Traders Expo New York How to Structure Your Trade for Maximum - - PowerPoint PPT Presentation

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Traders Expo New York How to Structure Your Trade for Maximum Profit

12-March-2019

MARK W. GUTHNER, CFA

@Mguthner web site: TheOptionsEdge.Com @The_OptionsEdge

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¯ Traditional Approach to Directional Option Trading ¯ Index Options Returns ¯ Why Options Are Different From Stock & Bonds ¯ Alternative Approach to Directional Option Trading ¯ Buy or Sell? ¯ Other Issues ¯ Track Record

Table of Contents

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Traditional Approach to Directional Options Trading

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$90 $110 $130 $150 $170 $190 $210 $230 $250 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Mar-19 Apr-19 May-19 Jun-19 Jul-19 Aug-19 Sep-19

Most Investors Trade to an Anticipated Price

Buy July 2018 165/185 Call Spread Stats assuming a random walk q $185.62 = Breakeven (up 6.1%) q 30% Chance of a Gain q 13% Chance of Maximum Gain q 61% Chance of Maximum Loss Risk $5.62 for a chance to earning $14.38. Payoff = 2.6:1 Is this really the best way to structure a bullish trade? Target Sell 1 $200 @ $1.73 (20.4%) Buy 1 $180 @ $7.35 (22.1%) Cost = $5.62 Apple Inc. (AAPL) $174.98 1-Mar-2019

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To Answer That Question, We Ask This One First… Are options fairly priced?

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Many Practitioners Argue That Puts are Overpriced

Market'Index' Minimum'Risk' 120%' 116%' 112%' 18%' 14%' 0%' 4%' 8%' 12%' 16%' 130%' 120%' 110%' 0%' 10%' 20%' 30%' Annual'Return' Risk('Stdev)'

Most Investors Lose Money Buying Puts Negative Beta Assets Should Produce a Negative Rate of Return. What Does the Data Say?

Negative <--------------- Beta ---------------> Positive

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Put Options Should Generate a Negative Rate of Return

Median Returns/Mo for Put Options on the S&P500 (SPY)

Out of the Money <-----------------------> In the Money

Put Options Have a Negative Beta => Negative Expected Rate of Return

Data Source: Bloomberg, Time Period Studied: 1/2005 to 1/2018

• 100.0%
• 90.0%
• 80.0%
• 70.0%
• 60.0%
• 50.0%
• 40.0%
• 30.0%
• 20.0%
• 10.0%

0.0% 10.0% 90% 95% 100% 105% 110%

1-Month 2-Months 3-Months 6 Month 12 Month 18 Month

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What About Calls?

Median Returns/Mo for Call Options on the S&P500 (SPY)

Out of the Money <-----------------------> In the Money

ü In-the-Money Call Options Generate a Positive Rate of Return ü Long Dates Calls Generate a Positive Rate of Return ü Out-of the Money, Short Dated Options Generate a Negative Rate of Return

Data Source: Bloomberg, Time Period Studied: 1/2005 to 1/2018

• 120.0%
• 100.0%
• 80.0%
• 60.0%
• 40.0%
• 20.0%

0.0% 20.0% 90% 95% 100% 105% 110%

1-Month 2-Months 3-Months 6 Month 12 Month 18 Month

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Underlying Days to Expiration Probability Cum Price 30 27 24 21 18 15 12 9 6 3

• f Event

Prob 0.1% 0.1% 3355.80 |- ----- $499.80 ------------------ ------------------ | 3295.59 |- ----- $439.52 | 0.5% 0.5% | 100.0% | 3236.45 |- ----- $380.33 | |- ----- $380.45 ------------------ ------------------ | 100.0% | | 3178.37 |- ----- $322.24 | |- ----- $322.33 | 2.2% 2.7% | 100.0% | | 100.0% | 3121.34 |- ----- $265.44 | |- ----- $265.27 | |- ----- $265.34 ------------------ ------------------ | 99.2% | | 100.0% | | 3065.33 |- ----- $211.15 | |- ----- $209.63 | |- ----- $209.30 | 7.1% 9.8% | 95.8% | | 98.7% | | 100.0% | 3010.32 |- ----- $161.73 | |- ----- $157.72 | |- ----- $154.84 | |- ----- $154.32 ------------------ ------------------ | 87.8% | | 92.4% | | 97.9% | | 2956.31 |- ----- $119.46 | |- ----- $113.16 | |- ----- $106.54 | |- ----- $100.87 | 15.6% 25.5% | 75.7% | | 79.7% | | 86.1% | | 97.1% | 2903.26 |- ----- $85.44 | |- ----- $78.03 | |- ----- $69.45 | |- ----- $58.91 | |- ----- $47.26 ------------------ ------------------ | 61.6% | | 63.6% | | 66.8% | | 73.5% | | 2851.16 |- ----- $59.46 | |- ----- $52.18 | |- ----- $43.75 | |- ----- $33.37 | |- ----- $18.31 | 23.4% 48.9% | 47.7% | | 47.6% | | 47.5% | | 47.2% | | 45.9% | 2800.00 $40.45 | |- ----- 34.08 | |- ----- 26.99 | |- ----- 18.86 | |- ----- 9.15 | |- ----- 0.00 ------------------ ------------------ 35.4% | | 34.0% | | 32.0% | | 28.6% | | 21.6% | | 2749.76 |- ----- 21.87 | |- ----- 16.43 | |- ----- 10.69 | |- ----- 4.86 | |- ----- 0.34 | 23.8% 51.1% 23.5% | | 20.8% | | 17.0% | | 11.1% | | 1.8% | 2700.41 |- ----- 9.91 | |- ----- 6.09 | |- ----- 2.66 | |- ----- 0.36 | |- ----- 0.00 ------------------ ------------------ 13.2% | | 10.0% | | 5.9% | | 1.4% | | 2651.96 |- ----- 3.49 | |- ----- 1.48 | |- ----- 0.26 | |- ----- 0.00 | 16.5% 27.3% 5.8% | | 3.2% | | 0.9% | | 0.0% | 2604.37 |- ----- 0.84 | |- ----- 0.17 | |- ----- 0.00 | |- ----- 0.00 ------------------ ------------------ 1.8% | | 0.5% | | 0.0% | | 2557.64 |- ----- 0.11 | |- ----- 0.00 | |- ----- 1.46 | 7.7% 10.9% 0.3% | | 0.0% | | 0.0% | 2511.74 |- ----- 0.00 | |- ----- 0.00 | |- ----- 0.00 ------------------ ------------------ 0.0% | | 0.0% | | 2466.67 |- ----- 0.00 | |- ----- 1.46 | 2.5% 3.1% 0.0% | | 0.0% | 2422.41 |- ----- 0.00 | |- ----- 0.00 ------------------ ------------------ 0.0% | | 2378.94 |- ----- 0.67 | 0.5% 0.6% 0.0% | 2336.25 |- ----- 0.00 ------------------ ------------------ 0.10% 0.10%

For the buy & hold investor, returns are path dependent

The buy & hold option investor needs the appropriate directional move (autocorrelation) of sufficient magnitude to capture value.

Option Price & Probability of expiring in the money Take S&P500 for Example S = $2,800 Call Assumptions K= $2,856

• Vol. = 20%

Price: $40.45 Zeta = 36% ZetaEver = 72%

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How Options are Priced & How they are Traded Usually Differs

In a fairly priced option, what is gained by “Gamma,” the bend in the curve, is lost by “Theta”, the rate of time decay

Not Explained by Delta Not Explained by Delta At the Money Strike & Initial Share Price

• $4
• $2

$0 $2 $4 $6 $8 $10 $15.00 $20.00 $25.00 $30.00 $35.00 Option Price Option Price Price Predicted by Delta Gamma Effect

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¯ Traditional financial assets are a claim on a real asset

ü Bonds = 1st Claim ü Stocks = 2nd Claim

¯ Options are a different kind of asset all together

ü Value is derived, at least in part, because the price of the underlying assets changes or is expected to change ü If the price of the underlying is fixed, a properly priced option will not have time value § Value of an in-the-money option would have intrinsic value § Value of an out-of-the-money option would not have any value

Options have value because of the potential for price changes

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¯ Using options for directional trades

ü Value is created when the price of the underlying moves enough (up for a call/ down for a put) to overcome time decay ü Value is lost rapidly when underlying price moves down for a call and up for a put

¯ Options are volatility instruments

ü Captures value when price moves in either direction ü Arbitrage condition trades off price movement with time decay

Options have value because of the potential for price changes

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Implications: Alternative Approach to Directional Options Trading

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$90 $110 $130 $150 $170 $190 $210 $230 $250 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Mar-19 Apr-19 May-19 Jun-19 Jul-19 Aug-19 Sep-19

Trade to where price is not going

Don’t Buy This Sell this instead

Sell July 2018 170/150 Put Spread Sell 1 @ $6.75 (30.0%) Buy 1 @ $1.85 (31.0%) Credit = $4.90 Stats assuming a random walk q $165.10 = Breakeven q 65% Chance of a Gain q 56% Chance of Maximum Gain q 14% Chance of Maximum Loss

Risk $15.10 for a chance to earning $4.90. Payoff = 0.3:1

Apple Inc. (AAPL) $173.80 1-Mar-2019

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Use Shorter Expirations When Possible

Potential Profit ü $399/78 = $0.051 per day ü Higher Chance of Success Profit Potential ü $490/138 = $0.036 per day

Stats assuming a random walk q $165.10 = Breakeven q 65% Chance of a Gain q 56% Chance of Maximum Gain q 14% Chance of Maximum Loss q 138 Days to Expiration q Collect $4.90 in Premium 19-July-2019 Expiration Stats assuming a random walk q $166.01 = Breakeven q 68% Chance of a Gain q 59% Chance of Maximum Gain q 8% Chance of Maximum Loss q 78 Days to Expiration q Collect $399 In Premium 20-May-2018 Expiration

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Comparing “Active” vs. “Passive-Aggressive” Approaches

Short Puts Spread ü Higher Probability of Success ü Higher Probability of a Max Gain ü Smaller Chance of Max Loss ü Less dependent on timing

Short Put Spread

Long Call Spread ü Bigger Payoff ü Smaller Maximum Loss Potential Your Choice should be driven by conviction and the size of the move expected

q $186.62 = Breakeven (up 6.1%) q 30% Chance of a Gain q 13% Chance of Maximum Gain q 61% Chance of Maximum Loss q Risk $5.62 to earn $14.38 Long Call Spread q $165.01 = Breakeven q 65% Chance of a Gain q 56% Chance of Maximum Gain q 14% Chance of Maximum Loss q Risk $15.10 to earn $4.90 q Risk $16.01 to earn 3.99 using shorter expirations

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Other Considerations

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Theta: Time Decay Time Decay Increases as Time to Expiration Decreases

ü Percentage Basis ü Dollar basis

• 0.90
• 0.75
• 0.60
• 0.45
• 0.30
• 0.15

0.00

• 30%
• 25%
• 20%
• 15%
• 10%
• 5%

0% 0.0 2.0 4.0 6.0 8.0 10.0 12.0

Time Decay

Time to Expira=on (Months) %age Price

When buying a call or put spread, consider buying longer dated ones When selling a call or put spread, consider selling a shorter dated ones The price of a December 2018 Put Spread is only $1.05 more than the cost of the July Expiration

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¯ Asset Prices are Assumed to follow a random walk

ü Normal distribution ü No Trend

¯ Individual stocks follow their

• wn path

ü Returns may not follow random walk

§ Skewness § Bifurcated § Fat tails § Skinny tails

Distribution of Returns

164 Day Investment Horizon

Chart by EzTrade.Com, Coupon Code MG70

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How to Trade a Crash

¯ Ratio Put Spread

ü Sell 1 near-the-money put ü Buy More out-of-the-money puts

¯ Proceeds from the sale pay for the downside puts ¯ Structure with small credit if possible.

If IWM Continues to rally, you keep the premium If IWM falls sharply, investor captures a large gain Margin requirement is the maximum loss = $1,059 per spread Roll when expiration is within 1–month or more

Example: IWM Underlying (Trading at $158.24) Sell a 1 x 2 Ratio Put Spread, Sell $158 Strike, Buy $146 Strike 17-May-19 (75 Days) Expiration, Collect $1.41 per spread

• $15
• $10
• $5

$0 $5 $10 $15 $20 $25 $110.00 $120.00 $130.00 $140.00 $150.00 $160.00 $170.00

Price of the Underlying

3 Mo to Exp Intrinsic 1 Mo to Exp

Profit /Loss

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Bios

Executive Editor and Senior Contributor Mark W. Guthner is a veteran of the financial services industry. His skills and experience stretch across multiple disciplines including trading, portfolio and risk management, securities analysis and valuation, investment banking and financial technology as well. Mark served as a Principal, Portfolio Manager, Proprietary Trader and Equity Derivative Strategist at Banc of America Securities, CRT Capital Group LLC and Dash Financial LLC. In these roles, Mark advised institutional investors on the use of options to express market views and to hedge or eliminate unwanted risks from institutional portfolios. In his proprietary trading activities, Mark generated returns on capital in excess

• f 35% per year.

Options Edge Executive Editor and Senior Contributor Michael Khouw is a veteran of the financial services industry whose derivatives trading experience began in the 1990s as a member and floor trader in the open-outcry pits of the Philadelphia Stock Exchange, the American Stock Exchange and the New York Mercantile Exchange. Since then Mike has broad experience working as a strategist, analyst, portfolio manager and proprietary trader of equities, commodities and equity and index derivatives. Mike has shared his insights as a contributor on CNBC’s Fast Money and Options Action, the first television show educating self-directed investors on the proper use of listed

• ptions. He also publishes articles and frequently speaks on

a broad array of topics including trading strategy, market structure and regulation at investment conferences