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Understanding the Basic Language of Option Trading
Wed, 22 Feb 2012 13:33:48 +0000by J.W. Jones
“Anticipate the difficult by managing the easy.”
~ Lao Tzu ~
The peculiar vocabulary and concepts inhabiting an options trader's thoughts are often the source of confusion to visitors to my world. I have often pondered that learning to understand options is a lot like learning a foreign language. When you arrive in the country whose language you seek to learn, you need a functional vocabulary immediately.
In order to be able to understand my world, I thought it would be helpful to discuss a bit of my language since it is helpful to grasp a few basics. I want to touch on some of the basic concepts necessary to form the basis for a functional language we can use to communicate concepts underlying a rational (hopefully) thought process leading to trade design and management.
In ruminations to come we will return to these fundamental concepts and begin to understand their function in the dynamic world of an options trader. The nuances of their specific structures are beyond the scope of this blog. We will return to consider these factors in virtually every trade because they re-appear each and every day in my world. For today, just shake their hands and remember their names.
One point not often discussed is the way in which options are priced. The quoted option price is in reality the sum of two separate components. These are referred to as the intrinsic and the extrinsic portions of the premium. I think of these as steak and sizzle respectively.
As I type, AAPL has closed at around $395. The January 390 call has 41 days to expiration and could have been bought for $18.90. Of this sum, $5 represents intrinsic premium and $13.90 represents extrinsic or time premium.
This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility. We will get to a discussion of implied volatility in next week's missive.
The intrinsic premium is subject to change solely due to changes in the price of the underlying security. There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.
The situation with the extrinsic premium is quite different. The value changes not only with time to expiration but also with the constantly changing implied volatility. It is for this reason that an option trader must be very careful with this extrinsic component. Depending on the specific option under consideration, extrinsic premium may represent all, a portion, or a trivial amount of the entirety of the option premium.
Another important concept is that of the “moneyness” of an option. An individual option can be classified in one of three categories of “moneyness:”
- At-the-money
- In-the-money
- Out-of-the money
At-the-money options by definition consist of a single strike price. Both in-the-money and out-of-the-money strikes usually contain several individual strikes within their groups.
In our example of AAPL, the at-the-money strike is the 395 strike. The in-the-money strikes consist of all calls with strike prices below 395 and all puts with strike prices above 395. The out-of -the-money strikes consist of all calls above the 395 strike and all puts below the 395 strike.
Obviously since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.
The reason for taking the time to discuss in some detail this classification of “moneyness” is that there are important reliable characteristics of each type of option.
At-the-money options characteristically contain the absolute greatest dollar amount of extrinsic premium. In-the-money options have the least amount of extrinsic premium. Out-of-the-money options consist entirely of extrinsic premium, and therefore only contain sizzle . . . no steak can be found there.
Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different “moneyness” to achieve trades with the best probability of success and the highest risk/reward scenarios.
For example, buying an in-the-money call and selling an at-the-money call gives birth to a call debit spread, a high probability trade structure for the trader who is bullish in the underlying.
Next week we will cover the stealth concept of option trading, implied volatility. Failure to understand the impact of this variable is the most common cause of beginning options traders' failure to succeed.
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This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.
The Long-Term Fundamental Case for Gold
Wed, 22 Feb 2012 01:21:26 +0000by Chris Vermeulen
The Long-Term Fundamental Case for Gold
“No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.”
~ United States Constitution, Excerpt from Article 1, Section 10 ~
A quick glance at most of the headlines over the weekend and the primary focus seemed to be either calling a near term top in domestic equity indices or a focus on the Greek debt situation. Why is anyone even paying attention to what is going on over there? Until the ISDA declares a default where the underlying Credit Default Swaps (CDS) are triggered, it is all just noise.
The ECB has broken the rule of law by placing itself as the senior creditor ahead of private creditors, the Greek government is trying to pass retroactive legislation to trap private sector creditors holding out of the PSI, and the leader of Greece was not even elected by the people of Greece - how much more manipulation and insanity do we need to monitor?
Similar to the price action since 2008, central banks around the world control everything from financial markets to the ascent of political leaders. These same political leaders help central bankers and planners control policy and decision making at the highest government levels in Europe and around the world. It would seem that the United States should change the motto from “We the People” to “We the Bankers.”
However, there is one particular asset class that even the central bankers have a hard time controlling. While they can impact short term price action through direct currency manipulation initiatives, in the longer-term gold is likely to move in only one direction - higher.
The price action on Tuesday reminded market participants that actions such as the Greek bailout come at a cost. Quantitative easing and/or printing money (depending on what one wishes to call the practice of producing fiat currency out of thin air) has a direct impact on the price of gold.
Many financial pundits argue that gold has no utility, but what they fail to recognize is that gold is the senior currency to all other fiat currencies. Silver is also a form of currency and is senior to all other fiat currencies as well. While one can draw the utility of gold into question, the idea that gold is the senior most currency to all other fiat currencies is not new.
The Constitution of the United States of America, which is over 200 years old, refers to gold and silver as forms of payment. Looking back thousands of years the Romans used gold coins as a form of currency. The idea that gold and silver are currencies is certainly not a grandiose thought or a stretch of historical concept. Trying to depict gold as a worthless asset depends on your view and consideration of fiat currency.
There are those that would argue that the Federal Reserve of the United States is not actively manipulating economic conditions domestically or abroad. For those that view gold as a poor investment or hedge against currency devaluation need to consider the charts illustrated below. The chart below was produced by Thomas Gresham of Gresham's Law.
Total Asset Growth of the Federal Reserve System - 1915 – 2012
It is rather obvious by looking at this chart that the Federal Reserve has actively sought to enter domestic and foreign financial markets. The surge in balance sheet assets serves to prove how far the Federal Reserve Bank is willing to go to maintain markets which seemingly are only allowed to move higher over time.
This chart is bearish for nearly any form of paper backed assets. The above referenced chart is long-term bearish for the Dollar and Treasuries and long-term bullish for physical gold and silver. As the Federal Reserve continues to debase the U.S. Dollar in concert with other central banks' monetary easing programs, gold and silver prices over time are destined to move higher in virtually every form of fiat currency.
During the same time frame that the Federal Reserve has seen its balance sheet grow exponentially, the rapid rise of M2 money supply is staggering. The long term chart of M2 is compared to gold futures in the charts presented below.
M2 Money Stock
Gold Futures Monthly Chart
It is rather obvious what has happened to the price of gold as the M2 money supply has grown. The idea that the Federal Reserve has not already destroyed a significant amount of the purchasing power of the Dollar can easily be refuted by the two charts shown above.
In the short-term, gold and silver could suffer from a pullback, but in the intermediate to longer term it is unlikely that we have seen the highs of this bull market for either metal. As long as central banks around the world continue to print money and expand their balance sheets gold and silver will remain in a long-term bull market. The daily chart of gold futures is presented below.
Gold Futures Daily Chart
As can be seen above, it is not out of the question that we could see gold pullback to test one of the key moving averages in coming days/weeks. However, I expect the key support area to hold in the event of a sharp selloff. Ultimately, I expect to see a breakout over the resistance zone in the days/weeks ahead. However, I would not be surprised to see gold consolidate or work marginally lower from current prices before breaking out to the upside. Right now the primary threat in this fledgling gold rally is a short-term spike higher in the U.S. Dollar. The primary catalyst which could drive a flight to the Dollar involves the sovereign debt situation in Greece and the Eurozone as a whole.
While the short-term price action may be bearish, the intermediate to longer term time frames are quite bullish for metals as central banks will continue to race to debase their currencies. Quantitative easing in the U.S. and around the world will become pervasive and gold prices could potentially soar in value. The data from the Federal Reserve Bank itself suggests that they are indeed increasing the money supply. As time has passed, the money supply and gold have seemingly grown in lockstep with one another. Surely inquiring minds do not consider this mutual relationship between gold and the money supply to be purely coincidental.
As further evidence that the Federal Reserve continues to use quantitative easing to manipulate asset prices through direct entry into financial markets, a chart of the velocity of M2 clearly depicts that the velocity of money is declining. I am not an expert regarding macroeconomic data, but if the velocity of money is declining to 1960's levels would it be a stretch to say that we may be going through a period of stagflation? The chart below illustrates the Velocity of M2 Money Stock courtesy of the St. Louis Federal Reserve Bank.
Velocity of M2 Money Stock
For those unfamiliar with the term velocity of money, it is simply the rate of turnover in the overall money supply. The velocity of M2 is expressed as the number of times that a Dollar is used to purchase final goods or services which are included in the total gross domestic product.
Conclusion
The short term technical picture in gold is a bit suspect due to overhead resistance and recent U.S. Dollar strength. However, the longer term macro factors that impact the value of the U.S. Dollar and precious metals are all telling us the same thing.
As time wears on and central banks do even more to prop up the broader economy and failing financial institutions, it is without question in my mind that gold and silver will both benefit handsomely from these decisions being made by central bankers from around the world.
Ultimately, I am very bullish of gold and silver in the intermediate to longer-term, but in the immediate short-term frame gold could consolidate or pullback before breaking out to the upside.
By: Chris Vermeulen - Free Weekly ETF Reports & Analysis: www.GoldAndOilGuy.com
Co-Author: JW Jones - Free Weekly Options Reports & Analysis: www.Optionnacci.com
This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.
Feb 15th- Did the SP 500 just peak at 1356?
Wed, 15 Feb 2012 22:51:39 +0000by admin
This is somewhat of a things that make you go hmmmmmm exercise, but lets examine this 1356 number for a second here. The SP 500 hit 1356 today and put on the brakes and reversed down to 1341 in a possible terminal top move.
1356 actually has fibonacci relationships. If we take the last major rally which was from the Summer 2010 lows:
1010-1370 (May 2011 highs)
360 points
.786 of 360 is 283 points
Take 283, add it to the 1074 October lows…. you got 1356/57
That would mean this last rally so far is .786 of the 2010-11 rally.
Also, 1356/57 is right in my 1352-1376 pivot ranges for a Major 3 top as well
Evidence is mounting for a good sized correction here is my point.
Possible count, though many will argue not valid:
Wave 1- 666 to 1221- 555 points
Wave 2- 1221-1010- 211 points, .38% of 1
Wave 3- 1010-1370 360 points, .61% of 1
Wave 4- 1370-1074- 296 points… 38% of 1-3 (A bit more than 38%)
Wave 5- 1074-1356 .786 of 3
Only rule violation here is Wave 4 would have delved into wave 1, which is a no-no for most E wavers. However, I would argue that 4 often does delve into the wave 1 arena and legitimately, but that is a topic for another article.
Nonetheless… pay attention to the fibonacci relationships… if anything they may be warning of 1356 as an interim high and top with correction starting. This would either be a 4th wave down with the 5th and final wave up left… or we topped at 1356. A drop below 1337 will confirm a correction at minimum to 1310 and then 1295 ranges.
Just food for thought…we have been lightening our positions and raising stops at my ATP trading service. If you’d like to have regular updates on the SP 500, Gold and Silver so you can benefit from major pivots ahead of the crowd, check us out at www.markettrendforecast.com for a coupon offer.
Two Short-Term Scenarios for the S&P 500 Index
Mon, 13 Feb 2012 14:19:44 +0000by Chris Vermeulen
For the first time since the last week of December of 2011, the S&P 500 Index closed lower on the weekly chart. Recently I have been discussing the overbought nature of stocks based on a variety of indicators. However, the real question that should be asked is whether last week was just a short term event or if we see sustained selling in coming weeks.
The issues occurring in Greece spooked the markets somewhat on Friday as Eurozone fears continue to permeate in the mindset of traders. The U.S. Dollar Index is the real driver regarding risk in the near and intermediate term future. If the Dollar is strong, market participants will likely reduce risk. However a weakening Dollar will be a risk-on type of trading event which could lead to an extended rally in equities, precious metals, and oil.
Friday marked an important day for the U.S. Dollar Index futures as for the first time in several weeks the Dollar held higher prices into a daily close. The U.S. Dollar appears to have carved out a daily swing low on the daily chart from Friday. Furthermore, the potential for a weekly swing low at the end of this week remains quite possible. The chart below illustrates how the 100 period simple moving average has offered short term support for the past few weeks.
U.S. Dollar Index Futures Daily Chart
I would also point out that the MACD is starting to converge which is a bullish signal and the full stochastics are also demonstrating a cross on the daily time frame. As long as the 100 period moving average holds price, a rally is likely in the U.S. Dollar Index in coming weeks.
Should that rally play out, it will likely push risk assets lower. My primary target for the S&P 500 would be around the 1,300 - 1,310 price range if the selloff transpires. It is important to note that headlines coming out of Europe could derail this analysis in short order.
Assuming that a selloff in the S&P 500 occurs it will present a difficult trading environment for market participants. Market participants are going to be in a tough position around the 1,300 price level. A rally from 1,300 could serve to test the 2011 highs. In contrast, a confirmed breakdown of the 1,300 price level could initiate a more significant selloff towards the 1,250 area.
Should price move towards the 1,300 price level the bulls and bears will be battling it out for intermediate control of price action. This is my preferred scenario for the short-term time frame, but I would only give it about a 60% chance of success at this point in time. We simply need more time to see how price action behaves the first few session of the forthcoming week.
S&P 500 Index Bearish Scenario
The alternate scenario which has about a 40% chance of success would be a sharp rally higher which likely would be produced by news coming out of Greece and/or the Eurozone that pushes the Euro higher. Right now risk is high due to the sensitivity of price to headline risk. With that said, the bullish alternative scenario is shown below.
S&P 500 Index Bullish Scenario
At this point we just do not have enough price information to give us clarity regarding the most probable outcome. The price action in the Euro is going to drive price action for the S&P 500 and other risk assets in weeks ahead.
Anything is possible in the short-term, but I have to give a slight edge to the bears simply based on the price action Friday and the fact that almost every indicator I follow is screaming that the equities market is severely overbought. The price action this week should be telling. Headline risk is excruciatingly high, trade safely in the coming week!
By: Chris Vermeulen - Free Weekly ETF Reports & Analysis: www.GoldAndOilGuy.com
Co-Author: JW Jones - Free Weekly Options Reports & Analysis: www.Optionnacci.com
This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.
How to Find the Most Active and Liquid Options for Trading
Mon, 13 Feb 2012 14:11:42 +0000by J.W. Jones
“Ah, to think how thin the veil that lies between the pain of Hell and Paradise.”
– George William Russell -
Welcome back to the musings from the desk of an options trader. I wanted to discuss some important facts readers should keep in mind when considering an options trade. There are lots of ways to make errors in my world, and I think I have made most of them. I suggest you at least consider the points I will discuss- each has cost me a lot to learn and I would like to save you the expense and frustration. After all, errors are inevitable, so at least make ones I have not warned you about.
Be forewarned that there is a voluminous set of specific data that derives from the various pricing parameters of options. The several data points for stock trading only require inputs of price and volume. Option datasets as a necessity include parameters of volume, implied volatility, and time to expiration. Each of these datasets exists for the various strike prices in each and every of the various expiration months available for trading. The data compilations are huge.
The magnitude of the data available is overwhelming in its entirety. It is for this reason that the options trader must approach each trade with a specific price, time, and implied volatility hypothesis.
One of the most important considerations with options is that of liquidity. Option volumes can vary dramatically between the various underlyings available. Consider the case of AAPL options which have trading volumes in excess of several millions of dollars each and every day; this is to be contrasted to the numerous underlying stocks having thinly traded options that trade only occasionally and by appointment only.
I believe that it is important to restrict your focus to stocks having options that reliably trade consistently and in significant volume. Buying and selling thinly traded options leaves you at significant risk of suffering from “Hotel California” syndrome- “you can check out any time you like, but you can never leave.”
It may be possible to negotiate a reasonable price to enter a position, but if you need to exit, you can expect to leave a pound or more of flesh on the table. Only bad things typically happen when trading these Kate Moss thin series; I strongly suggest that you avoid them like the plague.
Another benefit to using liquid series for trading is the fact that these issues generally have minimal slippage. It was not that long ago that a tight bid-ask spread was considered to be anything under 25¢. In the current environment of options trading, quotes in actively traded series routinely display spreads of 2-3¢. This is where you want to live and work.
The drag produced by egregious spreads dramatically increases your trading “friction” and results in leaving behind potential profits to fund the market maker's ski chalet in Aspen.
These missives are directed at those traders beginning to visit my world of options. As new visitors, I would like to see you test the waters gently in order to determine if you would like to become our new neighbors. While a host of proprietary sites exist and provide invaluable data to the experienced trader, there is less discussion of the free sites for those of you taking our introductory tour.
As a suggestion, I find the free resources of the Chicago Board Options Exchange (CBOE) to be excellent. Today's discussion has focused primarily on selecting only those options which are most active and liquid for trading.
An excellent place to start in order to find the most liquid options is the list of options available for trading the weekly option series. This diverse group represents a small portion of the entire options universe, but has been selected to include only the most actively traded series.
I will get to specific discussions of the peculiarities of weekly options in future postings. For now suffice it to say that the series included in the weeklies are the most liquid and the place to which the aspiring option trader should direct his attention. The list of underlyings which have weekly options can be accessed for free as a downloadable Excel file Here.
The tour of my world will continue next week, until then trade safely!
This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.
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