Bid/Ask Spreads Are Tightening On Option Contracts

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Besides the broker's commission, the bid/ask spread is the only transaction costs incurred by the trader, and fortunately, bid/ask spreads on option contracts have tightened significantly over the past several years. This is particularly true for longer term contracts. For buy-side traders, this is wonderful because options are being priced with over-precision as a result of market maker competition (and active participation in the market). This allows an individual trader to navigate the market with greater speed and at a lower cost.

How can you take advantage of tight spreads besides getting cheaper market-order fills? Depending on your trading strategy and broker commission, you have greater flexibility to enter/exit positions, while paying less than 1% for the transaction. This facilitates opening a multileg option trade without having to worry about paying a significant amount of money to exit the trade.

Determining the 'fair market value' of an option is really difficult and the black-scholes model is not a holy-grail. As a result, when you see a contract that looks really inexpensive and the bid/ask spread is less that 5% of the value of the bid, then do not be afraid to enter the position. Mathematical models and fierce competition among market makers has empowered individual traders to purchase contracts at a low cost, so take advantage of it. Stay smart and trade safe!

Take a look at today's long trade candidate:

Today's short candidate:

Record High for the S&P500

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Today the S&P500 broke to new highs - advancing nearly 1% this morning. Many momentum traders are stepping into positions as stock prices continue higher. Funds are also implementing new strategies based on recent news and data points released this morning. In this environment it is advantageous to be net-long, because there is no question that the markets can lift another 10% in a short amount of time. It is also smart to identify short candidates in the event that equities slide. It is better to buy insurance when you do not need it, especially if you can purchase it at a decent price. If implied volatility levels continue to fall, purchasing VIX call options can work as great insurance for a long portfolio. 

We will look at one short trade and one long trade.

The short candidate we are looking at is a pure seasonal play with a duration that is optimal for a swing trader.

The long candidate is XRAY, which is 10% off its all time highs. Here are the seasonal statistics:

Both of these equities are worthy of a glance. Most of the seasonal trades opened within the last quarter have been closed profitably, allowing for a cascade into positions like XRAY. Right now, there are a lot of really interesting statistics, both long and short, so I encourage you to dig through the database and find the trade pattern that meets your specifications. Stay smart and trade safe!

With Equities at All Time Highs Lets Explore PRG

Twitter@LoneStarQuant 

Overnight U.S. index futures rallied to all time highs with U.S. equity markets in the 6th year of a bull-run. I am going to be opening positions on PGR Friday morning using profits our position BDX opened in December.

The options chain is perfect for this particular pattern with contracts expiring in 80 days. I am going to combine a vertical spread with a call option, to create a unique payoff schedule using May contracts. Purchasing 5 OTM CALL options and selling 10 vertical spreads, I am able to still generate a net credit while purchasing contracts. See Below:

This is a position that, given the right price action, you collect time premium, long the stock, and in the event that there is an explosion then you will make a lot of money off the gamma obtained purchasing the 5 CALL options. Stay smart and trade safe!

Calendar Spread on Perrigo

Twitter@LoneStarQuant 

Perrigo has strong seasonal tendencies, so we are going to investigate opening a position based on the following pattern:

The objective of this trade is to structure a position that can be held for the next 70 days without purchasing call options and without using a vertical spread (bull-put spread).

Observing that contracts in May have a higher implied volatility than the rest of the summer contracts, you can sell the 160 strike PUT option expiring in May and purchase a 160 strike PUT option expiring in August, maximizing theta absorption. Opening such a position will leave you long the stock and allow you to collect premium. When opening and closing the trade you want to fill both legs simultaneously, with a close date on or before April 30, 2014.  Exiting the trade is a bit delicate. Even if the stock rallies, you need to be prepared to close the position near $160.  If you keep holding the position and the stock is at $170, you all of a sudden have lost money despite your directional prediction being correct.

Calendar spreads (and diagonal spreads) often have attractive properties. Anytime you are considering such a position, be sure to model it and check the greeks to make sure it offers the risk-to-premium you are looking for. Stay smart and trade safe!

What Are Option Greeks...And Why They Are Important

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In any position, whether purchasing a CALL or entering a multi-leg trade, you can estimate a set of risk parameters known as ‘option greeks.’ Each option contract has its own collection of greeks which can be added arithmetically with other option greeks that cover the same underlying asset. As positions become more complex, traders pay close attention to these hedging parameters to ensure there is not excessive risk from changes in underlying asset price, implied volatility, time erosion, and interest rates.  

Suppose you buy an option contract on SPY with a delta of 70. What does that mean?  It is actually really simple.  It means that if SPY goes up $1, then the value of the contract you bought will appreciate by $70, holding everything else constant.  Conversely, if SPY drops by $1, then the position value will depreciate by $70.

When SPY moves $2, will your position appreciate by $140? No. This can be explained by the second risk parameter commonly referred to as gamma.  Gamma measures how much the delta changes with movements in underlying asset price.  If gamma is positive, then you would expect a positive $2 move in the price to benefit the position by more than $280 ($140 X 2).  Once again this was because gamma, the partial derivative of delta (second derivative with respect to price), is positive.

The third parameter is vega, which is a measurement of the option contract’s sensitivity to changes in implied volatility.  This is important to note because a change in implied volatility will directly affect an option contract price.  A positive vega means that your position will appreciate from an increase in implied volatility, and a negative vega will appreciate from a decrease in implied volatility. Buyers are long volatility (positive vega) and contract sellers are short volatility (negative vega).

The fourth risk parameter is theta, which is the measurement of the option contract’s sensitivity to daily time decay. It can either work for or against you.  Most inexperienced traders end up purchasing time premium from sellers because they are hoping to hit a home run. However, selling premium (positive theta) means that even if the stock stays flat you’ll still win as the value of the position appreciates with time.

The fifth risk parameter is rho, which is simply sensitivity to interest rate risk. Typically for retail traders, this parameter is ignored. There is more of an emphasis on other parameters that impact day-to-day prices more consistently.  Below is a chart of the major risk parameters and how they are all related.  In order to have success as an options trader, you’ll need to have an intuitive understanding of how the greeks relate to one another.

A Year Ahead: 2014

Twitter@LoneStarQuant 
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Blackrock recently published its year ahead report, providing insightful analysis of macro themes. Although equities were choppy the last couple weeks, research indicates that there is still room for equities to rally to new highs this year before further correction.  

The banner below comes from BlackRock's report:

Again, from BlackRock

With the VIX at 15 and equities approaching record levels, Europium Funds has removed its short position on the VIX (opened last week at 20) and is once again systematically looking for prime long/short candidates.  

A Conservative Vertical Spread on 3M

Twitter@LoneStarQuant 

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3M is an innovative company that has evolved greatly over the past four decades. Interestingly, the stock has rallied following February 09 for twelve years in a row.  Take a look below:

Making the assumption that MMM is not going to depreciate over this same period in 2014, you want to structure a position that has a defined risk and benefits from premium erosion.  Here is an example:

Notice that the contracts expire in 67 days, which is approximately the duration of the seasonal pattern.  With the spot price at $130, you can sell the April $130 strike PUT option and purchase an April $125 PUT option and collect the difference. If you were to sell 10 of these 'bull-put spreads' then you would stand to gain $1,900 and would be risking $3,100.  In the event that the stock stays flat, you are still earning a few dollars per day in time (theta) decay. Stay smart and trade safe!

Thinking About Seasonal Patterns for Trending Stocks

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It is important to consider whether a specific equity is in an uptrend or downtrend.  In the event of an uptrend, you would naturally expect the likelihood of identifying a long (seasonal) trade to be much higher since the stock has been moving in the same direction for several years in a row. When doing due diligence, check to see if a stock has been trending.  Take a look at PCLN which rallies every February:

An enormous uptrend.

When looking at time series data, it is decomposed into the following:

1. Trend
2. Seasonal
3. Cyclical
4. Irregular

Priceline has benefited greatly from trend. As a result, it is not surprising to see the above seasonal pattern with an average move of 26.8% over 77 days.  Be careful with these trade candidates, in many cases when a major trend breaks the seasonal component has a good chance of disappearing also. Stay smart and trade safe!

Take a Look at YUM! Brands and V.F. Corporation

Yum! Brands runs approximately 40,000 fast food restaurants in more than 125 countries around the world. Popular names like Pizza Hut, Taco Bell, and KFC are all owned by YUM, which have been expanding rapidly in Asia. The company is currently valued at 30 billion dollars, with 30x earning multiple.  The company is a) not enormously expensive and b) priced for growth.  More interesting, the stock has a perfect 16 year history of stellar performance during the 91 days starting February 5th.  The average move over this period is a whopping 14.6%.

I hope you find the statistics above to be useful.  To equate 16 bullish years to a coin toss, the probability of someone flipping heads 16 times in a row is .0015%.  This anomaly in YUM's stock price should be noted.

Another great play is VFC.  Take a look at this amazing history:

Stay smart and trade safe!

Taking Control in the Midst of Uncertainty

Often correlated with equity prices, copper futures took a tumble alongside global index futures overnight as Asia's markets opened. China's PMI numbers were in line with analyst expectations at 50.5, but acted as a further catalyst for selling, pushing European index futures down .5%. Meanwhile, gold prices elevated this past month, which happens to be the first time since August. During uncertain times, investors take a flight to safety in gold, which also happens to be behaving seasonally. In fact, February tends to be a quite strong month, and March - April are historically weak.

Other indicators of fear such as the VIX are exceeding median levels.  Below is a histogram and density function VIX using daily prices for the past 5 years. Currently the spot VIX is at 18.60.

If you are looking for a way to play the rise in volatility, you can start shorting VXX leaps as the VIX futures curve flattens out.  If you are looking for a couple good opening trades for Monday, take a look at Allstate, which has rallied 17 years in a row over the same 91 day period.

Stay smart and trade safe.