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Contents

Understanding Options Trading Margin Requirements For Naked Options

February 10, 2020

Get ready traders – in this blog we are going to look at understanding the trading margin requirements for naked options trading and option selling.

If you plan to sell options as part of your overall trading strategy, you need to understand how margin requirements work. In this blog, we will look in detail at what your broker will require for you to execute these types of trades.

Our Trading System Is Based On Selling Options

I base my trade strategies in option selling. This doesn’t mean we only sell options; we trade iron condors and credit spreads as well. But each of these strategies allows us to collect option premiums up front and put up margin for the trade.

We know just how frustrating it can be to buy a call or put on a stock that moves against you and loses you money. Much of the time, you are paying for time decay which is slowly eating away at your profits each day. As a result, the stock moves and yet the option expires with little or no value at expiration.

Understanding Margin Requirements

Just like trading commissions, brokers can have very different margin requirements. However, they must all adhere to the minimum required by the Financial Industry Regulatory Authority (FINRA) and the option exchanges where the contract is traded.

For example, Charles Schwab’s margin requirements are much higher than the industry standard, while thinkorswim offers lower Portfolio Margin for higher account values.

At any rate, you should check the specific requirements of your broker to know which margin standards they will apply to your particular type of trading account.

Broker Clearance Levels For Options Trading

When you open your account with a broker, you should request options trading authorization. Some brokers will classify options trading clearance within different levels ranging from one to four.

Usually, to buy options you need the basic level or level one clearance. If you plan on selling naked puts (not calls) you more than likely need level two clearance. But the margin is much higher as you are still seen as a beginner trader by the broker. If you have the necessary experience, I highly recommend you try to obtain level three or higher approval as the margin requirements will be much lower and you will be able to buy and sell options at any time.

Sample Broker Margin Schedule

Below is a quick sample margin schedule from our broker thinkorswim. Margin schedules are great to help you quickly calculate and determine if you are going to have enough buying power for a particular position or strategy. (Click to enlarge).

How Do Brokers Calculate Margin?

We are going to assume for now that you have level three clearance which has slightly lower margin requirements than lower levels. For those of you who are math wizards, you are going to love this stuff. Everyone else, you are just going to have to take us at our word on these calculations.

Here’s the basic calculation:

(25% of the underlying stock’s market value + the option ask price – any out-of-the money amount) x 100 (per contract) x the number of contracts

The value of the above equation must be greater than:

* (The option ask price + 10% of the stock’s current trading price) x 100 (per contract) x the number of contracts, or

* The number of contracts x $500 per contract.

If either of these two calculations yield a higher margin amount, then the highest value is used.

We want to point out at this point that having margin clearance within your broker does not mean you will be forced into a “margin call” should your trade go bad. If you have enough cash or stock holdings within your account to cover the margin requirements, then a trade will not trigger the activation of the margin (borrowing capacity) that is available to you.

Ways To Reduce Your Margin

There are some strategies you can take to reduce your margin and we have created a short video looking at a couple of ways we can reduce our margin requirements on trades.

This is an excellent video, not only for people who have larger accounts but if you’re trading an IRA account and you want to mimic some of the undefined risk traits that we do here. Or that anybody does, basically your straddles and strangles and ratio spreads, it’s going to be hard to do that because those trades usually require a lot of cash up front for your IRA or your retirement account.

We look at some simple ways that you can reduce or cut your margin requirements and also increase your return. Again, with larger accounts, you’ll want to trade slightly more undefined risk trades. These give us the biggest PNL, dollar-wise, at the end of the year, but, of course, they tie up a lot of capital margin.

In the video, we talk about reducing those market exposures on selected strategies. This helps not only reduce overall risk in the portfolio, but also increases return on capital which can dramatically help with our overall profit, and use of funds.

We also have a second video which shows you how to free up more margin and cash to help you continue trading regularly.

If you have any other questions about understanding margin requirements for options trading, please feel free to add the into the comment box below, and we will answer them for you.

Basics of Options Trading

This guide is essentially an extension of our introduction to options trading. While our introduction section has been written specifically to provide a general overview of what options are and what trading them is all about, this guide to the basics focuses on some of the more precise details that you will need to know about before you should be thinking about getting involved in options trading.

We would suggest that if you are a complete beginner then you should start with our introductory section. However, if you already have a good general understanding of the fundamentals of options trading and what is involved, then this guide to the basics is the next logical step.

Here we cover the main types of options contracts that you can trade along with the types of orders you need to place to trade them. We also provide details of the various categories of spreads that are applied in trading, along with the different trading styles that can be used. You will also find comparisons between options and some of the other commonly used financial instruments.

  • Types of Options
  • Types of Orders
  • Types of Spreads
  • Types of Trader & Trading Styles
  • Comparing Options to Other Financial Instruments

Types of Options

Options can be categorized in a number of ways and there are actually several different types: calls and puts. Calls are contracts that give the holder the right to buy the underlying security while puts are contracts that give the holder the right to sell the underlying security. Obviously this is a very significant distinction and these are essentially the two main types of contracts. However there are many different ways in which options can be classified too.

For example, they can be classified based on the underlying asset involved, the way in which they can be exercised, how they are settled or the length of the contract. There are also a wide variety of exotic contracts, which are usually more complex and contain specific provisions. For a complete guide to the various different forms and full details on some of the more commonly used ones, please visit Types of Options.

Types of Orders

When you buy and sell options contracts you have to place orders with a broker, in a similar way to how you would buy and sell stocks, and there are several different types of order that can be used. There are four main types, two of which are the most commonly used. These are the buy to open order, which is used to enter a new position through buying contracts, and the sell to close open order which is used to exit an existing position by selling contracts you have previously bought.

The other two main orders are the sell to open order and the buy to close order. These are used for opening a position by writing contracts and closing a position by buying back previously written contracts respectively.

In addition to these four main types, orders can also contain other parameters relating to how the order is filled, the timing of the order, and automatic exit points. There are also combination orders that can be used to coordinate multiple positions. For an in-depth guide to the range of orders that can be used, please visit Types of Orders.

Types of Spreads

One of the biggest advantages of trading options is found in the creation of spreads. Creating options spreads is slightly more complicated than the straightforward buying and selling of contracts, but the concept itself is simple enough to understand.

An options spread is basically when you buy and/or sell two or more options contracts relating to the same underlying security. A simple spread would be buying calls on a specific security and then writing calls on the same security. Spreads are very widely used in options trading, usually for limiting the risk of entering a particular position or reducing the initial cost of entering a particular position.

There is a huge range of different spreads that can be used and essentially every options trading strategy involves the use of at least one spread. At some point you will want to learn all about the different spreads and how they are used, but to start with you just need to understand the main categories. These include call spreads, put spreads, debit spreads, and credit spreads. To read more on this particular subject, please visit Types of Spreads.

Types of Trader &Trading Styles

Most options traders employ a specific trading style when buying and selling contracts. It’s useful to understand the different trading styles and what is involved, as at some point you will want to decide which trading style is best for you. A lot will depend on what your investment objectives are, how much time you have to commit to trading, and what kind of skills you have.

For example, if you are planning on trading full time and are particularly good at making fast decisions under pressure then day trading may be a good style for you. Alternatively, you may want to start out using a style that doesn’t have to be so time consuming – swing trading.

You can visit Types of Trader & Trading Styles for more detailed information on the different trading styles that you can use.

Comparing Options to Other Financial Instruments

If you are trying to decide whether options trading is right for you, then it would be useful to compare options to other financial instruments that can be traded; such as stocks, bonds, futures and foreign currencies.

Even if you determine that options contracts are the right financial instrument for you to trade, it cannot hurt to have at least a basic understanding of these other instruments – you may even decide to trade a selection of different instruments.

It’s also worth bearing in mind that options contracts are derivatives that are based on the value of other financial instruments so knowing a little about how those instruments work is likely to benefit you whatever you decide to do.

Please visit Comparing Options to Other Financial Instruments for an in-depth look at the differences between options contracts and other forms of investment.

Day Trading Options: The Complete Guide 2020

The excitement, the exhilaration. Profitable sessions never get boring. If you know what you’re doing, options can provide the same benefit as day trading stocks. Fasten your seat belts, this is another comprehensive post from our ​day trading for beginners series.

But keep in mind, predicting the direction of the underlying isn’t the only variable.

Delta. Gamma. Vega. Misinterpreting the ‘Greeks’ can wreak havoc your bankroll.

In this guide, we’ll tell you what you need to know about day trading options. Learn how to get started, understand the ‘Greeks,’ and the top strategies professionals use on a daily basis.

But there is more. We will cover the most profitable option income strategies and take a closer look at selling weekly put options for income with 4 crystal clear options trading strategies.

Finally, you find a step-by-step guide on how to read an option chain the right way to maximize efficiency and profitability.

Table of Contents

Day Trading Options: The Basics

Is options trading considered day trading?

​​In a word – yes. Before you suit up, make sure you understand the day trading options rules.

The pattern day trader rule is a regulatory requirement passed down by the US Financial Industry Regulatory Authority (FINRA).

It stipulates that any investor who “executes four or more day trades within five business days” given the trades represent “more than six percent” of total trades within the same time period, must do so in a margin account of at least $25,000.

The rule applies to both stocks and options.

What about a cash account?

No relief either.

The US Federal Reserve employs a freeriding prohibition mandating you can’t use ‘unsettled funds’ to engage in another transaction.

Trades officially settle within two business days.

​When you day trade – whether in equities or options — you buy and sell so quickly that previous transactions don’t have time to officially clear.

​According to FINRA, this makes the strategy ​against the rule.

Bottom line: open a margin account and maintain a $25,000 minimum or use a pattern day trader workaround.

What are the ‘Greeks?’

Before you begin day trading options, make sure you understand the ‘Greeks.’ Financial variables, ‘Greeks’ are option factors that affect the option price within and outside of changes in the underlying.

First up is delta.

Delta is a first order effect and measures the linear change in the option price given small changes in the price of the underlying.

Call deltas range from 0 to +1 and put deltas range from 0 to –1. For example, if a call option has a delta of 0.70, it means a 1% change in the value of the underlying will result in a 0.70% change in the value of the option.

Next is Gamma. Gamma is a second order affect that attempts to quantify delta-error.

​Since delta measures the linear change in the price of the option, gamma accounts for non-linear changes or large increases and decreases in the underlying.

​Gamma is always positive and the larger the number, the less you can rely on delta. When you see a large gamma, be careful.

Vega is extremely important. It quantifies volatility priced into an option. Volatility is the most important variable in option pricing and the higher the volatility, the more expensive the option is.

Look at the implied volatility statistic on an options chain: the higher it is, the more you need the underlying to increase for your positon to turn a profit.

Th ​ ​ eta represents an options time value. Until an option expires, there is always some dollar value left in it – even if it’s completely out-of-the-money.

Rho is an options sensitivity to interest rates. This is important because rising rates increase the value of call options and decrease the value of put options.

The reason is: call options are considered ‘waiting to make a purchase.’ When money is still in your account – and not currently invested in the underlying – you can earn interest on that capital until you decide to exercise the option.

Because of this, interest rates are always added over the holding period.

Day trading weekly SPY options

​The SPDR S&P 500 ETF (SPY) is one of the most highly traded and liquid ETFs out there. Many professional option traders use the index to make speculative bets or hedge risky positions in their portfolio.

Because of its high liquidity, it makes a great underlying asset for day trading options.

Buy or sell weekly SPY call options

A simple strategy is to buy or sell weekly SPY call options. Beforehand, most options traders feel out the mood of the market and decide which direction offers the greatest risk-reward trade off.

If you believe the market is primed for a rally, owning call options is a great way to participate with very low risk.

​On the other hand, if you’re pricing in bearish sentiment, selling weekly call options can earn you quick income over a short holding period.

​The greatest upside of selling weekly call options – rather than longer-dated options – is the benefit of time value decay.

Above, I wrote about the importance of theta. For short-term options, theta is much higher, which means you earn a greater time value premium with short-term options compared to long-term options.

A second benefit is risk management. When selling weekly call options you can narrow your prediction down to a short interval.

Instead of being liable for weeks or months, the short-term contract expiration allows you to take profits without the long term risk.

Buy or sell weekly SPY put options

Put options are always popular.

They act as insurance for long portfolios and selling them can be a great way to add income to your account. The best part is puts are usually priced much higher than calls.

Because of the insurance characteristic, investors are willing to pay a premium for peace of mind. If you have a strong sense the market will rise over the week or even remain flat, selling weekly put options is a great way to turn a profit.

Trade SPY Volatility

Remember above, I wrote Vega (volatility) is the most important variable affecting option prices.

Well, if you believe the market is primed for turbulence, owning puts will pay off in two ways: the decrease in SPY’s price and the increase in volatility. Rising volatility results in the implied volatility statistic increasing on the options chain.

This will make future put option contracts more expensive and increase the value of your position along with it.

Options Day Trading Strategies – Fundamental and Technical

When day trading options, there are two perspective approaches: fundamental and technical.

Fundamental Options Trading Strategies

Trading Information

​​When trading information, you’re buying and selling options based on news of the day.

Economic data, interest rate rhetoric from the Federal Reserve, or just a Tweet.

If you follow the markets, you know a single piece of information can send equities spiraling in various directions.

It wasn’t that long ago the Dow erased an 800 point loss because Jerome Powell – Chairmen of the US Federal Reserve – issued a dovish statement regarding the direction of future interest rates.

When material information like this hits, volatility spikes as the market assesses the news. And for the third time, volatility is the most important variable affecting option prices.

If you can positon yourself on the right side of the wire, you won’t have any problem ending up on the right side of the trade.

Technical Options Trading Strategies

Trading Put-Call Parity

​​Trading put-call parity is a strategy built around exploiting arbitrage. Arbitrage profits occur when you earn a riskless profit without having to use any of your own capital.

The formula looks like this:

Put price + the underlying price = call price + present value of the call options strike price

When this equality formula doesn’t hold, you have an arbitrage opportunity. Say for example, we take Apple’s (AAPL) stock.​

If the current share price is $154, an at-the-money put option costs $5, an at-the-money call option costs $4 and the current yield a 10-year US Treasury is 3%, the math works out like this:

As you can see, equality doesn’t hold. As an astute options trader, you can earn an arbitrage profit by shorting the stock at $154, buying an at-the-money call option for $4 and selling an at-the-money put option for $5.

With the transaction, you earn $1 per share. As well, interest isn’t a factor because you can invest the short proceeds during your holding period.

Most importantly, you’re completely hedged. If the stock price increases, you can exercise the call and cover any losses from your short positon.

If the price of the stock decreases, that’s fine as well because — while the at-the-money put you sold will be exercised – you shorted the stock so you profit from all price decreases.

For equality to hold and eliminate the arbitrage opportunity, the call price would need to be $5.09.

Arbitrage opportunities like this don’t last long. When they spot it, traders execute the same riskless transaction over-and-over until supply and demand resets the price of the options.

As a daily strategy though, the opportunity can be quite profitable. Similar to scalping with equity day traders, arbitrage profits are minimal, but over time can add up to meaningful gains.

Day Trading Options Summary

Done right, day trading options is not that challenging. Day trading options can become one of your core option income day trading strategies​ as a good alternative to our favorite stock day trading gap and go strategy.

Before you start out, make sure that you know how to read an option chain and consider selling put options for income instead of day trading options.

Furthermore you should consider using a paper trading account first and once you are ready to start, make sure to use a brokerage account with low options trading commissions.

Option Income Strategies

How to increase your cash flow

Options. Options. Everyone likes options. From what to wear to what to eat – choice is the spice of life.

In a financial context, it’s no different.

Options give you the right but not the obligation to engage in a transaction. Ultimately, the choice is yours.

The great thing about financial markets is there are plenty of profitable opportunities just looking to be exploited. And with the right option income strategies, you can do just that.

So sit back and let us show you how to increase your cash flow.

What is option income?

Option income is the premium you earn from selling option contracts. Similar to bond interest or an equity dividend, option income is compensation for taking on risk.

When you sell a call, you give the buyer the opportunity to participate in a rally, so the premium is your return for the service.

When you sell a put, you’re protecting the buyer from downside risk. Thus, the cash inflow is similar to insurance premiums.

Do you pay taxes on options?

Yes. Option profits are considered short-term capital gains. They are taxed as ordinary income at your marginal rate – similar to bond interest.

Any investment held for less than one year receives the same tax treatment.

What are the best option strategies for income?

From beginner to advanced, there are plenty of profitable income strategies available.

Well start with the most basic:

Covered Call

A covered call is a beginner option strategy where you earn income on a stock you already own. Owing the asset acts as a hedge, but you’re still exposed to downside risk.

How do you write a covered call?

It works like this:

Say you own 100 shares of Microsoft (MSFT) and the current share price is $105. To execute a covered call, you simply sell a weekly – or longer – call op ​ ​ tion contract on the position.

A weekly at-the-money contract – with a $105 strike price — is currently priced at $1.55 per share. Since contracts sell in lots of 100, the transaction results in a cash inflow of $155.

The strategy is popular because outside of the underlying going to zero, there is very little risk.

Even if you suspect the stock is in trouble – since you own it – you can sell your shares and exit the positon.

  • Covered Call Max Profit: $155
  • Covered Call Max Loss: [(105 – 1.55) * 100] = $10,345

Covered Put

A covered put is similar to a covered call. The strategy involves shorting the underlying stock and selling put opti ​ ​ ons.

Remember, when you short a stock, you profit from any downside movement. Since puts increase in value when the underlying declines as well — having a short position ensures you’re hedged.

Unlike a covered call though, losses are unbounded. When a stock price falls it can only go to zero. However a stock can increase by 200%, 300% or even more.

While it’s unlikely to happen – especially for a mature company like Microsoft (MSFT) – the possibility still exists.

Weekly at-the-money put options for Microsoft (MSFT) sell for $1.56 per share. Executing the strategy results in a $156 cash inflow per contract sold.

  • Covered Put Max Profit: $156
  • Covered Put Max Loss: unbounded

Bear Call Spread

Now you get to mix things up.

A bear call spread is used if you think the underlying will decline. The strategy involves selling a call option with a lower strike price and buying a call option with a higher strike price.

The lower strike call is always more expense, so the transaction results in a cash inflow.

Using the Microsoft (MSFT) example, the strategy works like this:

A weekly-at-the-money call option – -with a strike price of $105 – is priced at $1.55 per share. An identical call option with a strike price of $108 is priced at 45 cents per share.

The net result is a cash inflow of $1.10 per share or $110 per contract.

The main advantage is less downside risk.

If the underlying increases, you’ll have to sell the stock at the lower strike price. However, since you also bought calls with a $108 strike – any increases above that are completely hedged.

  • Bear Call Spread Max Profit: [(1.55 – 0.45) * 100] = $110
  • Bear Call Spread Max Loss: [(108 – 105) – (1.55 – 0.45) * 100] = $190

As you see, the risk-reward trade-off is much greater.

Bull Put Spread

Similar to a bear call spread, you can use a bull put spread to generate income as well. The strategy involves selling puts with a higher strike price and buying puts with a lower strike price.

Again, the higher strike put is more expensive and results in a cash inflow.

Current Microsoft (MSFT) weekly at-the-money put options are selling for $1.56 per share. Put options with a $103 strike are selling for 77 cents per share.

The net result is a cash inflow of 79 cents per share or $79 per contract.

Again, risk-reduction is the greatest benefit. By owning the lower-strike put, you’re hedged for any decreases in Microsoft’s share price below $103.

  • Bull Put Spread Max Profit: [(1.56 – 0.77) * 100] = 79$
  • Bull Put Spread Max Loss: (105 – 103) – (1.56 – 0.77) * 100] = $121

Collar Strategy

A collar is clever way to hedge an existing position and generate option income at the same time.

The strategy involves owning the underlying, buying a put option and selling a call option. A collar acts as a hedge against both large increases and decreases in the stock price.

Take Microsoft (MSFT) again:

The current share price is $105. A weekly at-the-money call option sells for $1.55 per share while a similar put option sells for $1.56. Remember, both have a strike price of $105.

By selling the call and buying the put you’re completely hedged. The transaction also results in a cash inflow of 1 cent per share or $1 per contract.

  • Collar Max Profit: [(1.56 – 1.55) * 100] = $1
  • Collar Max Loss: 0

As you can see, a collar protects you in either direction. The downside though, is profits are minimal. The strategy is meant to mirror a risk-free investment, similar to owning a 10-year US Treasury.

To get around this, many collar-enthusiast decrease the put strike price to increase their cash flow. Remember, a $103 strike put is priced at 77 cents.

Positioning this collar results in a net inflow of 79 cents per share or $79 per contract.

However, there are two sides.

By lowering the strike price, you increase your downside risk. Any losses from $105 to $103 will not be hedged.

Short Straddle

A short straddle is the highest income generating option strategy available. It’s also the most risky.

You play it by selling both a call and a put – of the same strike price — without having a hedge in place.

Going back to the Microsoft (MSFT) example, weekly calls and puts are priced at $1.55 and $156 per share. If you sell both, you receive a total inflow of $3.11 per share or $311 per contract.

The income factor looks great, but the downside is significant. Naked calls are unbounded on the upside, so your losses can theoretically extend to infinity.

The put is bounded by zero so your maximum loss is Microsoft going bankrupt.

  • Short Straddle Max Profit: [(1.55 + 1.56) * 100] = $311
  • Short Straddle Call Max Loss: unbounded
  • Short Straddle Put Max Loss: [105 – (1.55 + 1.56) * 100] = $10,189

Keep in mind, a short straddle is a highly speculative strategy. It should only be used if you have significant option experience or have other hedges in place.

Short Strangle

A strangle is similar to a straddle, only here you’re mixing up the strike prices. The main benefit is more control over upside and downside risk.

For example, if you think Microsoft is more likely to rise than fall — you can sell an at-the-money put for maximum income as well as increase the call strike price to $108 from $105.

Conversely, if you think Microsoft is more likely to fall than rise, you can sell an at-the-money call and decrease the put strike price to $103 from $105.

Again, both variations are highly speculative, so proceed with caution.

So what is the best option strategy for income?

Basically, you should stay away from options trading. The risk of losing all your money is significant. Trading stocks might allow you to make a mistake without ruining you.

However, one wrong decision trading options can cost you all your money, and you can also end up losing more money then you have.

If you have experiences trading options and you are aware of the risk, then the bear call spread, bull put spread or the collar strategy might fit with lower risks.

When breaking down the math, it’s easy to see all three generate solid income while at the same time protecting from catastrophic losses.

As well, the strategies allow you to tweak your strike prices so you can tailor your position to your own perceptions about the stock.

If you want to increase risk, plenty of options are available, but you should definitely stay away from such high risk options income strategies.

Selling Weekly Put Options for Income

4 Option Trading Strategies for your portfolio

When most people think of income investing, the first products that come to mind are certificates of deposit, Treasury bonds or real estate investment trusts (REITS).

Pretty boring huh?

Well, if you dabble in put options, it doesn’t have to be.

Selling weekly put options for income can offer plenty of benefits for your portfolio.

And best of all — when done right –still allow you to maintain a low-to-moderate risk profile.

In this guide, we’ll walk you through our top-four strategies and show you how to start profiting today.

Premium Income

The first thing you need to know about options is how they generate income.

When you sell a put option, what happens?

First, you receive a cash inflow from the transaction. Option contracts are sold in lots of 100. What that means is: each contract is based on 100 shares of the underlying.

For example, a weekly at-the-money put option for Walmart (WMT) is priced at $1.19. When you sell one contract, you’ll receive an inflow of $119.

How much money do you need to sell a put option?

The great thing about selling weekly put options is you don’t need a large bankroll. The main issue is trading commissions.

Brokerages usually charge a higher commission for option contracts than tradition equity transactions. This eats away at your profit, so take that into account before you get started.

A second issue is initial and maintenance margin.

Selling weekly put options for income exposes you to future liabilities. If the share price of the underlying stock or index decreases, you’ll be liable to buy the shares back at the higher strike price.

Because of this, brokerages will insist you post collateral to cover any future losses. Since options mark-to-market each day, you’ll also be required to post additional maintenance margin if your position declines.

Different brokerages have different requirements, so discuss the issue beforehand. Recommended read: What is buying o ​ ​ n margin

Selling weekly put options for income: 4 strategies

People new to option trading usually ask: when should you sell a put option?

Well, the ideal time is when you expect the market to rise or stay flat. Put options profit when the underlying decreases in price and can be used for swing t ​ ​ rading strategies.

Since you’re selling the contract, you’re on the other side of the trade. When the underlying increases in price, you’re in the clear.

Selling naked puts

The term ‘naked’ means you sell put options without hedge in place. This is the most basic strategy available and you can generate monthly income by selling puts as long as the underlying doesn’t decrease.

When deciding if it’s the right time to pull the trigger, you need to assess the current market environment.

Volatility spikes are function of news hitting the wire: The US-China trade negotiations. Interest rate rhetoric from the Federal Reserve.

Macroeconomic data like jobs reports as well as PMI/CPI numbers.

Daily events like these lead to what professionals on Wall Street call, ‘repricing risk.’

Analysts and traders reset their models to adjust for new expectations on economic growth, interest rates and overall market sentiment.

This is your opportunity. Savvy traders who can gauge bullish or bearish sentiment and read through the tea-leaves of economic data have much better insight into where the market is headed.

It’s like predicting the weather. If you see sunshine ahead for the market, sell weekly put options for income. If clouds start to form, hold off for a better opportunity.

Bull put spread

A more advanced strategy is to incorporate spreads into your toolkit. A bull put spread is where you buy a put option at a lower strike price and sell a put option at a higher strike – both having the same expiration date.

The higher strike is always more expensive, so it results in a cash inflow.

It works like this:

A weekly at-the-money put option for Walmart (WMT) is priced at $1.19. The strike price is $95. The same weekly put option with a strike price of $93 is only 52 cents.

You can construct a bull put spread by selling the $95 strike for $1.19 and buying the $93 strike for 52 cents — which results in a net-inflow of 67 cents per share or $67 per contract.

The logic here is risk reduction. If you sell a ‘naked’ put at $95 your maximum profit – per contract – is $119.

Your maximum loss though, is the underling going to zero, minus the profit from the put option contract: [(95-1.19) * 100] = $9,381.

Now obviously the result is a little skewed. It’s quite unlikely a stock goes to zero in one week – especially a well-run company like Walmart – but you get the point.

Now check out the numbers from a bull put spread perspective. Your profit and loss looks like this:

  • Bull Put Spread Max Profit: [(1.19 – 0.52) * 100] = $67
  • Bull Put Spread Max Loss: [(95 – 93) – (1.19 – 0.52) * 100] = $133

As you can see, the risk-reward trade-off is much better. By implementing the spread, you’re hedged for any price reductions below the $93 mark.

You give up 52 cents in max profit but I’m sure you can agree, the reduction in maximum loss is more than worth it.

Bull calendar put spread

A bull calendar put spread is similar, but uses a slight tweak. Here, you buy and sell put options with the same strike price but mix up the expiration dates.

The strategy looks like this:

Buy the weekly at-the-money put option for Walmart (WMT) with a strike price of $95, priced at $1.19.

Then sell a two-week at-the-money put option with a strike price of $95 for $1.56. The net result is a cash inflow of 37 cents per share or $37 per contract.

Similar to a naked put though, you’re completely exposed on the downside. If the underlying goes to zero, you’ll be in for a loss of $9,463.

However, the reason this is such a popular strategy is because it allows you to trade time.

If you expect volatility to spike sooner rather than later, you can positon a bull calendar put spread, be fully hedged for the first week and earn income in the process.

The downside – of course – is the second week the hedge is gone.

If you’re just starting out, our advice is to stick with the lowest risk options trading strategy. Save the calendar spreads for when you have more experience.

Short Straddle

A short straddle is also very risky so proceed with caution. Unlike the other three strategies, here you implement call options into the trade.

The main benefit of a straddle is it offers the highest income generation possible.

The strategy is to sell both a call option and put option with the same strike price.

From the Walmart example, it means selling the $95 strike weekly at-the-money put option for $1.19 and selling the $95 strike call option for $1.06.

  • Short Straddle Max Profit: [(1.19 + 1.06) * 100] = $225

As you can see, the income potential is there.

A straddle is best used when the market trades flat. Since you’re exposed on both the upside and the downside — a large spike in either direction will cost you dearly.

When analyzing your maximum loss, the numbers are scary. From a call perspective, the loss is unbounded.

The underlying can increase to infinity which means you’re liable for any gains. From a put perspective, the underlying can only go to zero.

  • Call Max Loss: unbounded
  • Put Max Loss: [(95 – 1.19) * 100] = $9,381.

As with a bull calendar put spread, short straddles are best used when you’re comfortable predicting the mood of the market.

The exposure is immense, so if you’re just starting out, stick with the safer bull put spread.

Hedging strategies

If you’re keen on using the strategies above, there are ways to hedge your exposure so you gain the same risk-reward trade-off as the bull put spread without the downside of a naked position.

Inverse Index ETFs

When hedging a put position, you need an offsetting short position. The problem is, shorting requires a margin account, a stock loan fee and interest charges.

A more cost-effective approach is to use an inverse index ETF. You can use the ProShares Short S&P 500 ETF which is a great proxy for the US equity market.

When you feel the mood music starting to change and you want to hedge your put positon, you can buy shares of the inverse ETF.

For example, if you have $2,000 put position, you can buy $1,000 worth of the ETF and roughly cut your exposure in half.

It’s important to note though, indexes and options aren’t directly correlated so the two will not reprice exactly alike.

However – when accounting for costs — using an index to hedge is your best bet.

Conclusion about selling weekly put options for income

Options are high risk. While day trading stocks is more challenging than long term investing, day trading options is even more risky.

Make sure that you understand what you are doing here! Always start out with a demo account or trade simulation. Never risk you money right away.

How To Read An Option Chain: A Step-By-Step Guide

Many investors want to trade options but don’t know where to start. Unlike equities, it takes a bit of research to understand how option trades work.

Strike price. Open interest. The terminology can be confusing.

I mean, what’s implied volatility anyway?

Well, don’t worry because we’ve got you covered. In this guide we’ll show you everything you need to know about how to read an option chain.

We’ll breakdown all the little details so you have the confidence you need to make your first trade.

What is an option chain?

An option chain provides a list of various data — tallying prices, expiration dates and selling activity for call and put options of a given stock.

The data is displayed in real-time, which gives you a window into how the market is behaving and what is required to complete a particular trade.

So what is the best option chain website?

We recommend Nasdaq.com. It’s a reputable service and one of the largest stock exchanges in the world, providing real-time updates and plenty of other useful market information as well, or alternatively the option chain provided within your brokerage account.

How to read an option chain

When breaking down an option chain, a visual aid always helps. Take a look at the image below. It’s the most recent option chain for Nike (NKE).

So how do you read option symbols?

Well, let’s start from the left and work our way right.

Expiration Date

At the top of the picture you can see the months Jan 19, Feb 19, March 19 etc. These represent the expiration dates for various call and put options.

Calls are in the left column and puts are in the right column. When you click on a particular month, you find all the necessary data about contracts expiring within that time frame.

So how does option expiration work?

Think of it like a carton of milk. An options expiration is similar a milk’s best before date. If you don’t exercise your position by the expiration date, it’s worthless.

And like sour milk – you simply throw it away.

The ‘last’ figure describes the last price an option sold for. Check out the second row with the 7.47 figure. This means the most recent March 08, 2020 call option contract sold for $7.47.

Change

What is net change in an option chain?

Well, take a look at the right side of the image. Under the Chg. figure, you’ll notice there is a –0.34 five rows from the top.

This tells you the change in the option price from the most recent contract compared to the one before it.

For example, the last price for a March 08, 2020 put option is 50 cents. That represents a 34 cent decline from the contract prior.

Doing the math, you can infer that the previous contract sold for 84 cents.

Bid-Ask

Bid-ask quotes are like a supply and demand tug of war. Buyers – who set the bid – want to buy options at the cheapest possible price.

Sellers – who set the ask – want to receive the highest possible price; so they ‘ask’ buyers for more money.

The main takeaway is the bid is always less than the ask. The logic is the same as bid-ask quotes you see for traditional stocks.

One caveat – like we discussed above – is the last price. If you notice, the 7.47, 5.10 and 4.23 are all less than the bid and ask prices.

The reason is: the number of contracts sold for these options are very low so there isn’t enough activity to support the current bids.

The contracts that did sell — 7.47, 5.10 and 4.23 – were agreed upon many days ago and the supply and demand dynamics have changed since then.

Volume

Volume is extremely important. Like a stock – it determines the level of liquidity in a financial instrument.

With options, volume measures the number of contracts exchanged within that day for a given expiration date.

For example, one contract sold per-day contributes 1-unit of volume to the statistic.

Looking at the chain, you’ll notice volume is 0 for all of the call options and no more than 1 for all of the put options.

The takeaway is: no option contracts have been exchanged on that given day. Like I described above regarding the bid-ask, the 7.47, 5.10 and 4.23 contracts were finalized many days ago.

Open Interest

If volume is Batman, then open interest is Robin.

Open interest tells you the amount of option contracts that have yet to be exercised. American options – unlike European – can be exercised at any time.

However, because option prices have embedded time value, traders avoid exercising early. Doing so is like giving away free money.

It’s better to sell the option contract to another trader to ensure you receive full value.

Check out the chain again.

For the contracts I mentioned, you see open interest of 5, 4 and 2. With this information, you know 5, 4 and 2 contracts are still open and available for trade.

The root tells you the ticker symbol of the underlying asset. We’re using the example of Nike (NKE) and as you see — the chain root is NKE. Some option providers use different name variations but it’s not hard to figure out.

Strike Price

Now we’ll get into the important details.

When you buy an option contract, you specify the desired strike price.

For a call option, the strike price represents the price at which you can buy the underlying stock, should you decide to exercise the option.

For a put option, it represents the price at which you can sell the underlying stock, should you decide to exercise the option.

Keep in mind, we’re describing this from a buyer’s perspective.

The strike price is one of the most important factors because it determines the premium you pay for the option.

When an option is in-the-money, you pay more, when it’s out-of-the-money, you pay less.

In-The-Money (ITM) and Out-Of-The-Money (OTM) Options

Analyze the new section of the Nike (NKE) option chain. The shaded areas on the left represent in-the-money call options and the shaded areas on the right represent in-the-money put options.

ITM options have what traders call ‘exercise value.’ This represents a sum of money already priced into the option premium. Nike’s (NKE) stock is trading at roughly $81.25, so we’ll use the 81-strike call option to explain.

If you bought an 81-strike call right now and exercised it, you would make a profit of 25 cents per share. Because of this, option sellers add 25 cents to the cost of the option.

The rest of the option premium — $2.28 minus 25 cents – represents the cost of time value and implied volatility.

Implied Volatility (IV)

Now the most important point.

Implied volatility (IV) is the single most important factor determining option prices. IV is financial jargon for the statistical term standard deviation (SD).

When trader’s price options, they assess how likely a stock is to jump above the strike price for a call option or fall below the strike price for a put option.​

Using a normal distribution bell curve, a 1-SD move infers a 68% probability, a 2-SD move infers a 95% probability and a 3-SD move infers a 99% probability – assuming a historical sample repeats itself.

Now, from a seller’s perspective, dealers and traders use these probabilities to decide how much they’re going to charge you for the option.

Let’s look at the ‘Greek’ Statistics from Nike’s (NKE) option chain:

Pay attention to the numbers in the sixth column from the right. The other figures represent delta, gamma, rho and theta.

These are just as important but we cover them in other articles. For now though, look at the 0.09152 number next to the 81.5 strike price.

The figure implies the market is pricing – with a 68% probability – a 9.152% annual change in the price of Nike’s (NKE) stock.

Given the stock is trading at roughly $81.25 right now, you need to believe the end-of-year stock price is going to range somewhere in between $73.81 to $88.69 to justify buying the option.

  • [81.25 * (1 – 0.09152)] = $73.81
  • [81.25 * 1.09152) = $88.69

Since the options have roughly a two-month expiration, the two-month implied volatility (IV) of the option is [0.09152 * ] = 3.74%.

Thus, the market is assuming that within two months, Nike (NKE) has the potential to reach a price target of $84.29.

The current asking price for a two-month call option is $2.24. This requires a 2.76% increase in the current share price for you to breakeven.

Since the option price as a percentage of the share price is less than implied volatility — it signals the options may be undervalued and could provide a decent addition to your portfolio.

How to read an option chain: Summary

It is crucial to understand how you have to read an option chain. As an option trader it will become one of your main tools and chances are that you will place your orders right from the option chain.

You should never start trading options without paper trading. Remember that!

Day Trading Options Summary

Yes, you made it! Day trading options for beginners was yesterday. Now,

6,500 words later you learned the essential basics about day trading options.

​Finally, if day trading is right for you, then you should definitely take a closer look at Trade-Ideas A.I. Pro.

Trade-Ideas scans the market day in and out for the best trading setups with the highest potential. They also have an integrated options screener.

​As you know, I love customer-friendly terms and conditions. Trade-Ideas has such great customer friendly terms and conditions, and they offer a lot of free services as well as a good money back condition.

​Please take your time and re-read the article on your discretion and please, do never start day trading options with a live trading account! Seriously! Just never do that.

Once you believe, that you understood the basics, then make sure to start day trading options with a risk-free paper trading account. Furthermore make sure, that your free paper trading account provides an options chain and real-time prices.

Could, would, should will never be of help at all. This is why it’s crucial, that you put yourself in a position as trading with real money, even as a paper trader.

As always, in the end, it’s still up to you to decide, when you are ready to take action. However, with day trading options you have to be even more carefully.

Because day trading stocks might hurt you because you can lose all your money in your account. But day trading options can cost you much more.

I know, it sounds so easy. Your broker tells you that you only need a few bucks and you are ready to go. But rethink again and do the math first.

I hope this guide is helpful for you and it would be great if you share it with your friends.

What options are. 5 examples of options hedging.

Options are a sophisticated financial instrument that is why even if we try to explain what options are in simple terms, it would be quite difficult to understand it anyway. Especially when it comes to options hedging.

And we did our best in this article to give you easy-to-understand, interesting and useful explanation of:

  • what options are;
  • how options hedging works;
  • what is an options buyer and how an options buyer is different from an options seller;
  • why options income could be unlimited and risks are limited;
  • what options hedging strategies are;
  • how to buy or sell an option at a stock exchange.

The option or option contract (from Latin optio – choice or wish) is a contract, under which the option buyer acquires the right, but not the obligation, to buy or sell an asset (share, commodity or currency) by a certain price at a certain moment in future, specified in the contract.

According to the Chicago Mercantile Exchange, popularity of options grows every year by 5%. Thus, an average daily trading of the options market is around USD 4 million.

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WHAT A UNIQUE FEATURE OF OPTIONS IS

It’s all about the option value. It is fixed at the moment of its buying and stays unchanged until execution of an option. However, the options sellers run very high risks, but we will speak about it later.

Options are forward contracts that is why every options contract has the last day of its validity – the expiration day. From this perspective, options resemble futures (what futures are). Weekly, monthly, quarterly and yearly options help to plan commercial activity.

Options could be of American or European style depending on a date of their execution:

  • American options could be executed at any moment;
  • European options cannot be executed before the date of expiration.

The option holder has the right:

  • to execute the option, that is, demand from the option seller to deliver a security or commodity;
  • to sell the option to another participant;
  • to wait for expiration and get the remainder of its value.

The option seller:

  • is obliged to execute the option upon demand of the holder, that is, to deliver assets by the price specified in the option;
  • has the right to hand over the option to another participant who would assume an obligation to execute the option by the current price;
  • is obliged to ensure a higher guarantee collateral, since the seller bears the risk of an unlimited loss.

WHY OPTIONS ARE REQUIRED

The main purpose of the option is its application as an insurance (hedging) from a negative scenario in the futures market of currencies, shares and commodities.

The underlying assets for options are:

commodity futures;

currency futures;

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equity futures;

index futures.

Which means, if we deal with the option on the currency futures, the currency futures would be the underlying asset (UA) in this case.

The underlying asset price changes depending on supply and demand of traders, who wait for the UA price decrease or increase. However, their forecasts with respect to the future UA value can fail. And, in order to reduce the risk of loss, the options come to help.

Various hedging techniques will be considered closer to the end of this article.

HOW TO BUY AN OPTION ON THE EXCHANGE

To buy or sell an option is not more difficult than to deal with futures. The deal could be made through a broker. Having received your order for buying an option, the broker sends it to the exchange core.

If you send a limit order, it is posted in the order book at a specified price. The market order will be executed at the expense of offsetting orders. In order to reduce slippage of the market order, make sure that the order book is filled with offsetting orders, since some options have low liquidity.

The order book in the options market has the same structure as on futures.

Sell orders are above the current price and buy orders are below it. A guarantee collateral in the amount of the option price plus broker’s commission would be required for posting the buy order

In order to open the option short position, a higher guarantee collateral, which is several times bigger than the option value, would be required.

The open position in the option results in a variation margin, that is, the state of deposit would change depending on the option value. In order to close the long option, it is sufficient to sell it. And vice versa, in order to close the short option position, it is necessary to buy it. In order to execute the option, it is necessary to send the option execution order to the broker.

Take heed of the picture above. Si066000BW8 is a unique ticker code of a specific option. In order to have a better understanding of how options on the Moscow Exchange are coded, have a look at the code specification here: https://www.moex.com/s205.

WHAT A STRIKE IS

There are a number of options for one underlying asset, because various options display all possible prices of one and the same underlying asset. The market participant himself chooses the price by which he wants to buy the option.

For example, imagine that the Brent Oil futures price could be any within the range from USD 65 to USD 96 per barrel. The exchange breaks this whole range of possible prices down into graduation with the price pitch of USD 1. We get a price grid. Each price in this grid is called a strike. We have a grid of strikes: 65, 66, 67 … 95 and 96.

Then the exchange introduces two options – Call and Put – for each strike.

  • the Call option insures against the UA price increase;
  • the Put option insures against the UA price decrease.

Strike is an important concept, thereupon we will see how it works in more detail.

Strike is the price, at which the buyer has the right to execute the option, that is, to exchange the option into the futures contract. The option strike is fixed at the moment of buying the option and it stays unchanged during the whole option’s lifetime.

For the option holder, the strike is a pointer to the underlying asset price, at which he would like to buy the asset in future. The option buyer has the right to buy the option with any strike within the available range.

But there is a nuance. There are many strikes, but there is only one current strike.

What is a current strike?

The underlying asset price changes depending on supply or demand and always denotes the current strike.

Let us assume that if the oil price is USD 65.73, then the 66 th strike is the current one. If the oil price goes down to USD 65.49, the 65 th strike becomes the current one, and so on. That is why the current strike value is ever changing.

Let us provide a demonstrative example with the use of the Si underlying asset on the Moscow Exchange and option strikes

  • the UA price from 65876 to 66125 belongs to the 66000 strike;
  • the UA price from 66126 to 66375 belongs to the 66250 strike;
  • the UA price from 66376 to 66625 belongs to the 66500 strike, and so on.

Figuratively speaking, we can say that the underlying asset price moves the current strike along the strike grid.

What options boards are

Let us take the gold market. In fact, there are several futures with different dates of expiration in the gold forward market. And there is a set of options with various strikes for each futures.

That is why options boards are used for more convenient and easier work with options. These boards are tables where one can adjust own parameters for displaying options, for example:

  • option code;
  • option price;
  • number of open positions;
  • strike.

Let us consider an example. We take an options board for BR-2.19 oil futures on the Moscow Exchange with the execution date on January 28, 2020. 26 Call options and 26 Put options, with the price pitch between options of USD 1, are traded under this contract. A market participant selects options from the price range from USD 65 to USD 90.

For example, the current oil price is USD 75. If a market participant anticipates the price increase up to USD 80 and/or higher, he can buy the option with the BR000080BL8 code for USD 1.76. For the option holder the risk would be USD 1.76 from each contract and would stay unchanged until expiration. Another market participant also anticipates the increase, but he prefers to buy futures and to limit the risk with a stop-loss order. Major players can shift the price towards the area of accumulation of stop-losses for taking on the position. After that a major player will turn the market around and will support the further growth. Such manipulations are not dangerous for the option holder, however, the futures holder will fix his loss by stop-loss and will drop out with a negative result.

OPEN INTEREST AND OPTIONS

Open interest, which means a number of open positions between buyers and sellers, is formed in option contracts in the course of trading. Open interest is broadcast by exchanges. For example, open positions on EUR/USD options on CME look as follows:

Open interest on the Moscow Exchange could be analyzed using the options board. It is available at:
https://www.moex.com/ru/derivatives/optionsdesk.aspx.

WHAT “ IN THE MONEY ” OPTIONS ARE

According to the official terminology, options could be:

  • in the money
  • out of the money
  • at the money.

The Call option will be in the money if the underlying asset price becomes higher than the strike.

The Put option will be in the money if the underlying asset price becomes lower than the strike.

The Call option is out of the money if the underlying asset price becomes lower than the strike.

The Put option is out of the money if the underlying asset price becomes higher than the strike.

The Call and Put options are at the money if the underlying asset price becomes equal to the strike or close to it.

Options in the money bring profit to its holder. In order to fix the profit, the option holder can sell it to another market participant, in which case the variation margin turns into income.

If you never traded options and read ads about option traders who make big money, you might decide that options ensure easy money, which is not true.

Options in the money always have high value, which means that a possible loss is quite high, although it is fixed:

We can see from the table that the current strike is the 66000 level, which means that the underlying asset is traded within the 65876-66125 range. All Call options below the 65500 level are in the money, all Call options above the 66500 level are out of the money and the options within the range from 66750 to 66250 are at the money.

Example. Let us assume that we buy one 66000 Call option and its price is RUB 677 per 1 contract. If we execute the bought option we would get an open long position on the futures at the price of 66000.

This deal will have no sense, since one can just buy a futures at a current price without paying a premium for the option (a premium for the option is an amount paid by the buyer to the seller). That is why we anticipate that futures will go up and hold the option. If our forecast is correct and the futures price in the nearest couple of days would reach the 67000 level, then the bought option will get up to approximately RUB 1,266. Now we can sell the option to other market participants and get profit. If the price will not go up in the nearest couple of days or, even worse, will start to go down, then the bought option will start to lose its value.

OPTION PRICING

Factors that influence the option price:

– supply and demand;

– underlying asset price;

– time until expiration;

– volatility of the underlying asset;

– interest rate (in case of currency options);

– dividends (in case of stock options).

The option price is calculated by the stock exchange and is a theoretical price. However, in practice, the current price could insignificantly differ from the theoretical one, since traders could change the option price in the process of trading.

If the underlying asset price changes the current strike, the theoretical price is recalculated by the exchange and the remained limits are satisfied by the market maker in order to level the current price with the theoretical one.

Time is always against the option holder and the option becomes cheaper day by day. The option seller wins in this case, keeping a part of the premium.

If the option is not in the money by the date of expiration, the seller would keep the whole premium, which was paid by the buyer. If the option is deep in the money, the seller would not only pay back the whole premium, but also would have to cover, at his own expense, the profit to the option holder.

There are strategies of making money on selling the options due to the time decay. The trader sells the option, waits for the price decay and keeps the premium.

The time decay is included into the formula of determination of the theoretical price of the option. The more time there is until expiration, the more expensive the option is, and vice versa. Many options depreciate to zero by the date of expiration. This can be demonstrated by a chart in the low-volatility market.

However, there is a joke among traders: “do not sell Motherland, mother and options!” meaning high riskiness of this activity.

Why is the options selling considered to be a high risk trading?

The answer to this question could be demonstrated by the chart.

Relatively recently, namely on April 9, 2020, the Russian market was shaken by the news about sanctions. In the chart you can see the Put option on the RTS index with the 90000 strike. This strike contained an anomalously big amount of the open interest. Losses of the sellers reached 2700% from the original premium.

That is why selling naked options (“naked” means that they do not have insuring positions) is the most risky trading.

Option expiration date

Option expiration date is a date, after which the option expires and the residual value is paid back to the holder if the option is not executed or not sold to another participant.

At the options expiration date:

  1. the rights and obligations of sellers and buyers are abrogated;
  2. the guarantee collateral is released;
  3. the clearing chamber redistributes the margin between buyers and seller.

Maybe you observed strange, unconditional and strong focused movements of the futures contract prices, which are beyond the classical technical or volume analysis. Often such unexplainable movements are a result of the expiration date approach. We will demonstrate what we mean at the end of the article.

Why does it happen this way? The matter is that the option sellers can accumulate a significant negative balance in the course of their activity. And in order to avoid fixation of this loss by the options expiration, these traders tend to get rid of such options. A major option seller is capable of moving the underlying asset to the level where losses for some options are compensated by premiums for other ones. The pressure on the market stops after expiration and the price continues its natural movement on the basis of supply and demand.

OPTION LEVELS

What are option levels and how do they influence the market? Let us explain it using an example. We take option contracts on futures on the RTS index:

Strikes with a maximum open interest form option levels, which, as a rule, are support or resistance levels. However, the maximum volume of the open interest on a specific strike does not mean at all that the price will turn back from the level – in each specific situation things unfold according to an individual scenario.

Use the following formula for determining the option level:

a strike with a higher interest + weighted average price of the option contract

The weighted average price takes into account only those trades, which resulted in increase of the open interest that is why the total volume of trades is not taken into account.

Why option levels work as a support and resistance

Why do option levels render support and demonstrate resistance and who is interested in holding the price? The answer lies in distribution of the rights and obligations among the option buyers and sellers.

The options buyer has only rights and the options seller – obligations. The risk of the options buyer is limited to the buying cost, and the risk of the options seller is not limited and could result in the loss of deposit. It follows that the seller is interested in holding option levels, however, his capabilities are not known in advance. A major market maker (most probably) would hold the level, but if there is a crowd of small speculators instead of one major market maker, the price, most probably, would break the level and go further.

Let us see how option levels work using an example. We will use historical data that is why we go back to the not very distant past. We take the SiZ7 contract, traded on the Moscow Exchange, as a basis. This is a quarterly futures contract of December 2020.

We will take expiration of the August options contracts, which took place on September 17, 2020, as a base point. Note that the futures price was traded higher than the 60450 level before September 17. After expiration, the old option levels stop to work and the new levels come into force.

The calculation showed that the option resistance is at the 59300 level and support is at the 58000 level. The price started to decrease softly after the expiration. On September 1 the price broke the upper level of 59300 with the powerful downward movement and settled itself between the option levels until the next expiration on September 21, 2020.

This example clearly demonstrates the influence of option levels upon the futures market. If you have information about option levels, you will be able to understand market movements more objectively.

5 EXAMPLES OF OPTION HEDGING

As we already specified at the beginning of the article, the main purpose of options is insurance (or hedging) from unfavorable scenarios in the financial market. We will consider 5 basic examples of options hedging.

EXAMPLE 1. STOCK GROWTH STRATEGY.

An investor wants to buy a company stock at the price of RUB 150 in anticipation of growth. In order to insure himself from the stock value decrease, the investor buys the Put option at a current strike. If the stock continues to grow, the option loss will be fixed and equal to the cost of buying. If the stock starts to go down, the bought option will start to bring profit to the investor after passing the break-even point. Under this strategy, the loss of the investor is limited and the profit is unlimited.

EXAMPLE 2. BEARISH STRATEGY. LONG BEAR PUT SPREAD.

The investor anticipates that the market would go down. This strategy envisages selling a Put option and buying a Put option with a higher strike. In case of using this strategy, both profit and loss of the investor will be limited.

EXAMPLE 3. LONG STRADDLE.

Long straddle envisages simultaneous buying of the Call and Put options at one strike. Such a combination allows making money on volatility. Irrespective of where the market would go, the bought options will ensure profit. In the event of absence of volatility, the loss of the investor will be limited by the paid premiums.

EXAMPLE 4. LONG STRANGLE.

EXAMPLE 5. CURRENCY RISK HEDGING.

Options, as well as futures, allow currency risk hedging. Insurance from the fall in the exchange rate of a foreign currency envisages buying the foreign currency and buying a Put option with the current strike.

  • If the foreign currency becomes more expensive, the loss on options will be limited.
  • If the foreign currency becomes cheaper, the options (after passing the break-even point) will bring profit to the holder.

As opposed to the futures hedging, which merely levels the risk balance, the options hedging can bring profit to the trader.

The opposite is true in this example. The investor keeps the national currency and buys the Call option with the current strike for hedging the foreign currency appreciation.

  • In case of the foreign currency appreciation, the option (after passing the break-even point) will bring profit.
  • In the event of the national currency strengthening, the option loss is limited by the cost of acquisition.

CONCLUSION

In conclusion we will show you a situation that took place in the Russian market at the moment when this article was being written. This article clearly demonstrates:

– how options expiration can influence the market;

– how market participants make mistakes;

– how patterns of technical analysis break down.

So, November 15, 2020, is the day of expiration of November options. The SiZ8 futures contract for the USD/RUB pair formed the pennant pattern in the chart – a classical model of technical analysis of continuation of the trend.

Let us analyze activity inside the triangle. For convenience we present a range chart as of November 13, which allows us elimination of the market noise and detection of important areas of accumulation of the large position.

There are two indicators in the presented chart – Cluster Search and Open Interest. Cluster Search searches for clusters with the volume of more than 2000 contracts with the bid-ask overweight of 80% (blue squares). Such settings of the Cluster Search indicator allow searching for clusters, in which the purchase volume exceeds the sales volume by 80% with the total purchase volume being not less than 2000 contracts.

The chart in the RangeUS format with 0/75/50 settings filters out the market noise and clearly shows us horizontal ranges and trends.

The Open Interest indicator visualizes a change in the open interest by the instrument. The open interest value constituted 2 495 294 at the moment of the session opening and it increased by 104 824 by the session closing.

Combination of the RangeUS chart and Open Interest and Cluster Search indicators allow determination of areas, in which positions are gained.

Indicator readings could be interpreted as gaining long positions by an active major market player in the range of 67950-68220.

By the end of the session the price closed at the 68477 level. Now have a look at what happened the next day.

One day before the options expiration the price lost more than 1000 points and reached the 67320 level by the end of the session on November 14, 2020. The open interest value decreased by 241 080 in comparison to the previous session. We believe that the market participants closed their long positions with massive sales in a hurry.

If we look at the options board on the Moscow Exchange, we will see that a major volume was formed on 66000, 66500 and 67000 Call option strikes and the open interest in total exceeded 60 thousand of contracts. The average weighted price of this volume pointed at the 67500 level.

A rough estimate shows that if the price is 68500, the seller’s loss would be approximately RUB 30 million (60000/2*1000). We do not know who the options seller is and whether it is one participant or several, but his/their impact on the market is evident.

Take this into account in your trading, be extremely careful on the eve of expirations and do not tolerate drawdowns. Happy trading.

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