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.
Ok, I have to admit I used the word “dumping” to get your attention. This is not a bear rant on a good company but rather a strategic maneuver to create a favorable risk/reward proposition. In fact, what I will demonstrate is my rationale for replacing the stock with call options.
Here are some facts about the stock:
- Magna is currently trading near its all time new highs at $116.00 after an impressive 20 month 170% rally that started November 2012 at $43.00 a share.
- Even after an impressive advance like that, the stock does not have valuations that are astronomical with a P/E ratio in the mid teens and a dividend just over 1%.
- Magna’s growth rates have outpaced the industry average and continue to boost the earnings per share.
- Technically, the stock remains in a decisive uptrend and is showing no immediate sell signals. The pattern of higher highs and higher lows is very evident and buyers use every short term consolidation to accumulate the stock.
SO WHY AM I SELLING?
First off I am not bearish on the stock, nor do I necessarily believe that a serious drop in the stock is imminent. Rather, I am strategically adjusting my position based on the current market circumstances.
Here are some facts that I deemed important to take into account when I was assessing my situation:
- I own my Magna shares in my RRSP, which immediately removes the variable of tax considerations.
- While I did not buy my shares at the 2012 lows, I have made a considerable amount of profit in the recent advance. The consideration is that anyone that has been around the block in regards to the stock market recognizes that stocks don’t just go up in a straight line. Rather,it is common to have numerous corrections that check an investors resolve to remain invested.
- The stock market as a whole is very complacent and market volatility remains historically low. While the current option prices are deemed to be the “right price”, they are structurally cheap when compared to historical comparisons.
- The stock started the year at $80.00 a share and has advanced $35.00 through the first half of 2014 to its current $116.00 range. In addition, the stock paid a $0.412 dividend on May 28th and is expected to pay another dividend in late August.
Now, I am not selling my shares to abandon the stock, but rather replacing my stock with call options to redefine a new asymmetric risk/reward proposition. Here is what I am doing:
- I am selling my shares of Magna at $116.00 and taking my profits in my tax sheltered RRSP.
- For every 100 shares, I am buying 1 Magna July $115 call option for $2.30.
- If I continue to like the position at the July 18th options expiration, I will consider rolling the call to the August 15th expiration.
So what benefit have I created?
- If the stock proceeds to rally to $120-$130 over the next month or two, I will continue to participate in further share appreciation by being able to exercise the call option and buy back my shares at the $115.00 strike price.
- If the stock continues to advance and I do buy them back, I will take ownership before the next August 28th dividend.
- What I have created is a trade where, under no circumstances, will I be in a position to have lost the profits I made beyond the cost of the call option. Instead of risking an uncertain amount of unrealized profits to an unexpected market correction, I have realized all the gains and have limited my risk to the $230.00 per contract for the call options.
This may not be a consideration for all investors, but works well for the way I look and assess risk and reward in the markets.
The objective of any trader or investor is to achieve the greatest return for the least amount of risk. This is what you hear hedge fund and money managers referring to as “asymmetric returns”. One of the benefits of using options to participate in a directional view is the limited risk exposure of the purchased option premium compared to the theoretically unlimited profit potential.
An additional benefit of understanding the dynamics of the options market is the ability to create combinations that can further reduce our risk exposure while maintaining that asymmetrical risk/return structure.
The Debit Spread
In past articles we have reviewed the application of debit spreads as one such strategy. The debit spread involves the purchase of an at-the-money option and the subsequent sale of an option at a further out-of the-money strike price. The credit received from the out-of the-money option offsets the cost of the purchased option resulting in a lowered cost basis and break even point. The trade off is that the “spread trader” gives up the opportunity to profit beyond the written strike for the benefit of lowering the cost basis, break even point and risk of the position. This also mitigates the impact of implied volatility contraction as well as time depreciation. For more insight into this strategy you can review the M-X educational video on Advanced Option Strategies for Active Investors.
The Credit Spread
We have also dedicated significant attention to the idea of generating cash flow through credit spreads. As a refresher, the primary objective of the credit spread trader is to write (sell) an option contract with the expectation that it will expire worthless. Provided that the option contract is out-of the-money on expiration all of the time value disappears and the writer keeps the premium. The concern for some is the unidentified and theoretically unlimited risk exposure of selling “naked” options. Don’t get me wrong, naked option writing is a powerful income generating strategy but it requires sufficient margin and the investor must truly understand and manage the risks accordingly.
To limit and identify the risk of option writing, an option contract that is further out-of the-money could be purchased using a portion of the credit received. The credit spread trader still collects a premium, however the risk and margin required is limited to the spread minus the premium. For more insight on this strategy you can review the Bullish Spread Strategies and Bearish Trade Strategies videos found at www.m-x.tv.
So…what happens when you combine the two?
As I suggested in the opening paragraph, we can meet all sorts of objectives by combining the purchase and sale of various option contracts. In fact I consistently maintain that the seemingly most advanced strategies are combinations of the more simple strategies. If you understand the basics…such as debit spreads and credits spreads, you have the ingredients to construct something very interesting.
Enter the Condor
In simple terms, the Condor is constructed by combining a debit spread and credit spread with the same expiration months. The objective is to take a directional position using a debit spread, but further reduce the cost by adding a credit spread. This condor is named for its risk/reward profile and its resemblance to a big bird.
Condor Risk/Reward Profile
The maximum profit of the strategy is realized when the stock is trading between the written strikes of the combination. In this case, the debit spread is fully in-the-money and at its maximum profit, while the credit spread is out-of the-money and expires worthless resulting in the collection of the full credit.
The trade off, unlike just using a debit spread, is if the stock exceeds expectation and trades beyond the written option of the credit spread. At that point profits are diminishing as losses are being incurred on the credit spread side.
A Practical Example with Barrick
I’m sure everyone is exhausted with gold stocks, but we are seeing some renewed interest in the mining sector reflecting an appreciation in share value across the board. That said, there have been many false starts over the last year and traders are tentative to buy.
Barrick Gold (ABX.TO) is one of the most heavily traded stocks on the TSE and the options on the Montreal Exchange show good volume and liquidity. If an active investor felt there was the opportunity for continued upside into a specific price zone, but wanted reduce the cost of trading that view to enhance the asymmetric risk/reward potential, a condor could be considered.
The first trade
Buy the October, 18 strike call - $1.35 debit
Sell the October, 20 strike call - $0.60 credit
Net Cost = $0.75 (this is the maximum risk for the debit spread)
Max Profit = $1.25
- This is offers the potential for a 166% profit if the stock is trading above $20.00 on expiration
- Break even on expiration is determined by adding the cost of the spread to the purchased strike equaling $18.75
Max Risk = $0.80 ( $2.00 spread minus the credit received)
- Break even on expiration is determined by adding the credit to the written strike equaling $21.20