An Insiders Perspective on Executing Option Spreads

Probability and Theoretical Pricing

Good trade/Bad trade
Expiration Insights, Earnings Ideas and Trade Concepts
Trading Ideas requiring minimal capital(1000$)
Stock strategies and Active Trader tips
Real-time trade ideas and strategies
Trading Strategies for Range Bound Markets
Finding Trades: Strategies that limit capital exposure
The Art of Tape Reading
Calendar Spread
Guest Technician John Carter
Managing Risk
Vertical Spreads
Tom Sosnoff - Friday Wrap Up 21 Apr 2011

An Insiders Perspective on Executing Option Spreads

calendar spread - jpm looking for down move
buy 41 put calendar ~ 0.96 debit

horizontal - always click on front month

vertical - click on bigger option

always sell a month for which impl vol is greater than the one you are buying
sep 40.38 % vol
oct 36.37% vol

never pay to roll a vertical

are cal spreads good to put in low vol - yes

calendars on low beta stocks

eem calendar spread 33 put ~1.38

right now it is at 1.32
even though the stock moved by 3% , calendar lost only a nickel

Probability and Theoretical Pricing

use theoretical pricing calculator to calculate where to sell at
use stock adj and vole adj to see price variations
you can use it for spreads as well pm
Good trade/Bad trade
xyz 25 , buy 26 call at 1 $ for a unlimited upside
stocks goes to 26 , on paper you are right , but it doesnot go fast enough so option value drops to 0.50 $ [ time decay offsets
the appreciation ]
this happens all the time

same trade
sell 24 puts at 1 $
stock at 24 from 25 ,
24 puts at 0.50 , so you can buy back
you are completely wrong , but still you made some money

UNG , /NG
Close 12.2
is at a low of 12.11
making new lows every day
16 some time back , now at 12
contrarian to get involved - trading at lows, govt to get a regulation to prevent speculators

prognosis -direction high

liquid yes
1. vol is at 71%
2. vol,open interest on both call and put - high - 3000,12000
3. stock volume - 38 mil
4. single strike option
5. could bouncce back to 15/16 ranfe
6. 13 call @ 0.90 , 25% prob, 75% prob of losing [bad trade] , BE 13.90
7. that is not completely accurate , that 75% is by expiry , prob of touching is 2 * 25% = 50%

○ [good trade] buy 12/14 call spread - when buying debit spreads or when playing upside , buy one
strike in the money and one strike out of the money

BE 12.75 , 40% to get here

risking 0.73 to make 1.25 with a 40% chance of winning

chance of lossing is now only 60% from 75%

what if i wanted even a higher chance of success ???

● sell nearest otm puts

sell 12 puts - prob of touching is 38% , so 62% success
12-1.05 [credit recv’d ]

we require about 20% capital in the account , so for one lot [11*100=1100] we require about 200$[20/100*1100]
so ROC = 100/200 =50%
what about return on risk ? 10%
stock could drop to zero , risking 11 to make 100
11/100 = 10%

● trading range - 875/977

XLE - energy sector

etf - lots of trading volume
Close - 44.53
range bound
prognosis - bullish
sell a put spread @ stock 44.53
45/43
as a matter of consistency we would not like to teach u to sell itm put spread , only otm

so the one above does not meet our criteria

sell 44/46 call for .95 cents debit

even though the above two are syntetically same

but consider
sell 44/42 put with strike in 30 % prob and collect 1/3 of width of strike ~ credit

price/action -we are ok since s&p is at 875 , but if we are at 900 , then sell further otm [42/40] put spreads since there is some
downside in the cycle

940 down to 910 , bullish in oil - which put spread to sell when i am bullish on oil .. look at co-relations....
xle & s&p are highly cor-related
many oil companies are in s&p

if at bottom of s&p range and xle at 44.50 , sell put spread at 42/44
top 40/42 , 41/43

xle

Good Trade Bad Trade

selling otm put spread selling itm put spread

buying itm call spread buying otm call spread

Iron Condor - Good trade

if you think we are in the bottom range ,

be of 43 - prob of 43 by expiration

short strangle
let say you want to take more risk
Naked Put - builish with a lot more risk
sell naked put , 43 @ 1.75
750 required in account
175/700

what if the stock starts to bounce up

sell out of the call - 48 @ 95cents , more credit
so 2.70 in credit, adding that to call strike [48+2.70 = 51.70 ] , prob of exp at 51.70 is 12% , so 80% on the upside movement
of stock

on the downside , 41 - 30 % prob ,so 70 % on downside

margin on shorter strangle [ greater of options]
equivalent to covered call - short a put , positive delta [49:12 ]
this is a good smart trade

alternatively i think xle going to rise hugely

long strangle
buy 45 calls - 2.10
buy 43 put - 2.00

be on downside - 39.00 ,80% chance of losing

upside - 49 , 80% of losing
so a bad trade, time working against you

AAPL
up a lot
137
135/145 - trading range

market at bottom

want to play sideways

calendar spread - buy jul 135 call , sell aug 135 call
criteria - always otm as we want fastest rate of decay on the nearest otm options
bad trade

so choose buy 140 oct 09 ,sell 140 oct 09 , debit 3.80 , 2 month
each month 1.65 for a roll
-apple rangebound between 135/145
3.30 to make 10
so a good trade

Expiration Insights, Earnings Ideas and Trade Concepts

Before Expiration Friday
oct less volatile sometimes - because they are not triple witching months, there are no futures expiration for some indexes
so volatility is a little less

lowest close in vix and eur/usd

oct expiration - things happen as per history

cash settled index positions [ spx,oex,ndx,rut] - rollover as long as you like the direction
roll over - do not necessarily roll to the same strike , look at probability as well

one strike in the money , one out of the money ~ you have to close out or close itm options by a penny
otherwise you will be long / short the stock

butterfly - close all legs else you will be long/short stock

no reason to carry positions into friday afternoon
if you are short a call for a stock which is announcing dividend , get out or roll over

for dia there is a dividend ,so close out/ roll thoes those itm short for you will be assigned otherwise

Trade Concepts { what do you in market ??? }

what to do when s&p moved from 666 to 1100

market was bottom - low cost and high volatility , love short put and covered calls
market tops - no covered calls { synthetically equal to short puts } , cost basis is so high
wide iron condors on index - not like because of chance of a pullback , because we might get a 1 SD move
e.g 10/50 wide ic for 1$ debit - i hate it

- low cost and high volatility is exploding - you need diff. strategies vs other way around
- lets say we are in a danger zone - 68% bullish
- donot like covered calls
- no short puts
- donot like wide index iron condors because we might a 1 SD move
- otm call calendar spreads - with the market going higher , diff for options to expand , might drop down to zero

if you are bullish and still think there is a 5-15% move , buy call debit spread
with buy one strike in and sell other out , risk 1 to make 1 or 1 to make 2 , 1 itm and 1 otm
[or] upside butterfly - atm or just otm because they are not expensive
[or] upside front month calls - as volatility is low around 20’s
very bullish - sell otm put credit spreads

neutral market
- tight/flat iron condor - 1 or 2 strike wide
- otm put calendar spread - if the market were to go down , vol might pop up and you risk 1 to make 1.5/2
- otm/atm put butterfyl - because they are cheap given rising markets
- good time to hedge long portifolio - if you are long in ira etc - short credit spreads , short delta strategies as long as your
collecting premium
- pairs trading [long/short fund] - buy 1 sell another , sell call and put , do a vertical spread here and there

bearish
- long debit spread - put one strike in the month and another two strikes out in the money
- given low volatility - ok to do buy a put not front month but a 2 month out
- short call verticals - trade for big premium because of skew inversion
- skewed butterfiles and iron condors - as long as skew in the call side , as long as call side has multiples of width compared to
put
- otm put calendar spread - because volatility will explode if you can nail the price for a good payout . good support level for a
good 50% more payout

Earning Ideas
bunch of earning coming out over the next few days
C,BAC, GOOG , IBM , NOK , GE , HAG

C
front month volatility at 160% { guess earnings are tomorrow}
and back month at 60 %
one year ago 19-20 , now 5 $

buy oct 5 put or call at 0.15$ , no directional bias

if you have a direction bias , 15 cents will be a reasonable bet

expected move with two more days to go can be calculated by taking the front straddle and strangle,add them and divide by 2
to get expected market

move may be double your money for 30 cent move

bearish - buy 5 put

bullish - 5 call

BAC
C 18.59 , 80% vol
do on a small scale for one day
sell 18 straddle
expected move in here is about 65 cents
[ avg of front month straddle and strange is 1.30/2 = 65 cents ]
consider 18/19 straddle
sell 18 call
sell 19 put
collect 1$
betting 17-19 range

GS
Close 192.28 , up 5.00
buy 190/ sell 195 put spread for 2.50 debit

risking 2.50 to make 2.50 with a 30 cents theoroticall

they better nail their number because the stock got already downgraded yesterday.
NOK
Close 15.39
has been in 14-16 range

vol for front month - 115% , for all other months - 45%

bullish 16 call calendar spread

bearish 14 put calendar spread

IBM
C128.35
same like gs
bearish - buy put spread 130/125

bullish - buy call spread 125/130

best play ~ vertical as front month vol is 56% and back month is 27 %
expected move around 5 bucks

never buy { premium } straddle or strangle 2 days before expiration

HAG
C 26.26 +1.62
vol front month - 115 %
vol back month - 54%

because of high volatility differential

GE - choppy
sell 16 calls and 17 puts
front month vol - 76 % , back month vol - 46 %
not enough money on the trade

GOOG
Close 536
front month vol - 75 , back month vol - 34%
pinning tendency
fun for butterfly traders and sometimes for iron condor
look at front month strangle and straddle

1] b 540 puts / s 530 puts

2] bearish , might drop to 510

butterfly 10 point wide
b 520 put
sell +2 520 put
buy 1 510 put

expected to land between 501 and 519

risk a 1$ to make 9$ ( if you land at 510 $ )

play otm
3] choose call side - bullish , choose put side - bearish

Trading Ideas requiring minimal capital(1000$)

expiration insights - short one - long some other underlying
unwinding of arbitrage positions - unnatural buying pressure because there are lots of shorts

quarterly dividends - be careful of etf’s [ sept dec march and june ]

offcycle - aug - only dia [ no dividend risk ]
mnx , ndx , spx - thursday is the last time when you can hedge / trade /close it
on friday morning it is marked up or down , you will not be able to hedge it

value is based on the print in the morning

if you have a calendar in spx , front month is turned to cash and later month becomes open ended
e.g. oex deep ITM , you should roll

vertical spreads should be closed before the expiration thursday

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somewhat market directional

EEM - emerging markets index

h 37.19, l 19.36
current at 35.16

put calendar buy sept -dec 33 ~ 1.38 in debit

the reason 33 is picked because we are bearish

no volatility skew as it is same across sept and dec

so no volatility risk
itm cal spread - bullish
atm cal spread - nuetral
otm calendar spread - bearish

the reason it is loved , it is a 3 month cal spread

three rolls in there
3 months so 1.40/3 = .46

looking at the current itm cal spread

sell 35 aug/sept cal spread - 1.00 credit [ two days before expiry ]
the reason this is being shown is to show the profit potential
you are risking .46 to make 1.00
so looking at this atm , we can get a idea of what happens if we go down from 35 - 33
+
one neat thing is even now for sell 33 aug/sep call spread ~ 0.64
which is one third of the cost

when happens if it goes up [ only possible near expiration because all prices come into line]

sept 30 put is between 0.23 to 0.26 cents

breakeven is 32 for the 33 put as we are paying 0.46 cents
lossing 50% of my investment would be the 30 strike because it is at 0.23

if i want to get at my upside and downside

so in another words if the index moves 1 point , i am ok , 35-36
if it moves up three strikes i loose 50% , 35-38

old high was 37 , so i loose only 50% if it goes above old high
+
probability of expiring above 38 is 17%
risking ½ to make 2 times

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ung - bulish
futures trade all over the place

low was 11.91 and today we are almost there

more oversold [ last nine close in red out of 11 days ]paying .84 to make 1.16 , one of the reason people buy these kind is
because they can make more when the direction is correct only paying .14 , this drops .14 and you reach be
if you are bullish , buy one strike in the money

capital you have to put up is

spread - credit
prob of success is 56%
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QQQQ
last at 39.30
index had parabolic move
long put vertical - debit . always itm

if i do short put vertical - credit , otm

already 70 cents in the intrinsic value

positive theta decay generated
probability of expiring

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FAZ
27.27
gaint moves and it went sideways
non-confirmation
when the market blewup , it just went sideways and i think it has some upside
good liquidity and volatility
bullish play in a bearish etf

if you are trading leveraged etf , 2 times do ½

3 times do ⅓ of your normal trade
100 shares 1 stop away for normal etf
50 2 for 2 leveraged

low in faz is 24.07

vol is now 110 %

intrinsic is 27 cents, so premium paid is 73

risking 1 $ to make 3$
expected vol is 110 % , range is 0 - 60 for next year
if vol is 70% , this would be a stupid trade
we are taking a expected shot off of volatility
expected move is 10% a month , 0.10*27 = 2.70 , so you could easily hit 30
make two lose 1 with 33% probability

when you do itm debit spreads, you want to go to the expected move , 30 in this case
we are taking expected move of volatilty with a better probability
if you are bullish , you do the opposite trade
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bearish in oil use OIH
AAPL
skewed skp strike butterfly
bearish stint to it
close at 164.60

max risk is 500 $ per contract , max profit is 1000 $ per lot
34% of appl going above 170
profilt potential from 145 to 165 - maximize
166 - you loose 100$
168 - you loose 300$
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Stock strategies and Active Trader tips

Real-time trade ideas and strategies

10-12 % range expectation
VIX - 29 , lowest - volatility contraction from 60

game plan - /ES at 900 , range 920 - 930/40

downward range is may be 840 - 800
10-12% range for remainder of summer

have a bias - bullish or bearish

i think we are at the top end of the range
vix at lowest range , interest rates wrt yield curve are flashing warning signs, top end of range

risk/reward favors playing a small downside tweak to trading range

not going to be a oppurtunity to get long premium , entire street is selling volatility

divergence between major indexes SPX-NDX, SPX-DJX rolling over

so SPX has to rollover as well

[setup ] inverted yield curve , most stocks at pin , large divergences , low volatility [ option prices are so cheap]
[1] EEM 32.61 ,buy june 34/32 put spread for 1.03 ~ bearish [30:54]
parabolic move
always look for risk 1:1 with no extrinsic premium
be is near top end of range - so good
overbought underlying
resistance in stock is at 33
break even in stock is at top end of range
prob should be at 50%
always buy 1 strike ITM and other OTM

looking at the chart , stock zoomed by 50 %

[2] XHB@12.57 buy june/sept $12 put calendar spread for 0.75$
sideways move
overbought underlying
1:2.5
10 spreads only use 750$
jun-july , july-aug , aug-sept - three rolls

looking at charts - stock is range bound all the way to last 6 months
[3] jpm 34.43
sell the june iron condor
http://www.optiontradingpedia.com/free_iron_condor_spread.htm

downside play
always choose nearest month when doing nuetral iron condors
you sell the top end and buy the lower end and hope it stays in between
risking 55cents to make 95 cents

[4] spy 91.75

really bearish - credit spread

sell june 93/95 call for .77

sell otm premium
add credit to your short strike and that becomes your be

30% of expiry
always look to collect premium = 1/3 of width of strike

[5] spy/dia pair trades

spy 91.25 dia 81.84
buy june spy 90/88 put -0.80
sell june dia 84/82 put 0.80
spy will go down more than dia
spy are over bought when compared to dia
look at the divergence chart of spx-djx
it is a parabolic move

[6] XLE very bearish

parabolic to down side

http://www.optiontradingpedia.com/free_butterfly_spread.htm
Trading Strategies for Range Bound Markets
Establish range 780 - 860 , 60/800
at top of range , create positions short in delta - so that as market falls you position rise
exact opposite at the bottom of the range
spy top end 860 - 880 , choose mid-point ~870 call
spy bottom end - 760-780 , choose mid-point ~770 put

probability of reaching mid point is usually 30% , so pick this

if you sell something for .35 with a single strike of width , prob of expiring worthless is 65%

** upside call spreads are richer than downside put spreads

Criteria
1. enough time to go to expiration - > 23 days
2. [Strategy 1] otm call spread 87/89 , 0.65 credit - always if you get 1/3 in credit for any strike width , you minimize the trading
costs ,
3. [Strategy 2] condor 87/89 , 79/77 , BE is 87+1 on the upside , 77-1 on the downside, look at the probabilities of reaching these
4. [Strategy 3] unbalanced condor- lets say you did your homework and feel that on the downside , it will breakdown below 810
sell 81/80 put spread taking a credit of 0.93 ... you risk only 7 cents on the downside and chance of reaching upside is 28%
5. at low end of range - buy stock , sell covered calls

Finding Trades: Strategies that limit capital exposure

VIX - 22 ~ very difficult to set up a trade
watch commodities , gold, futures , forex etc to get a idea of the markets

how can you trade broad based etfs’ without watching the futures ?
GLD - at all time high
GLD - rising by the day , but impl volatility atm is too low 23 % so pricing will be low
cheap/crushed volatility usually means , prices are lower
112.25 , consider 109 put buying at 1.45 , so the BE will be at 107.50 , the prob of getting to 107.50 is 23% , so the chance of losing is around
70-80%
to make double you investment , it should move 3 dollars from BE ( 107.50 - 3 = 104.50 ) , 6% drop in gold , prob of getting here is 10%

if you 10 contracts , chance of losing 1500 is 75% , 25 % for break even and 10 % for doubling you money
risk/reward doesn't look good
---------------------------------------------------------------------------------------

instead consider buying a closet itm put spread , 113/111 for a debit of 1 $ ,
premium exposure is only .25
so you are paying 1$ for 75 cents . be is at 112 ( 50% ) [ 31.36]
so for max profit , to get down to 111 , prob of expiring here is 43.72%
so all of a sudden you are moving prob in your favor from 10% to 50% ~
---------------------------------------------------------------------------------------

[if you are looking for a smaller profit] ~ risk 2 to make 1 to increase probability
sell a otm call spread
risk 60 cents to make 40 cents
113/114 sell call spread for 40 cents credit [ 60 % probability , blind guess because of perfect pricing model]
---------------------------------------------------------------------------------------

[ bullish that gold is going to 1150 , GLD 115 ]

buy 112/114 call spread , 86 cents debit , 60 cents extrinsic risk
risk 86 cents to make 1.14

bullish 112/114 call spread

bearish 113/111 put spread
---------------------------------------------------------------------------------------

VIX 21.63 [tough to trade for retail customers]

difficult index to trade , non standard expirations , expire to future prices
some people vix as disaster protection
as vix gets cheaper , one fun way is to sell naked puts , because of limited downside as volatility can’t go to zero
volatiliy will never touch zero

vix topped at 80 in oct when the market was at rock bottom

for a product which can go from 20 to 80 or 80 to 20 , that rules out short calls
*** never do calendars on vix , too much risk
*** no short calls
enough volatility when you sell a naked put
last low was 20.1 , present at 21.63 , may be it will be double bottom

bearish - naked 20 put not good as you collect only 20cents for a 1% return ???
selling itm put is ruled out
samething for naked calls as well
otm butterfly [ capitalize on vix closing ] you have to pick a target
call butterfily of 2 wide
buy butterfily [ usually trade at 2cents around theo price]
market sell off prognosis
22.5/.25 / 27.5 [ risking 35 cents to make 2.15 , this vix couldbe in a range ]
bet 22.85 and 27.15 , i make money
below(19) and above ( 80) , you loose 35 cents
similar butterfly on intel etc would be much higher as volatility is low .
where as here volatility on volatility is in the range of 70%

one other way

sell calls spreads when vix pops up [ 29/30 when vix popped to 28]

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Interest Rates
TLT - perfect product for play on interest rates in lieu of futures where margins are really big
volatility is only 17%
how do u make money with such low vol? difficult
if i think rates will lower , and this will pop , if i buy otm calls
buying otm puts and calls - but change of be is like 20% - horrible trade

one way - butterfly

tlt 94.97
93/95/97 buy butterfly at 50 debit (expensive ) , profit potential is only 1.50
but in case of vix , it was 2.50 , this is because of volatility

[ play a little directionally ]

bullish , put spreads are ok,when stocks have low vol , otm options tend to skewed higher

directional trades work better if you

sell nearest otm put spread - long
sell nearest otm call spread - short

*** when vol is low , stay away from straddle,strangle and butterfly [you pay more ]
always look for potential return of 8:1 and not like 3:1
---------------------------------------------------------------------------------------
FAZ
vol is very high , triple leveraged stock
prognosis - range bound
high vol because it is triple leveraged

covered call candidate[ low cost basis and high volatility] - if it is trading at its lowest range
buy stock and sell nearest otm call
@18.69 and sell 19 call

sell otm nearest put [ on account of high vola]

18/17 vertical spread for 0.46 credit , be is 17.54 , only 13 cents higher than old low with a 54% prob
risk 1 to make 1 - good trade

buy itm call vertical

buy 18/21 calll because of high vol at 1 debit
risk 1 to make 3
70 cents of of intrinsic
30 cents only for leveraged play
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EUR/USD

usd is in a free call

currencies are leading indicators for stock market

The Art of Tape Reading

how does tom trade ?
watch currencies,futures, volatility

if market volalitility is sucked out , market will not go down, probably close at same level [ up 12 , down 5 ]
● e.g. umemployment report , 3 day volatility taken out in first 30 minutes

whenever market opens like 20 up , then 8 down

● most anticipatory traders think of shorting the weakest market ~ but which one ~ nasdaq -20 , s&p -5 ,
choose nasdaq to short
● filter out head fakes , a particular stock going against the market

Calendar Spread
don kaufmann - apr 09 2011
marketcast, shadowtrader - get an idea of orderflow

Guest Technician John Carter

for stocks which pin
set up thurs afternoon 2 pm
goog - look at open interest , pick ones with highest open interest
498.37

tendency to pin at 500

[ calls since current price is less than pin target ]

buy 490 call
sell 500 call

bidu - 73.15
usually pins at 70
after verifying open interest
buy put 73
sell put 70

delta of atleast 70 to get capital appreciation

Managing Risk
start using prob of touching
get out of a trade 4-10 days before expiration

use 3-5% of your amount for each trade

beta wiegthing
beta is relative to s&p. beta for s&p is 1.

put calendar when volatility is low

to reduce negative delta , buy stock , put spreads

Vertical Spreads
selling call spreads - bearish

Tom Sosnoff - Friday Wrap Up 21 Apr 2011

interest rates when they are going down , xlf goes down
usually financials and spx go up or down, not the case today