Put and Call Option Secrets » Stock Options Trading

Learning to Trade Stock Options Could Enhance Your Ability to Make and Keep Money from the Markets

admin — Sat, 16 Jan 2010 02:41:16 +0000

Stock options trading can be dangerous business–very dangerous. Of course, folk get entangled with it because it can also be very , very rewarding. With options, you leverage underlying assets for a certain time period. You don’t have to buy the assets, just pay a premium up front in order to have control over them during the specified time. But , as with all investments, the more that you stand to potentially make, the more that you stand to possibly lose. So. You want to know what you’re doing for stock options to work for you. First, you have to have a strategic plan in mind up front. There are many stock options secrets that different financiers use. You need to study them and select those that you think are best suited to your risk toleration and your objectives. Never enter into a trade without knowing ahead why you are taking that approach and what you may do under certain circumstances, no matter how you’re feeling about them. In line with this, you have to select a good stock options broker. Find those online who are renowned for good reputations and good experience, and then compare their fee structures and what you get for your money. A good broker will be a good guide, but won’t try to tell you what to do. Another aspect of preparing your strategy is knowing the market. This means that you can understand the fundamental assets of the stock options you select. Follow online stock charts and economics reports concerning those assets so that you can make informed decisions and anticipate wisely, not shooting from your hip. And yet more preparation for the arena of stock options trading will entail good money management. You will keep your investment money budgeted and separated from the money that you require to live on and cannot risk. If you run out of that money, stop investing till you have reconstructed your bank account thru careful savings and even handed spending. However–don’t get out of a choice contract too shortly. You will take losses, especially when you’re getting your first experiences. You may expect to always take some losses, but the way to success is reasonably simply to make more than you lose over a period. Never give up too easily. At the same time, with stock options, you don’t want to hold it too long. Know when it’s time to sell a choice so that you can lessen your losses. But when it does come to your earning profits, don’t blow it by taking a heavy loss shortly after. That’s the worst experience in the world. Instead, understand how to use trailing stops. You must also be well informed in the easiest way to figure out a break-even point. Study both of these basic and obligatory stock options trading techniques before you dig into this world. But in the end, success in stocks options all boils down to ceaseless research. Again, know the market, know the stocks, know the corporations, know the basics, and know what methods to use when. And how can you be most guaranteed of keeping up with all this? Thru reading a high quality options newsletter. An options newsletter written by experienced, successful options trading professionals can be like gold itself to you. So, let your research start with finding such a service.

Learning to Trade Stock Options Could Enhance Your Ability to Make and Keep Money from the Markets

admin — Sat, 16 Jan 2010 02:41:16 +0000

Learning to Trade Stock Options Could Enhance Your Ability to Make and Keep Money from the Markets

admin — Sat, 16 Jan 2010 02:41:16 +0000

Options Seller Risk/Reward

admin — Sat, 19 Dec 2009 02:22:58 +0000

The seller of a time spread buys the nearer month option and sells the outer-month option in a one to one ratio.
In order to profit from the sale of the time spread, the seller is looking basically for two things.
First is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.
Second, the stock can move. As stated before, a time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. So, as long as the stock moves in either direction away from the strike, the seller’s position could be profitable provided that time decay does not outperform the stock movement.
Time, unfortunately, never works in favor of the time-spread seller. The passage of time hurts the seller because the nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value. That obviously produces a loss for the time spread seller. Time can neither be stopped nor turned back. It only moves forward which always hurts the time spread seller.
Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long) due to the out month option’s higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.
The seller, in theory, has an unlimited loss potential. For the seller, the maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out- month call. As we know, the out month call will be more sensitive to movements in implied volatility due to a higher vega or volatility sensitivity component. If implied volatility increases then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.
The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, he/she will be left short a naked or un-hedged option and a loss on the position. If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured. As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.
Once the long option expires and the seller is left short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem. While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they probably will not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

Options Trading Mastery: Time Decay and Volatility Trading Opportunities

admin — Thu, 17 Dec 2009 02:58:41 +0000

When vertical spreads are mentioned, they quite often come with monikers such as ‘bull’ and ‘bear’. This lends most to think of vertical spreads as directional plays which is true. However, vertical spreads can be used to take advantage of two other potential trading opportunities – time decay and volatility movement.
If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. Knowing a little about them now, you will recall that a vertical spread has a limited profit potential but also a limited loss scenario for both the buyer and the seller. So, how do we use this covered trade to take advantage of time decay.
At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays away over time, you could set up a vertical spread by selling an at-the-money option and buying either the out-of-the-money option (creating a credit spread) or buying an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay away at a faster rate than either the in-the-money option or the out-of-the-money option due to the fact that the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.
Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea, but now there are a couple choices. Should you do the put spread or the call spread? Should you buy it or sell it? The decision of what to do from here should first be based on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you can’t expect the stock not to move at all. So even though you are playing time decay, you still want to form an opinion about in which direction the stock is most likely to move. By doing this, you’ve now give yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.
Now that you have picked which at-the-money strike you are going to sell and you’ve picked your anticipated stock position you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember both the vertical call spread and a vertical put spread allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up. For the bears, you can buy a vertical put spread or sell a vertical call spread. For each direction there are two choices to decide from. One is a purchase, one is a sale. The best way to decide which to do, other than your own style or comfort ability is a simple risk/reward analysis.
By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.
Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility. Volatility is a huge component of an option’s extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.
As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less. Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the spread.
So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.
As to how to set it up, you would follow the same guidelines as you would for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.
Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the spread will have to be constructed with the short option being the at-the-money.
As you can see, the vertical spread does not have to be used only in directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to both the buyer and the seller.

Options Trading Mastery: Effects of Volatility on the Time Spread

admin — Wed, 16 Dec 2009 14:44:15 +0000

When purchasing a time spread, the investor should pay attention to not only the movement of the stock price, but also the movement of volatility. It plays a very large roll in the price of a time spread, which is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.
Option Volatility
Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads. Let us start with option volatility.
We measure an option’s volatility component by a term called Vega. Vega, one of the components of the pricing model, measures how much an option’s price will change with a one-point (or tick) change in implied volatility. Based on present data, the pricing model assigns the Vega for each option at different strikes, different months and different prices of the stock.
Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 Vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick).
Keep these facts in mind as we continue to discuss Vega:
1. Vega measures how much an option price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at-the-money options.
4. Vega is a strike-based number. It applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.
It is important to note that an option’s volatility sensitivity increases with more time to expiration. Further out-month options have higher Vegas than the Vegas of the near term options. The further out you go over time, the higher the Vegas become. Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that Vega values increase as you move out over future months.
The at-the-money strike in any month will have the highest Vega. As you move away from the at-the-money strike in either direction, the Vega values decrease and continue to decrease the further away you get from the at-the-money strike. Remember, Vega (an option’s volatility component value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike.
The chart below shows Vega values for QCOM options. Observe the important elements. The stock price is constant at 68.5. Volatility is constant at 40. Time progresses from June to January. Finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time and how the value decreases as you move away from the at-the-money strike.
Chart 3- Vega
Stock Price 68.5 Vol. 40
Strike June July October January
50 0 .008 .064 .114
55 .004 .030 .102 .153
60 .023 .063 .135 .184
65 .053 .090 .157 .205
70 .056 .094 .165 .215
75 .032 .077 .154 .213
80 .011 .052 .142 .203
Another important fact about Vega is that it is a strike-based number. This means that the Vega number does not differentiate between put and call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. Therefore, the Vega number of a call and its corresponding put are identical.
The chart below shows the Vega values for calls and the corresponding puts. As you can see, these values match up in every instance.
Chart 6
Strike Price-Call Vega-Put Vega
June
60 .023 .023
65 .053 .053
70 .056 .056
July
60 .063 .063
65 .090 .090
70 .094 .094
October
60 .135 .135
65 .157 .157
70 .165 .165
January
60 .184 .184
65 .205 .205
70 .215 .215
Vega can also calculate how much a specific option’s price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved. Multiply that number times the Vega and either add it (if volatility increased) to the option’s present value or subtract it (if volatility decreased) from the option’s present value to obtain the option’s new value under the new volatility assumption. The calculation works on individual options and can analyze the value of the time spread.
Apply Vega to Time Spreads
Now, let us apply the concepts of Vega to the Time Spread. When you apply the Vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher Vega will increase more than the closer month option with the lower Vega. That widens or increases the spread.
The chart below shows a time spread and its reaction to increasing volatility. Each time that implied volatility increases, the value of the time spreads increase. This increase would naturally favor the buyer.
Chart 4
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 30 1.09 2.09
65.5 40 1.43 2.75
65.5 50 1.77 3.41
65.5 60 2.11 4.05
65.5 70 2.49 4.60
If an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.
Of course, the Vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher Vega will lose value more quickly than will the nearer month option with its lower Vega. In the chart below, you will see how decreasing volatility affects the time spread’s value.
Chart 5
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 70 2.49 4.60
65.5 60 2.11 4.05
65.5 50 1.77 3.41
65.5 40 1.43 2.75
65.5 30 1.09 2.09
Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.
We discussed how to use Vega to calculate an option’s price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult.

Options Trading Lessons: Using Base Volatility

admin — Wed, 16 Dec 2009 02:23:14 +0000

Spread traders must understand how to properly calculate accurate volatility. In order to get accurate volatility levels, you must first determine a base volatility for the two options involved in the spread. Getting a base volatility must be done because different volatilities in different months cannot and do not get weighted evenly mathematically.
Since they are weighted differently, you cannot simply take the average of the two months and call that the volatility of the spread. It is more complicated than that.
The problem relates to calculating the spread- volatility with two options in different months. Those different months are usually trading at different implied volatility assumptions. You cannot compare apples with oranges nor can you compare two options with different volatility assumptions.
It is important to know how to calculate the actual and accurate volatility of the spread because the current volatility level of the spread is one of the best ways to determine whether the spread is expensive or cheap in relation to the average volatility of the stock.
There are several ways to calculate the average volatility of a stock. There are also ways to determine the average difference between the volatility levels for each given expiration month. Volatility cones and volatility tilts are very useful tools that aid in determining the mean, mode and standard deviations of a stock’s implied volatility levels and the relationship between them.
The present volatility level of the spread is comparable to those average values and a determination can then be made as to the worthiness of the spread. If you now determine that the spread is trading at a high volatility, you can sell it. If it is trading at a low volatility, you can buy it. You must know the current trading volatility of the spread first.
To accurately calculate volatility levels for pricing and evaluating a time spread, the key is to get both months on an equal footing. You need to have a base volatility that you can apply to both months. For instance, say you are looking at the June / August 70 call spread. June’s implied volatility is presently at 40 while August’s implied volatility is at 36. You cannot calculate the spread’s volatility using these two months as they are. You must either bring June’s implied volatility down to 36 or bring August’s implied volatility up to 40. You may wonder how you can do this.
You have the tools right in front of you. Use the June Vega to decrease the June option’s value to represent 36 volatility or use August’s Vega to increase the August option’s value to represent 40 volatility. Both ways work so it does not matter which way you choose.
We will use some real numbers so that we may work through an example together. Let’s say the June 70 calls are trading for $2.00 and have a .05 Vega at 40 volatility. The August 70 calls are trading for $3.00 and have a .08 Vega at 36 volatility, so the Aug/June 70 call spread will be worth $1.00. To be able to calculate the volatility of the spread, we must equalize the volatilities of the individual options.
First, let’s move the June calls by moving June’s implied volatility down from 40 to 36, a decrease of four volatility ticks. Four volatility ticks multiplied by a Vega of .05 per tick gives us a value of $.20. Next, we subtract $.20 from the June 70 option’s present value of $2.00 and we get a value of $1.80 at 36 volatility. Now the two options are valued at an equal volatility basis.
Looking at this first adjustment where we moved the June 70’s volatility down to 36 from 40, we have a value of $1.80 at 36 volatility. The August 40 call has a value of $3.00 at 36 volatility. The spread will be worth $1.20 at 36 volatility.
If you wanted to move the August 70 calls instead, you would take the August 70 call Vega of .08 and multiply it by the four tick implied volatility difference. This gives you a value of $.32 that we must add to the August 70 call’s present value in order to bring it up to an equal volatility (40) with the June 70 call. Adding the $.32 to the August 70 call will give it a $3.32 value at the new volatility level of 40, which is the same volatility level as the June 40 calls. Now, our spread is worth $1.32 at 40 volatility. August 70 calls at $3.32 minus the June 70 calls at $2.00 gives the price of the spread at 40 volatility.
It does not make any difference which option you move. The point is to establish the same volatility level for both options. Then you are ready to compare apples to apples and options to options for an accurate spread value and volatility level.
Since we now have an equal base volatility, we can calculate the spread’s Vega by taking the difference between the two individual option’s Vegas. In the example above, the spread’s Vega is .03 (.08 – .05). The Vega of the spread is calculated by finding the difference between the Vega’s of the two individual options because in the time spread, you will be long one option and short the other option.
As volatility moves one tick, you will gain the Vega value of one of the options while simultaneously losing the Vega value of the other. The spread’s Vega must be equal to the difference between the two options Vega’s, so, our spread is worth $1.20 at 36 volatility with a .03 Vega or $1.32 at 40 volatility with a .03 Vega.
Going back to our original spread value of $1.00 with a Vega of .03, we can now calculate the volatility of that spread. We know the spread is worth $1.20 at 36 volatility with a Vega of .03. Therefore, we can assume that the spread trading at $1.00 must be trading at a volatility lower than 36.
To find out how much lower we first take the difference between the two spread values, which is $.20 ($1.20 at 36 volatility minus $1.00 at ? volatility). Then we divide the $.20 by the spread’s Vega of .03 and we get 6.667 volatility ticks. We then subtract 6.667 volatility ticks from 36 volatility and we get 29.33 volatility for the spread trading at $1.00.
We can also determine the volatility of the spread as the spread’s price changes. We will fix the spread price at $1.30. To calculate this, we must first take the value of the spread ($1.20 at 36 volatility) and find the dollar difference between it and the new price of the spread ($1.30). The difference is $.10. The Vega of the spread must now divide this dollar difference. The $.10 difference divided by the .03 Vega gives you a value of 3.33 volatility ticks. Then add the 3.33 ticks to the 36 volatility and you get 39.33 as the volatility for the spread trading at $1.30.
Let us double-check our work by calculating the volatility the other way. This time we will do the calculation by moving the August 70 calls up to the equal base volatility of the June 70 calls. As calculated earlier, the August 70 calls will have a value of $3.32 at 40 volatility. The June 70 calls are worth $2.00 at 40 volatility, so the spread is worth $1.32 at 40 volatility.
Now, move the spread price to $1.30, $.02 lower than the value of the spread at 40 volatility. As before, we take the difference in the prices of the spread. The result is $.02 ($1.32 – $1.30). Then, divide $.02 by our spread’s Vega of .03 (remember that the Vega of the spread is equal to the difference between the Vega of the two individual options). $.02 divided by .03 gives us a value of .67. We must subtract that .67 from our base volatility of 40. That gives us a 39.33 (40 – .67) volatility for the spread trading at $1.30. This volatility matches our previous calculation perfectly.
At first glance, you might be wondering why we went through all of these calculations. With the June 70 calls at 40 volatility, price $2.00, Vega .05 and the August 70 calls at 36 volatility, price $3.00, Vega .08 why not just take an average of the volatility? This would give us a 38 volatility for the spread with a price of $1.00 when in actuality $1.00 in the spread represents a 29.33 volatility.
This would be almost a nine-tick difference, which represents a whopping 30% mistake! As stated earlier, Vega is not linear. You cannot weigh each month evenly and just take an average of the two months. For argument’s sake suppose you did. Let’s say you found the difference of the Vegas of the options and came up with a spread Vega of .03, which is correct. However, when you try to calculate the spread’s volatility and price you would have difficulty.
Now, recalculate the spread with the trading price of $1.30, or $.30 higher than your value at 38 volatility. Divide that $.30 higher difference by the spread’s Vega of .03. You get a 10-tick volatility increase. Add that increase to the base 38 volatility. That would mean you feel the spread is trading at 48 volatility instead of a 39.33 volatility! This type of mistake could be very, very costly. Remember, apples to apples, oranges to oranges. It does not matter which option’s volatility of the spread you move as long as you get both options to an equal base volatility.

Options Trading Mastery: Behavior of the Time Spread

admin — Tue, 15 Dec 2009 15:39:18 +0000

Time spreads can be a profitable investment strategy if you understand the concept of time decay. A time spread is designed to take advantage of the fact that an options decay curve is non-linear, that is, an option’s value does not decay evenly over time. As an option gets closer to expiration, its rate of decay increases meaning the option loses value more quickly. That decay rate increases progressively until expiration.
An option’s decay rate begins to accelerate when the option is about 45 days out. It picks up steam at 30 days out and really comes under decay pressure at about 15 days out. This scenario is similar to a boulder rolling down from a hilltop. As it starts, it rolls slowly, then gains more speed, and momentum the further it gets down the hill until it achieves its maximum speed at the bottom. Option decay acts the same way – gathering speed and momentum as the option approaches expiration.
In time spreads, both options have the same strike price that remains constant. Each option’s value decays at different rates and over different lengths of time. The option, with one month until expiration, experiences value decay at a faster rate than the one with three months until expiration.
If you buy an option with three months to go and sell an option with the same strike but with one month to go, you have set up a spread between the two options values (prices). As time passes, your short option loses value more quickly than your long option that decays more slowly. The value of the spread widens and you profit from that spread’s expansion. This is the fundamental behavior of the time-spread.
Consider that you are long the 60-30 day time spread. That means you are long the 60-day option and short the 30-day option. We will assign a price of $3.00 to the 60-day option and $2.00 to the 30-day option. Since you pay for the one and receive payment for the other, the bottom line cost of what you put out for the spread is $1.00.
During the same 30-day period, it goes from $3.00 to $2.00. Remember, the spread’s bottom line cost was $1.00. The 30-day option (now expired) will be worth $0 while the 60-day option (now a 30-day option) will be worth $2.00. If you had invested in this spread, after 30 days decay you would be holding one option worth $2.00. The investment has provided a nice return!
This is an ideal situation. The stock price and volatility remain constant and you capture the decay. The time spread has worked just as it should. It does work that way sometimes, but nothing works as it should all the time. As we know, stock prices and volatility levels do not remain constant. They are always changing. In the time spread strategy, the investor must choose opportunities carefully. In addition to picking a stock that will be in a stagnant period, the investor should look for two other situations where the spread has profit possibilities: changes in volatility and to a lesser degree stock price movements.

Options Trading Lesson: The Butterfly

admin — Sun, 13 Dec 2009 02:28:08 +0000

I am sure many of you have heard of a sophisticated sounding strategy called the Butterfly. For some reason, it seems to be the darling strategy of many of those ‘teach-you in five hours’ type option companies. They publicize the ‘mystical magical Butterfly’ and the ’sophisticated Condor’ as if they were going to unlock the options version of Pandora’s box. I guess they feel that, by introducing you to the catchy named strategies, they will grab your attention and thereby give them a chance to promote themselves. From a marketing standpoint, that is not a bad idea.
However, the Butterfly is a ’sophisticated’ only for those that do not know options! If you have done your homework and have learned the option basics properly, then the Butterfly is a simple strategy that is just a combination of an already familiar, basic strategy. Let’s take a closer look and uncover the secrets of the mysterious Butterfly!
Butterfly Construction
The first thing you must understand about the Butterfly is that it is constructed by using either all calls or all puts. The Butterfly is never a combination of the two. (We will talk about an exception called the Iron Butterfly later.)
Whether you choose to use calls or puts, butterflies are always constructed in a ‘1-2-1′ arrangement. For the long Butterfly, you would buy one low strike, sell two medium strikes and buy one high strike with the strike prices equally spaced. The center strike typically matches the current price of the stock.
For example, if the stock is 55 and you decide to create a long Butterfly by using calls, you could buy a 50 call, sell two 55 calls, and buy one 60 call. If you decided to use puts, you could buy a 50 put, sell two 55 puts, and buy one 60 put. The long Butterfly is always long the outer strikes and short the center strike.
You would construct the short Butterfly in the opposite way. The short Butterfly will always be short the outer strikes and long the center strike. For example, to create a short Butterfly, you could sell a 50 call, buy two 55 calls, and sell one 60 call. The short Butterfly trader is simply taking the opposite side of the trade with the long Butterfly trader.
This is not a complicated construction. The trick is to understand that while there are three strikes to a Butterfly, there are four options involved. I know the construction will be hard to associate with long or short in the beginning, so here is a little trick or two to help you remember how to differentiate a long Butterfly from a short Butterfly.
When I think of whether a Butterfly is long or short, I always look at that first strike. If that first strike is long, then it is a long Butterfly. It is as simple as that. Some people find it easier to just focus on the center strike where you have the two-option position. If you are short the center strike, then you are long the Butterfly.
The opposite would be true for short butterflies. These are just a couple of ways that you can determine whether a Butterfly is long or short until you become so familiar that you automatically know which Butterfly is which. Until you get to that point, you will want to use little tricks to remember which one is which. Use whichever is most comfortable but I suggest you focus on only one ‘trick’ and use only it until you become so familiar with butterflies you don’t need it any longer to recognize which one you have. Make your choice and stick with it!
The following chart shows the long and short Butterfly construction:
Notice that the strike prices are equally spaced. This is a necessary aspect of all butterflies. However, while the strikes must be equally spaced, they do not need to be spaced by five dollars as in this example.
We could have spaced them by ten dollars and created a different long Butterfly by purchasing the 45 call, selling two 55 calls, and buying one 65 call. You just have to understand that the strikes must be set up in an equidistant manner and they must be either all calls or all puts in the proper 1-2-1 ratio.
From a terminology standpoint, we call this the 50/55/60 Butterfly or, more simply, the 55 Butterfly taking the lead from the Butterfly’s middle strike.
We add to that term whatever month you are dealing with. If we are referring to the June expiration cycle, it would be called the June 55 Butterfly. If we were in April, it would be called the April 55 Butterfly.

Discover how to Trade Options

admin — Tue, 01 Dec 2009 14:59:35 +0000

If you want to learn how to trade options you have definitely come to the right place. Trade options and stocks are very much alike. For instance both of them are purchased and sold in the stock markets. The only thing is option holders can purchase or sell at a certain price range and during a specified period of time only. This is the way the trade options work. Stock traders are free to buy or sell stock as and when they feel like it but option traders are governed by particular time periods. That is perhaps the major difference of all between trade options and trading stocks.As is well known, anything to do with investing in the stock market or any other type of exchange involves a certain amount of risk. If you do well, you can make enough money to retire even when you in your youth or if things don’t go too well for you could lose the short off your back so to say. Hence it is very important that you learn how to trade options before you dabble in this art of trade options and stocks. You have to decide exactly how you would like to trade options and when you would want to do it; after all it’s your income that you are putting on the line. Although it is not possible to tell everything about how to trade options in this short article I will share with you some pointers that I use in my stock options trading. If you decide to use them to trade options, it is at your own risk or you may rather modify them or ignore them altogether. To start with it is better if you get familiar with the language and terms associated with the trade options before you embark on learning how to trade options. You should learn everything about stock options and trade options and how put options differ from call options. Learn about the option premiums and how they affect your trade costs. In order to become a successful options trader you have to first understand these fundamental principles. There is a vast amount of information available on the Net but you may also choose to join a newsgroup of forum for option trading so you can learn something from other option traders who have already learnt from their mistakes.When you think you are ready to use the knowledge you have acquired on how to trade options, you can begin with paper trading. Once you have gained some confidence that your paper trades are doing well, then you could consider the possibility of going in for the real trading. There are no guarantees in the stock market so make sure you downplay your risk. Try to buy trade options that have a low option premium meaning they are price at low rates so you don’t bear too much of a risk and don’t lose too much money even if you make a mistake. A lot of option traders who start out invest small amounts in several stock counters in order to get a better financial trade protection. You should definitely not invest all you have in one basket and even more so if you are a novice trader.