility is the amount that a stocks share price has been fluctuating over a period of time. For more information on volatility check out out Patrick’s blog Trading Volatility. The price of the November contract is suggesting that there is a moderate chance that shares of BB are going to trade above $12.00 by the November expiration based on its historical trading behavior. Not a good bet in my books. By allocating more time, the trader has a higher probability of being correct. Remember, if the move happens in a day, you can still close your longer term option out for a profit. However if the move happens over a 3 month period, the November option will be long expired and a full loss potentially realized.
Because we are focused on trading shorter term price movements on volatile stocks, we tend to focus on selecting 2-3 months out for our expiration dates. This is with the expectation that we are likely going to be out of the position within 1 or 2 weeks. Despite the fact that we have a shorter term outlook, we realize that our anticipated price move may not happen immediately. By allocating more time than anticipated we believe we are “erring on the side of caution”
You also don’t want to purchase too much time either. As a general rule, slower moving stocks need to be given more time for the price to reach the anticipated level. You also must consider whether you are an active trader with a short term outlook or whether you are more passive and have a longer outlook.
Rule of thumb
Know the stock you are trading options on, determine your outlook, select the appropriate time frame and manage the position accordingly. And when in doubt GIVE YOURSELF A LITTLE MORE TIME!
As for my lesson
I did all of the research, analyzed the price chart and was confident the stock was going to move. I wanted to get the best bang for my buck so I chose a cheap, short term option. Long story short…I was right about the stock but wrong about the time I selected for my option contract. 1 month passed, my option expired worthless and then the stock took off as anticipated. In hindsight, I could have purchased fewer contracts but with more time. This would have tipped the probabilities of being correct more in my favor and allowed me to profit from my original outlook.
Remember, learning to trade and invest with options is an ongoing journey and we learn from our mistakes. Be sure to analyze your losses to see if you took all things into consideration. We are dealing in a business of probabilities, so if we can filter out mistakes such as the one discussed here, we tip the odds a little more in our favor.
- Posted by Patrick Ceresna on September 24, 2014 filed in Events, Options Market, Trading Strategies
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It is common for traders that are new to options to make many of their trading decisions based solely on the prediction of the price move. While the price move is an important component of the overall success, the ultimate profitability is dramatically impacted by volatility pricing.
Implied volatility is materially different than the stock’s historical volatility. The historical volatility is a reflection of the stock’s actual past range. On the other hand, the implied volatility is far more a gauge on the sentiment of investors.
In the options market, there needs to be a buyer for every seller. It is a zero sum game. Suppose there is a considerable demand from option buyers to accumulate calls on a hot stock. If the demand is skewed, the implied volatility would need to steadily increase until it incentivizes the sellers of the options enough to reach an equilibrium. This is a process of price discovery in the live markets.
What does this mean for traders and investors?
It means that almost all known information or consensus expectations on a price move are often fully accounted for in the option price. Taking that into account, how does a trader create consistency in profits?
Well this is a question we will seek to answer in detail during the Toronto Options Education Day on Saturday, September 27th, 2014 at the Metro Convention Center. In Package 2, I will spend the morning going into detail on understand volatility.
9:00 a.m. to 12:00 p.m. – Vega: Friend or Foe? – MX instructor Patrick Ceresna
(Break from 10:15 a.m. to 10:45 a.m.)
Volatility seems to be a recurring theme that many options traders struggle to fully understand. It is a crucial component in the pricing of an option contract and it is extremely important that investors learn to fully utilize it. Join Patrick to be equipped with all the essential knowledge to not only hedge against volatility risk but also to trade volatility! This workshop provides an introduction to volatility strategies and explains how Vega, the measurement of sensitivity to volatility, can either work for or against the investor. Strategies covered will include straddles, strangles as well as the effect of volatility on debit and credit spreads!
There are a few seats still available, if you are interested, please register using the following link. http://www.m-x.ca/evenements/optionsdayTor14_en
I look forward to meeting you at the show.
Canadian energy stocks have been bulling higher for most of the year. The iShares S&P/TSX Capped Energy ETF is up 18.68% year-to-date (as of Aug 28). This renewed strength in the energy stocks has been a major contributor to the robust bull market advance in the broader Canadian indices.
Can the energy stocks keep rising?
While there are a number of fundamental input variables and broader market conditions that must be taken into consideration, there is one underlying divergence that continues to raise red flags. This is the divergence between the underlying stock prices and the price of crude oil and natural gas.
January 2014 low of WTI crude oil was $86.00. Between January to June, crude oil prices have risen to a high near $105.00 (on the October contract) or a $19.00 rise. During that advance, the iShares S&P/TSX Capped Energy ETF has rallied from $17.00 per share to a high near $21.50. Since the June highs in crude, we have seen a steep decline of over $12.00 a barrel, bringing prices just a few dollars from the start of the year. At the same time many energy stocks have not reacted. As an example, Imperial Oil (TSX:IMO) is at $57.50 and trading at its 52 week high, Canadian Natural Resources (TSX:CNQ) is at $46.67 and just a few dollars from its 52 week highs, Suncor (TSX:SU) is at $44.14 and also just a few dollars from its highs.
The question to ask - Can the Energy stocks hold their robust gains and advance higher when the underlying commodity prices declining?
At minimum, we can conclude that the divergence does create short-term risk in fundamentally good stocks that can be owned for the long-term. With the current low implied volatility, buying short-term protective puts becomes an increasingly beneficial proposition.
As an example, an investor that has held shares of Imperial Oil throughout the year has participated in a $12.00+ advance from $45.00 at the start of the year to the $57.50 current highs. In consideration of the paper profits made, the investor can buy the October $56.00 put for $0.75 (as of August 28th). For a modest cost, the investor can create a unique scenario where:
- The investor is guaranteed a $56.00 sale price if the stock drops in reaction to deteriorating oil prices.
- If oil prices were to bottom and begin advancing, the investor remains long the stock and continues to participate on all further gains.
In light of gains made and the divergence in crude oil prices, protecting the profits made over the short term may have some appeal to some investors.
First of all, let me preface this post with the disclosure that I am not an accountant, and it is always best to consult with one before making any investment related decisions pertaining to taxation. That said, many Canadian investors have been benefiting from a healthy bull market with nothing more than the odd hiccup in the S&P/TSX Composite since July of 2013. Few sectors have performed as well as the Canadian banks.
Let’s take a look at TSE:ZEB which is the BMO S&P/TSX Equal Weight Banks Index ETF. This exchange traded fund represents the value of an equal number of shares held in the 6 top Canadian banks. As of August 21st, 2014 the holdings are as follows:
Below is a weekly chart reflecting the strong uptrend in the TSE:ZEB.
Investors who took a position at the beginning of the year are up just over $3.00 per share or approximately 15%. The consideration at this point is how to insure that this healthy profit is not lost as we move towards the end of the year. While there is the potential for the banking sector to continue to appreciate, the potential for a healthy “correction” is always present and becomes an increasingly higher probability the more the shares continue to trend higher.
For an investor that is holding a position in a non-registered account the dilemma may be two-fold. The first consideration, should profits be taken at the risk of losing the benefit of further upside? The second is, that if the shares are sold, a capital gain will have to be realized for this year, which may not be in the investors best interest.
So how do you resolve this issue?
An investor who has limited expectations for further upside on a stock and wishes to lock in the profits generated at minimal cost can use a Collar strategy. The Collar involves the sale of a call against the shares held and the purchase of a put. In essence you are combining the Covered Call strategy with a Protective Put.
Since the investor does not wish to sell their shares this year, the strategy can be constructed using options expiring in 2015.
Currently, only March 2015 options are listed for TSE:ZEB
Prices are as follows:
TSE:ZEB shares - $24.40
March 2015, 25 strike Call - $0.35 Bid
March 2015, 24 strike Put - $0.85 Ask
The investor would collect $0.35 per share for the call write and use the credit to pay for a portion of the $0.85/share cost of the put. The net cost of the Collar is $0.50/share.
With the Collar in place, the investor cannot make any gains beyond $25.00. If the shares are trading above this on the third Friday of March, 2015 the stock will be called away. Including the cost of the Collar, this is still a 15% profit. Keep in mind that the position can be offset in January despite the later dated expiration if the investor wishes to sell the shares and lock in the profits in the new year.
The intention of the strategy is to insure that the profits are protected. This is where the Protective Put comes in to play. The investor has the right to sell the shares at $24.00 regardless of how low they may drop. With the shares of the stock at $24.40 and the cost of the protection reduced to $0.50, the maximum loss on the position is now limited to $0.90.
Regardless of how low the shares drop, the investor has locked in a $2.10 ($3.00 profit - $0.90 Collar cost) or 10% profit into the new year. This can also be offset in January if this meets the investors objective.
worst case, a 10% profit and best case, a 15% profit for holding the position into the new year.
Things to consider
There may be a little more upside to the Canadian banks leading into the fall. With this in mind, it may be appropriate to just add a protective put expiring in December. It will cost a little more for the protection, but the investor will participate in any continued upside while locking in profits. As we move closer to the year end, the January options will become available and a Collar could be constructed at that point to carry the position through to the new year. Food for thought as we enter the final quarter of 2014.
- Posted by Patrick Ceresna on August 1, 2014 filed in Options Market, Trading Strategies
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The S&P/TSX60 closed at 890.00 the other day. The market is now just 10 points away from the 900 level, which also corresponds with the 2008 all-time high prior to the great bear market that wiped out 50% of the value of the index.
This leaves many investors asking the question: will the S&P/TSX60 be able to make all-time new highs or will we see the impressive bull market advance stall out at this psychological threshold?
Here are the considerations that I am using to draw my conclusions:
- The Canadian bank and railway stocks have accounted for a very large portion of the advance, but it is unrealistic to anticipate them continuing higher at the same pace. Other sectors must pick up the slack when these stocks begin a much needed correction.
- The energy stocks have advanced significantly in a few short months, but is it sustainable considering the underlying commodity prices are not validating the advance.
Year to Date Performance
WTI Crude Oil
iShares Energy ETF (XEG)
If we reflect on the robust bull market advance in the Canadian markets from 2003 to 2008, it occurred on the back of a historic rise in commodity prices driven by demand from China and the emerging markets and a defined U.S. Dollar decline.
Can we witness a similar market condition? I don’t assign a high probability to it. I am sure there are a number of alternative arguments that can be made, but I consider the Canadian stock market vulnerable to a much needed market correction.
So should investors sell?
Maybe, but there are a number of problems and/or obstacles for investors and advisors. The first is the risk of exiting too soon. If an investor begins taking profits and raises cash, there becomes an increasing amount of anxiety if the market continues to advance and the bull market continues. In addition, there are a number of tax considerations to profit taking. If a market correction proves to be shallow and uneventful, the investor would have triggered unnecessary taxes and have to deal with the challenge of trying to strategically buy back into the market.
This is why it is an interesting proposition to consider S&P/TSX60 Index Options. There are strategic advantages to the European style index options. The index options are cash settled and do not involve the exercise of an underlying equity position. This ensures that no tax disposition occurs. This allows a diversified Canadian investor to hedge the downside risk of the broader Canadian markets with put options while leaving the primary composition of the portfolio unchanged. This puts the investor in a relatively reasonable position. If the markets continue to rally, the investor remains fully invested, if the market corrects or crashes, the index put hedge will substantially reduce the damage caused.
Few Canadian stocks have garnered as much attention as Blackberry LTD (TSE:BB). In fact, it has been the topic of a few of my postings over the last year or so. Why, you may ask? Well, option traders love volatility. By that I mean price action, and fewer Canadian stocks deliver as much action as Blackberry. With a historic volatility of close to 60%, this stock can deliver some significant price movement within a short period of time.
As a reminder, historic volatility is the measure of the fluctuation in share price (up or down) from the average share price over a period of time. The higher the number, the greater the deviation from the average and subsequently, the more volatile the stock.
Blackberry shares delivered a 47% move higher from $8.50 to $12.50 from mid June until mid July. I was amazed at how many people reached out to me when the shares were at $12.50, asking if it was a good time to buy. This in and of itself is typically a contrarian indicator.
Beyond that, there were a couple of technical observations that indicated upward momentum was slowing and that there may be a pull back which would offer the die-hard Blackberry bull and opportunity to “buy the dip”.
Stock prices never move in a straight line and investors should never feel so compelled to take action that they can’t wait for a more favorable entry.
The recent pull back in Blackberry (TSE:BB) was largely attributed to Apple and IBM announcing an alliance to create new apps for business. This is a space that Blackberry was largely focusing on. That said, prior to the significant drop in share price, the chart was suggesting that a pullback was highly probable.
It is important to note that these observations are not a 100% guarantee that the shares are going to sell off, nor does it suggest the scope or duration of the potential move. These observations simply suggest to an ambitious bull to be patient. A trader looks to lock in profits, and with Blackberry being a “traders stock” these observations (along with a 47% move in share value) would be all I would need to ring the register and sell some shares.
So…now that we have seen a pull back how would I play Blackberry (TSE:BB)
To circle back to volatility, using a strategy with a limited risk on a volatile stock makes the most sense. With the stocks historic volatility being high, the options implied volatility, which is the expectation of movement priced into the options, is equally high. I would use a Bull Call Spread to offset volatility, reduce my cost basis, lower may break even and limit my risk in case Blackberry shares continue lower.
I would look to capture a re-test of the $12.00 resistance level by constructing a 10/12 Bull Call Spread out to September. I would do this by purchasing the $10.00 strike call and simultaneously selling the $12.00 strike call.
Prices for the options at close yesterday were as follows:
September 10 Call - $1.40 BUY
September 12 Call - $0.55 SELL
The net cost of the spread would be approximately $0.85
The profit potential is $1.15 if the shares of Blackberry (TSE:BB) are trading anywhere above $12.00 on the September expiration.
With the shares currently trading at $10.73, this spread is just shy of its break even point, which is $10.85. This is calculated by adding the cost of the spread to the purchased strike.
In my opinion, this offers the Blackberry bull an asymmetric risk/reward opportunity with a limited risk exposure on a very volatile stock. In addition, the stock does not have to move all that much higher for the spread to break even, and only has to be trading around the $12.00 level to realize full profits.