Tag: Peter Knight Advisor trading

But with options on futures there are more dimensions, or forces, acting on the price or premium of the option.

There are metrics to measure each of these different forces impacts on the premium of an option. These metrics are often referred to by their Greek letter, and collectively known as “the Greeks.”

Theta

Delta and gamma measure the effect of price movement of the underlying on the option premium. As we demonstrated in previous videos, both are dynamic as to the option being out-the-money (OTM), at-the-money (ATM), or in-the-money (ITM).

Now we will investigate the effects of time on an option. The Greek that measures an option’s sensitivity to time is theta. Theta is usually expressed as a negative number. Be careful to always make sure what time is referenced in the model you are using.

For example, if the value of an option is 7.50 and the option has a theta of .02. After one day, the option’s value will be 7.48, 2 days 7.46. etc.

Theta is highest for at-the-money (ATM) options and lower the further out-the-money or in-the-money the option is. The absolute value of theta of an option that is at- or near-the-money rises as the option approaches expiration. Theta for an option that is deep in- or out- the-money falls as the option approaches expiration.

In the prior example, theta was a constant value of .02 for all three days. In reality, the theta loss increases as the option approaches expiration.

Example

In March, a September option will have a daily time decay of .02. By August, the daily decay will increase to .06 and the option more quickly decays.

Time decay is not linear, and moreover, for ATM strikes decay continually accelerates into option expiration.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Options Gamma

But with options on futures there are more dimension, or forces, acting on the price or premium of the option.

There are metrics to measure each of these different forces impacts on the premium of an options. These metrics are often referred to by their Greek letter and collectively known as the Greeks.

Gamma

We discussed previously that delta is the change in the options price or premium due to the change in the underlying futures contract price.

We will now discuss how delta itself changes with a change in the underlying futures price. This is known as gamma. Think of gamma as the delta of the delta.

Look at it a different way; you are driving a car at 30 miles per hour (mph). If you increase your speed to 40 mph, you have accelerated by 10 miles per hour. If you think of speed as your delta, then the change in your speed is your gamma. In other words, gamma is your acceleration.

Understanding Gamma Movements

Gamma is usually expressed as a change in the delta per one point change in the price of the underlying.

For example, if the futures price is 200, a 220 call has a delta of 30 and a gamma of 2.

If the futures price increases to 201, the delta is now 32. Conversely, if the futures price decreased to 199, the delta is 28.

Just like delta, gamma is dynamic. It is the highest when the underlying price is near the option’s strike price.

As the underlying moves away from the strike price, the gamma decreases. As the underlying moves towards the strike price, the gamma increases.

At the money options have the highest gamma, because their deltas are the most sensitive to underlying price changes.

Calculating Gamma

Gamma is the difference in delta divided by the change in underlying price.

You have an underlying futures contract at 200 and the strike is 200. The options delta is 50 and the options gamma is 3. If the futures price moves to 201, the options delta is changes to 53. If the futures price moves down to 199, the options delta is 47.

Across the two-point underlying futures contract move, the delta changed by 6.

If you are going to trade options, Gamma is a measurement you will want to study.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Options Delta

But with options on futures there are more dimensions, or forces, acting on the price or premium of the option.

There are metrics to measure each of these different impacts on the premium of an options. These metrics are often referred to by their Greek letter symbols and collectively as “the greeks.”

Let’s look at one of the most commonly used Greeks – Delta.

Delta is the change in the option’s price or premium due to the change in the Underlying futures price.

It is some portion of the movement of the underlying. Delta is a percentage measure.

Assume, we have a call option priced at 1.00 and it has a .50 delta. This means whatever the change of the underlying future is, the option will move by 50% of that change. Our underlying futures product moved from 96 to 97.5. This is a 1.5 point move. So, our option’s premium will now change by 50% of 1.5 or .75. Making the option’s new price 1.75

Calls always have positive delta between 0 and 1.00, while puts always have negative delta between 0 and -1.00.

The delta of a futures contract is 1.00.

Traders usually refer to the delta without the decimal point. So, a .40 delta is commonly referred to as a 40 delta.

Being Long a call will result in positive Delta; being short a call results in negative Delta. Conversely, being Long a put results in negative Delta; being short a put results in positive Delta. The absolute value of the Delta also tells the approximate probability that the option will finish in-the-money.

For example, if the option has a delta of 20 it suggests it has a 20% chance of finishing in-the-money. A delta of 50 suggests it has a 50-50 chance of finishing in-the-money.

If an options delta is less than 50 it is said to be out of the-money. If the delta is greater than 50 the option is said to be in-the-money. If the delta is equal or close to 50 the option is said to be at-the-money.

The delta is used in calculating hedge ratios to establish a neutral or delta hedged position using the underlying futures. Let’s say we sold 8 call options that have a 25 delta, we have a delta position of -200. To be delta neutral, we need to buy 2 underlying Futures contract.

Delta is dynamic and changes with movement in the underlying. That means delta neutral ratios and other hedge ratios using options are also dynamic and change too.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Option Collars

Introduction to Collaring a position (3:29)

Long or short positions in any liquid market can be collared, Collars define your risk on the trade and for the duration of the trading period without wasting investment capital on net purchases of option time premium. If you’d like me to walk you through how we collar a position contact me.

Explaining Call Options (Short and Long)
Explaining Put Options (Short and Long)
Videos, setting up collar trades in S&P and Gold

Summary of collaring a long position

Write the call at 105 (profit objective) collecting option time premium
Long the futures at 100
Purchase a put at 95 using the collected premium from the 105 call write

Example of collaring a long position

A collar spread consists of a long futures contract, a short call and a long put. The call and put are different strikes. But have the same expiration and the same underlying futures contract.

Traders will collar a futures contract to protect against downside risk of the futures contract. The long-put leg will protect against downside market movements while the premium received from shorting the call will help finance the purchase of the put.

A collar strategy is used when a trader has a long position in the underlying market and wants to protect that position from downward market movement. Executing a collar strategy will cover downside risk but cap the upside potential.

For example, in June, a trader bought a December futures contract for $100. In July, the future is still trading at $100. The trader still believes the market will move up before expiration, but for the next month, he is worried about the downside and does not see dramatic upside potential.

He can manage his risk by buying an out-of-the-money put financed by selling an out-of-the-money call.

He buys the August 95 put for $4 and sells the August 105 call for $4. The spread’s premium is zero.

First, look at the payoff profile for the December future. We can see the unlimited upside potential. Buying the 95 put mitigates the downside risk and the maximum loss for the position is $5.

The dotted area shows the protection provided by the put. Selling the 105 call limits the upside potential to $5 and the dotted area shows the foregone profit from shorting the call. We will look at three different market scenarios for the end of August. One with the underlying market below 95 dollars, one above 105 and the third in the middle.

It is the end of August and our options have expired. If the futures ended at 92, the 105 call expires worthless and will not be exercised. The 95 put is in-the-money. Our trader exercises his put, thereby selling his future at 95 thus taking himself out of the market.

Without the put, the trader would have lost $8 on his futures contract. By having the 95, 105 collar, his loss was limited to $5.

If the futures ended at 108, the 95 put expires worthless and will not be exercised. The 105 call is in-the-money. Our trader is obligated to sell his future at 105 to the call owner. Since the original future was delivered to the call owner, our trader is out of the market.

Without being short the call, the trader would have made $8 on his futures contract. By having the collar, his profit is limited to $5.

If the futures ended at 100, both the 95 put and the 105 call expire worthless and will not be exercised.

Since neither option was exercised, the trader still holds the original future. Had he not utilized the collar, his position would be the same, namely long one future.

As we have discussed, if there are significant downward or upward market movements, either option will be exercised. Our trader would need to reevaluate his view of the market and decide on re-initiating a futures position.

Collar spreads allow traders to express an opinion about the market in a defined way – allowing for known maximum profit and loss ranges.

Collaring a short position

Long the call 102, purchased purchased with premium collected on the put

Short the futures 100

Write the put at 98, the profit objective and collect premium

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Option Bear Spread

A bear spread consists of a buy leg and a sell leg of different strikes for the same expiration and same underlying contract. This strategy will pay off in a falling market, also known as a bear market, that is why it is referred to as a bear spread.

Bear spreads can be constructed from either going long a put spread or short a call spread.

Put Bear Spreads

A trader believes that the market will have a moderate drop before the options expire. If the underlying market was trading at 100, he would buy a 95 put for $3 and sell the 90 put for $2.

By selling the 90 put, he receives a premium which offsets the cost of the 95 leg. The total cost of the spread is $1. The breakeven point for the spread is 94: the 95 strike minus the cost of the spread.

The best-case scenario is if the market finishes at or below 90. Because the 95-90 put spread will pay off $5. This is the maximum payoff for the spread, regardless where the underlying finishes. If we subtract the $1 cost of the spread, the total profit for the trade will be $4

Assume the underlying finished at 87. The 95 put will pay the trader $8, but he will need to payout $3 on the 90 put. If the market finishes at 70, the 95 put will pay the trader $25, but he will need to payout $20 on the 90 put.

The worst-case scenario is if the market finishes at or above 95. Because both the 95 and 90 put expire out-of-the-money and are therefore worthless. So, the trader loses the full cost of the spread, $1. If the trader purchased only the 95 put at $3, his loss would be $3 versus $1.

If the underlying finishes at 92.5, the long 95 put will be worth $2.50 and the short 90 put expires worthless. The trader’s payout of $2.50 minus the $1 cost of the spread gives him $1.50 profit.

If the trader bought only the 95 put, his payout would still be $2.50, but that is less than the $3 he would have paid for the 95 put alone.

Call Bear Spreads

Selling a call is another way to be bearish on the market by allowing you to collect a premium that you keep if the underlying futures finish at or below the strike price.

Instead of buying the 95-90 put spread, we can sell the 90-95 call spread. This would entail selling the 90 call and buying the 95 call, which would result in a $4 credit with the underlying future trading at 100.

The breakeven point for this spread is 94: the 90 strike plus the spread credit of $4. This is the same breakeven point as the put bear spread.

If the market finishes below 90, the calls expire worthless. Therefore, the trader keeps the $4 he received by selling the call spread.

If the market finishes at 97, the 90 call is worth $7 and the 95 call is worth $2 . Therefore, the call spread is worth $5 dollars. The trader received $4 and must now payout $5, resulting in a $1 loss.

If the market finishes at 92.5, the 90 call is worth $2.50. The 95 call expires worthless. So, the trader must pay out $2.50 from his $4 credit. Resulting in a $1.50 profit.

These scenarios have the same outcome whether we sell a call spread or buy a put spread to create a bearish position. Traders still want the market to below the high strike of the spread.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Option Bull Spread

A bull spread consists of a buy leg and a sell leg of different strikes for the same expiration and same underlying contract.

This strategy will pay off in a rising market, also known as a bull market, that is why it is referred to as a bull spread.

Bull spreads can be constructed from either going long a call spread or going short a put spread.

Call Bull Spreads

A trader believes that the market will have a moderate rise before the options expire.

If the underlying market was trading at 100, he would buy a 105 call for $3 and sell the 110 call for $2. By selling the 110 call, he receives a premium, which offsets the cost of the 105 leg. The total cost of the spread is $1. The breakeven point for the spread is 106. This is the cost of the spread plus the 105 strike.

The best-case scenario is if the market finishes at or above 110 because the 105-110 call spread will pay off $5. This is the maximum payoff for the spread, regardless of where the underlying finishes. If we subtract the $1 cost of the spread, the total profit for the trade will be $4.

Assume the underlying finished at 113. The 105 call will pay the trader $8, but he will need to payout $3 on the 110 call. Another example, if the market finishes at 130, the 105 call will pay the trader $25, but he will need to payout $20 on the 110 call.

The worst-case scenario is if the market finishes at or below 105. Because both the 105 and 110 call expire out-of-the-money and are therefore worthless. The trader loses the full cost of the spread, $1.

If the trader had purchased only the 105 call at $3, his loss would be $3 versus $1.

If the underlying finishes at 107.5, the long 105 call will be worth $2.50 and the short 110 call expires worthless. The trader’s payout of $2.50 minus the $1 cost of the spread gives him $1.50 profit.

If the trader had bought only the 105 call, his payout would still be $2.50, but that is less than the $3 he would have paid for the 105 call alone.

Put Bull Spreads

Bull spreads can also be constructed from selling a put spread.

Selling a put allows you to collect a premium that you can keep if the underlying futures contract finishes at or above the strike price.

Instead of buying the 105-110 call spread, we can sell the 110-105 put spread. This would entail selling the 110 puts and buying the 105 puts which would result in a $4 credit with the underlying future trading at 100

The breakeven point for the spread is 106, the 110 strike minus the spread credit of $4. This is the same breakeven point as the call bull spread.

If the market finishes above 110, the puts expire worthless. Therefore, the trader keeps the $4 he received by selling the put.

If the market finishes at 103, the 110 put is worth $7 and the 105 put is worth $2. Therefore, the put spread is worth $5 dollars. The trader received $4, and must now payout $5, resulting in a $1 loss.

If the market finishes at 107.5, the 110 put is worth $2.50 and the 105 put expires worthless. The trader must pay out $2.50 from his $4 credit. Resulting in a $1.50 profit.

We can see in this chart, that these three scenarios have the same outcome whether we buy a call spread or sell a put spread to create a bullish position. Traders still want the market to finish above the high strike of the spread.

Bull spreads are a commonly used and valuable options strategy.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Options Education Homepage

Trading Option Calendar Spreads

Trading Option Calendar Spreads

Being long a calendar spread consists of a selling an option in a near-term expiration month and buying an option in a longer-term expiration month. The options are both calls or puts, have the same strike price and the same contract. There are always exceptions to this.

One reason to buy a calendar spread — also referred to as a horizontal spread and a time spread — is because of its low-risk and profit potential from the passage of time. This may be due to known events, such as an economic report or an election, that you feel will not move the market as much as anticipated.

Let’s look at an example.

How an option calendar spread works – an example

A trader believes that the market will be very quiet and stable until after September expiration, when she believes that the market will rally tremendously.

She could just buy a December call. The December call premium, however, will be expensive due to the amount of time left in that option.

She can offset some of that premium by selling a shorter-term call. This is referred to as buying the calendar spread: Sell 1 September 2440 call and buy 1 December 2440 call for a net premium of 33.75.

In the best-case scenario, the market stays stable until after September expiration.

Let’s look at a few possibilities.

Exploring the possible outcomes in September

It’s now September and the underlying futures have fallen dramatically to 2000. The trader’s short call expires worthless – allowing her to keep the premium collected from the short leg of the spread. She still is long the December call, but the value has decreased due to the market drop.

Her maximum loss is only 33.75 – the initial cost of the spread. Had she purchased the December call only, the loss would have been 70.50.

Conversely, if the market rose to 3000 before September expiration, her short September call would be worth 560.00, and her long December call would be trading close to parity at 560.00. The spread is worth zero, and she is out the premium of 33.75. In this case, had she purchased the December call only, it would have been very profitable.

Say we’re at September expiration, and the futures prices have not moved. In this case, the September call expires worthless. The December call is at the money with three months remaining. It still would be worth about 50.00 – minus the spread cost of 33.75, netting the trader a profit of 16.25 if she sold the December call, thus closing out her position.

Possible outcomes at December expiration

Following her initial instinct, she keeps the December call, hoping for a rally. Come December, let’s look at the different scenarios.

If the underlying future dropped to 2000, the December call expires worthless. She would net lose the 33.75 from the spread versus losing the 70.50 premium had she bought the December call alone.

This also would be the case if the futures didn’t move and stayed around 2400. She would lose 33.75 on the spread versus the 70.50 had she bought the December call alone.

We had said the best-case scenario would be the market stabilizing until after the September expiration. If futures rose to 3000, the December call would be worth 560, Less the spread cost of 33.75, this nets her a gain of 526.75.

Conclusion

As we’ve seen, the trader can design a spread position that minimizes her loss potential while leaving open the possibility of tremendous profit.

Another trader may sell the calendar spread if they feel the underlying will have dramatic moves in the near term and stabilize on a longer time horizon.

Traders may have a complex view of future market activity and implied volatility.

Calendar spreads are one tool for traders to express their views within a certain timeframe.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Option Ratio Spreads

Another commonly traded strategy is the ratio spread. A ratio spread consists of long and short options, the quantities of which are in simple mathematical ratios such as 2 to 1 or 3 to 2. Traders will refer to these spreads as a 1 by 2, or 2 by 3.

Ratio spreads generally consist of all calls or all puts, with the same expiration and the same product. There certainly can be exceptions to this.

How the spreads are structured

These are not just random combinations of strikes. They are frequently a function of the deltas of the options in the spread. For example, a trader may want to buy upside exposure to the market. The trader will buy two of the 23 delta calls and sell one – 46 delta call to help finance the purchase.

The 375 strike has a 46 delta. The 405 strike has a 23 delta. The 405 option will need to be far enough in the money to overcome the loss from the 375 option. Therefore, the market will need to have a considerable upward move.

Examining the three instruments involved

Because this trade consists of three separate instruments, let’s look at each of them. Looking at te short 375 strike first, the payoff for that leg will look like a short call position.

Profit earning

Now let’s look at the 405 strike, these options both will have a long call payoff. The first 405 call that the traders bought will cap the loss on the 375 call that they sold.

As the market moves higher, any further losses incurred by the short 375 strike will be counterbalanced by gains on the 405 strike.

When we include the second 405 call, the payoff profile will look like this.

The trader receives a net credit of 0.75 for the ratio spread. Because he sold one option for 13 6/8, or 13.75, he bought two options for 6 4/8 or 6.50 each. Let’s look at this spread’s breakeven points.

If the market ends below 375, the trader will keep his .75 credit because all the options expire worthless.

Loss reducing

If the market ends at 375.75, the payout he must make due to the short call’s being .75 in the money equals the credit he had received for the spread. This is the lower breakeven point.

If the market ends at 405, this is the point of his maximum loss: the 405 calls expire worthless, and he owes the market 30 for the short 375 call. If we subtract his original credit for the spread of .75, this lowers his loss to 29.25.

If the market ends above 405, both the 375 and 405 calls are in the money. Any further increases in the market that make the 375-call increase in value will also make the 405 call increase the same amount. Being short one and long the other, the trader is no longer affected by the upward market movement.

The second 405 call needs to overcome the max loss of 29.25 for the spread to be profitable.

Therefore, the market must reach 434.25 for our spread to reach its upper breakeven point. Anything above 434.25 is unlimited profit.

Conclusion

Ratio spreads can have multiple results based on market outcomes. Traders can express their view of the market with unlimited upside potential and limited downside exposure. Ratio spreads can be a capital efficient method for market participation.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Option Butterfly

We have learned about both the similarities and differences between a straddle and strangle. Now we will look at a commonly traded strategy, referred to as a butterfly. Going long a butterfly, the trader buys a call of a low strike, sells two calls of a middle strike, and buys a call of a high strike. The three strikes are equidistant. The options have the same expiration and the same underlying product.

For example, if we bought a 2395 call, sold two of the 2420 calls and bought a 2445 call, this would be referred to as the 95, 20, 45 fly. The cost of the butterfly in this example would be 1.75. The 2395 and 2445 strikes are referred to as the wings, while the 2420 is known as the body of the butterfly.

Trading a Butterfly

Traders will buy the butterfly if they expect the market to stagnate. In our example, we are expecting the market to be around 2420.

You might be asking, if I expect the market to stagnate – why wouldn’t I just sell the 2420 straddle? As we learned, selling the straddle is a possible way to profit from a stagnating market, but the straddle’s loss potential is unlimited. That could be very costly for a trader.

The wings of the butterfly protect the trader from the unlimited risk of the straddle. Buying a butterfly limits the risk of being wrong to the cost of the butterfly.

If we sold the straddle by selling the 2420 call and put, we receive 105 from the buyer. Therefore, the maximum profit is 105 if the market is at 2420 at expiration.

The cost breakdown of the butterfly is:

Buy 2395 call at 69.75
Sell 2420 call twice for 53.25 each
Buy 2445 call at 38.50
For a cost of 1.75

In that same scenario, we can calculate the maximum profit from our butterfly.

The 2395 expires 25 points in-the-money. The short 2420 calls expire worthless. The long 2445 call also expires worthless. Less our initial cost of 1.75, we will make a profit of 23.25.

Butterfly versus Straddle

Compare the breakeven points between a straddle and a butterfly. The breakeven points are where the payoff equals the original premium for each strategy. For the straddle, they are the strike plus or minus the premium received. For the butterfly, the breakeven points are the lower strike plus the premium paid and the upper strike minus the premium paid.

In our example, we bought the butterfly for 1.75. The low strike of the fly is 2395. Adding 1.75 to that strike gives us our first breakeven point of 2396.75. Our high strike of the fly is 2445. If we subtract the butterfly’s premium of 1.75 from that our high breakeven point is 2443.25. Recall that the maximum profit for the butterfly is 23.25 and the maximum profit for the straddle is 105.

Time Decay

The time decay of a butterfly is greatly dependent upon the current level of the market. Near the short strikes, time decay is in your favor. Near the wings, time decay works against you.

Looking at our chart, we can see the butterfly has a lower cost, lower maximum profit potential but a much lower loss potential.

	Sell Straddle	Buy Butterfly
Maximum Loss	Infinite	Cost of butterfly
Cost	Receive 105	Pay 1.75
Maximum Profit	105	23.25
Breakeven – Upside	2525	2445
Breakeven –Downside	2313	2443.25

In our example, the straddle’s breakeven range is much greater than the butterfly. Although that range for the underlying market to land is greater than the butterfly’s, if the market does not land there, the potential loss could be detrimental.

Utilizing the butterfly allows traders to profit on their view that the market will be at a certain point at expiration; and the wings limit the loss if they are incorrect.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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