Pin Risk at Option Expiration
Pin Risk
Pin risk is a term that is understood by professional options traders, but generally not very well understood by the investing public. Covered call writing is the most basic of all option strategies and is widely used by many investors. It has been proven that covered call writing can reduce risk and enhance return in a portfolio. In today’s low interest rate environment, more and more investors are turning to covered call writing as a way to produce some needed income from a retirement account.
When a covered call is written there are two scenarios that can unfold at option expiration. One is that the underlying stock or ETF will be above the call option strike price and the stock will get called away. The other scenario is that the price of the underlying stock is below the strike price of the call option and the call option will expire worthless.
So, what happens if you are very close to option expiration and the underlying stock is right at the strike price? The answer is that you can’t be sure whether or not the stock will get called away. It’s not an issue if you don’t care whether the stock gets called or not. It can be a major problem if you want to get called and don’t. For example say you bought 100 shares of ABC at $45 and sold the $50 call for $1. The stock is over $50 on the last trading day prior to expiration and this is a situation where you want the shares called away from you. You either need the capital for another investment, or no longer want the stock in your portfolio due to deteriorating fundamentals or technical analysis. With 30 minutes to go on the Friday before expiration, the stock is at $50.05, it looks like you should get it called, but what happens if the stock settles right at $50 or moves below in the final seconds of trading? You may end up holding a stock that you wanted to get rid of. You could think that the stock was going to get called and find out on Monday morning that you still own it and that it has gapped down at the open creating a substantial loss.
The best way to eliminate pin risk is to close out positions on the last trading day before option expiration to be sure that you have the result you want. Buy back the calls for a few cents and sell the stock in the open market if you want it called away.
The same thing applies to any other short position, like puts, spreads, etc. Close the position if the underlying is very close to the option strike price near expiration if the unexpected option assignment or lack of an assignment will create problems for you.
Bear Call Spread
Bear Call Spread
The bear call spread is a vertical credit spread. With a vertical credit spread the investor will sell a lower priced strike call option and purchase a farther out of the money call option as insurance to limit risk. The credit received is the premium received for the short call minus the premium paid for the long call. The maximum risk is defined as the distance between the strikes selected minus the net premium received. The bear call spread is used when your forecast for the underlying is neutral to bearish. To obtain the maximum credit we want the underlying to stay below the short call so that both options expire worthless and we collect the credit. Let’s look at an actual example that currently has decent profit potential. On April 27th, 2012, Amazon, AMZN closed at $226.85. If we look at the weekly call options that expire on May 4th, the $230 call will sell for $2.80 and the $235 call can be bought for $1.44. The net credit we’ll receive is $1.36 or $136 per contract. If we set our maximum allowable loss at $5,000 we’d use 13 contracts. The actual maximum loss would be $4,732, the theoretical profit or expected return would be $1,453 and the maximum profit would be $1,768. If AMZN rises to the lower strike at $230 you could close out the position or do some dynamic delta adjusting to control loss. The position could be adjusted by adding some long calls, short puts or buying some AMZN stock or any combination of those. The chart below shows the profit/loss points for this call spread.
Investors who have long term stock holdings may also want to use a bear call spread to produce income and have potential for upside gain. One of the disadvantages of the popular covered call strategy is that in exchange for the income received from the covered calls, the investor is forced to forgo upside gain. If the underlying fund makes a large upside move, the investor does not participate. With a bear call spread income is produced by selling out of the money calls and purchasing further out of the money calls in the same quantity. This way in the event that the stock makes a large upside move, the investor will participate and still receive some income. For example if our investor owns 100 shares of ABC at $25, she could sell one $30 call and buy one $35 call for a net credit. Above $30 the shares would get called away, but she would still own the $35 call. Therefore, if the stock were to rise above $35 she would still have unlimited profit potential from the remaining long call at the 35 strike.
Regime Change
Regime Change
No, I’m not discussing political leadership changes in a foreign country due to intervention or a coup. The term “regime change” also applies to the stock market. The stock market goes through regime changes or shifts. What the term refers to is the state of the market in terms of its trend and volatility. The majority of the time, the market trends quietly upwards with low volatility. These periods of low volatility are interrupted by brief periods of rapidly falling prices and high volatility. Without delving into the underlying mathematics of the econometric models that calculate regime change, it can be summed up in simple terms to mean that about 85% of the time the market will trend higher with low volatility. We’ll call this “state one”. About 15% of the time the market will be in “state two” characterized by falling prices with high volatility. The trend is approximately three times as large in the negative direction when the market is in state two. Also, when the market is in state two, it tends to revert to state one quickly with 90% probability.
Ok, so what does this type of quantitative research mean to investors? What it means is that if you invest in the market you should expect most of the time to see your portfolio increasing in value with modest price swings, but also expect to have those quiet periods interrupted by brief periods of rapidly falling prices with larger price swings. Long term investors can use the periods of falling prices to add to market positions. Investors with a shorter time horizon, like those who are already retired can find the state two periods to be very unsettling. Investors can always consider using some sort of hedging mechanism if the volatility is causing too many sleepless nights. Index options can be used to hedge downside risk as can some of the new volatility and inverse ETFs.
What this can mean for option traders is that if we are in a period of high volatility, we can expect the market to eventually return to normal which means that the high volatility will eventually subside and we can expect to profit from strategies that involve selling options and collecting premium.
Expected Return
The concept of expected return is critical for options traders to understand. The expected return is known as the weighted average outcome. The math is really simple and can be shown as follows; say you were considering an investment that had a 25% chance of a 20% return, a 25% chance of a 10% return, a 25% chance of a 5% return and a 25% chance of a -5% return. The formula would look like this;
Expected Return = (0.25) (0.2) + (0.25) (0.1) + (0.25) (0.05) + (0.25) (-0.05) = 7.5%
As an options trader or if you use options to reduce risk and enhance return on your investment portfolio you need to get in the habit of using an option calculator and calculate the expected return on any position that you are considering. Options without an expected profit should not be used. Scan the market for strategies that have a positive expected return.
Say for example someone challenges you to a game of coin toss. You can pick heads or tails and you can play as long as you wish. If the payout was the same for either heads or tails say $1, there is no statistical advantage to the game and no reason to play. Now if you were the receive $2 when you won and only had to pay $1 when you lost, you’d have a huge statistical advantage and should play that game as much as you can.
Casino games are like the above example but the casino gets $1.05 when it wins and you get $.95 cents. When trading options, use an expected return calculator, find trades where the expected return is on your side and manage your risk always.
The Long Straddle and Gamma Scalping
The Long Straddle
The long straddle is a limited risk strategy used when the tactical option investor is forecasting a large move in the underlying or an increase in the implied volatility or both.
I don’t believe that traders should have a strategy bias. Traders should study the market and apply the strategy that best applies to their market forecast. Traders with a strategy bias tend to limit their opportunities.
However, I do think that it’s ok to have a few favorite strategies that you employ when you think that the time is right. One of my preferred strategies is the long straddle. For those of you unfamiliar with the strategy, the long straddle is the simultaneous purchase of at the money call and put. For example if XYZ stock is trading at $25, an investor would purchase the 25 strike call and put at the same time. The long straddle is a limited risk, theoretically unlimited profit potential strategy.
Why purchase a straddle? A straddle should be purchased when the investor forecasts a large price move in the underlying or an increase in implied volatility, or both. It is easier to forecast a move in the implied volatility than to attempt to predict price movement. One of the best times to put on a long straddle is in the weeks preceding a quarterly earnings report. Implied volatilities can have a tendency to rise in anticipation of the earnings numbers and peak out just prior to the announcement.
A straddle purchased before the volatility increase can be profitable. Generally they should be put on 3-4 weeks before the announcement, so they can be purchased when the implied volatility is low and appreciate in value as the implied volatility increases as the earnings announcement date is approached.
What are the risks associated with the long straddle? Well the implied volatility may not increase and the stock price may remain very stable. In that case, the enemy of the option purchaser, time decay or theta will take its toll on the position. You may also want to consider the volatility of the broad market before purchasing a straddle. If the broad market has a very high volatility level due to some recent event, it may not be the best time for a straddle. If the VIX is at high levels you might want to consider another strategy. If the VIX is at normal levels or has declined and the investor is forecasting a rise in the VIX and a rise in the implied volatility of an individual equity due to an impending earnings announcement, a long straddle may be an appropriate strategy.
Is there any way to offset the effects of the time decay as measured by the theta? One tool that can be employed by aggressive traders is known as gamma scalping. When you purchase a straddle you have the right to buy or sell the underlying at the strike price. So, if you are long or short the stock in the same amount of shares as your equivalent number of straddle contracts, you have protection against an adverse move in your stock position regardless of whether you are long or short.
I like to do some scanning to find stocks with a history of implied volatility increase as the earnings date approaches. Then I use a 20-day window and try to locate issues that are trading near a strike price and at a 20 day moving average. I use soft numbers, so the entry can be plus or minus a few cents from either parameter. Then I calculate the daily standard deviation by dividing the annual standard deviation by sixteen.
Why use the number 16? The square root of time is used to calculate standard deviations across multiple time frames. There are 256 trading days in a year. The square root of 256 is 15.87, so that is rounded to sixteen.
So I have now entered my straddle when the price of the underlying is at a strike and near a moving average. My position is close to being delta neutral. The at the money calls and puts should have roughly the same delta. Again, I use soft numbers, so I consider a delta of -50 to +50 as being delta neutral. Because I have a long position it will be gamma positive, so that means that the delta can change rapidly with movement in the underlying and that I will profit from large price swings.
Once the option position is on, if the stock moves up by one standard deviation, I’ll short enough shares to make my position delta neutral again. If the stock moves down by one standard deviation, I’ll take a long position in the stock. Using round lots, I’ll buy enough shares to become delta neutral once again. When the stock returns to its mean, I’ll close the position for a small gain. Remember if the stock moves one standard deviation from its mean, there is a 68% probability that it will return to the mean. If it makes a two standard deviation move, there is a 95% chance that it will return to the mean.
By gamma scalping this way, the investor can attempt to earn day trading profits sufficient enough to offset the time decay of the position. When things go right, I have been able to earn enough day trading profits from this method to completely cover the cost of the straddle before it is liquidated around the time of the earnings announcement. I don’t have a hard rule for exiting the straddle. If profits are adequate from the implied volatility increase I may liquidate the entire position just before the announcement. On the other hand I may decide to sell part of the position and keep some through the announcement and try to profit from a large move in the stock. If the position has been paid for by gamma scalping on a daily basis along the way, the investor has a lot of flexibility with their money management strategy at the exit.
Alcoa Long Straddle P&L
TVIX, Two Times the VIX? Not Today.
Investors who followed the price action of TVIX today witnessed a great example of what can happen when using leveraged and inverse ETNs. The TVIX is designed to give an investor twice the daily price movement of the VIX. If you want to place a hedge and think that volatility is going to rise, the TVIX should give you double the action of the VIX and make for a good hedge when IV is rising.
Today the VIX rose and TVIX got crushed. In February, Credit Suisse announced that it was not going to create any more shares of TVIX. As a result TVIX is driven by market forces and can trade at a premium or discount to its indicative value, like the NAV of a closed end fund. The last few days TVIX has been trading at a substantial premium to its NAV. Because Credit Suisse is not creating new shares the algorithm that allows it to track its index, the VIX could not work and the mass selling on very high volume brought the shares down to an all time low. Volume was more than two and a half times its three month average. Today’s fall was almost 30 percent. Yesterday it had closed over 80% above its indicative value at $14.43. Today it closed at $10.20.
When using any leveraged or inverse funds investors need to do their homework and know what they are buying and how to apply them to a trading or investing strategy. Before purchasing a levered or an inverse fund it is critically important to understand the structure of the fund. They have added risks. The funds are designed to move up by twice the amount of an index, or move up if an index declines or move up double or triple the amount an index declines on a daily basis. The key word here is daily. Over longer time periods they will not perform with double leverage. Due to what’s known as ‘roll costs’ and after factoring in how daily market volatility works, the funds may not perform well over longer time periods.
You can own a leveraged index fund, watch the index gain over a long time period and see the leveraged fund decline in value. Here’s a real world example as reported by the SEC, the Securities Exchange Commission. Between December 1st, 2008 and April 30th, 2009 a certain index gained 2%. A leveraged fund that delivered twice the daily performance fell by 6%. During the same time frame an ETF seeking to deliver three times the daily performance of an index fell by 53%, while the underlying index gained about 8%.
Before using a leveraged or inverse fund, check past price action to see if it is performing as it should relative to its index. Check the fundamentals of the issuer for changes to its credit rating or if they have suspended issuing any new shares.
ETNs can be great tools for portfolio management, but one must understand the risks.
2 Minute chart of TVIX vs VIX
The Iron Condor
The Iron Condor
The iron condor is a defined risk market neutral strategy. It is composed of a bull put spread and a bear call spread put on for a net credit. The risk is defined as the distance between one of the spreads minus the credit received. The investor hopes that the underlying market will stay between the two short strikes and the net credit will be collected as profit. This can be a good income strategy. It can have a high probability of success depending on the width of the condor or how far the short strikes are from the underlying. It can also have a poor risk reward ratio depending on the distance between the short and long strikes on the call and put spreads. The closer the strike prices are together, the less risk there is, but you’ll also receive less credit for the overall position.
Let’s look at an actual example as of the time of this writing. The SPY closed at 137.57. If you had the market opinion that the SPY would not rise by more than $4.43 or fall by more than $5.57 by expiration, you could consider selling an iron condor that would consist of 1 short SPY 132 put, 1 short 142 SPY call, 1 long SPY 145 call and 1 long SPY 129 put. The net credit using the current bid/ask prices and by going out 41 days in time would be $88 for each condor. The risk would be defined as the distance between a spread and the net credit or $212. Volatility is low now so the option prices are not real high. You can get more credit by widening the distance between the spreads, but then there is also more risk. For example is you decided to use a 4 point spread, it would be for a net credit of $104, but now the risk would be $296.
Using the standard deviation is a good way to determine where to place the spread, it can be calculated so that there is a low probability that the underlying will move far enough against you, but you’ll also have the long positions there for the absolute risk control.
The iron condor can be applied when you think that volatility is high and you believe it will fall. If the implied volatility is high in the current month and lower in the farther out months, a calendar spread might make more sense.
SPY Iron Condor
The Covered Put
The Covered Put
The covered call is probably the most popular option strategy used today. It is very simple. Most investors tend to be long stocks and the idea of writing a call option, collecting some premium and being willing to accept a higher price for your underlying equity position appeals to many investors. Covered calls can provide some decent income and limited downside protection while you are waiting for your stock to appreciate to your desired exit price.
The married put is similarly another simple option play that is very common. With a married put, the investor will purchase a stock or an ETF then buy a put for insurance to protect the downside. With a married put the risk is limited and the upside reward in theoretically unlimited.
The covered put is not commonly used at all, yet can be a good strategy. Most investors don’t short stocks, so it is not nearly as common as the two strategies mentioned above. The covered put is just about the opposite of the covered call. The investor will identify a stock or ETF that he thinks has topped out and believes that it’s time for a short position. The stock is sold short and then a put option is sold on that position at a price point that the investor will be happy to buy the stock back. The profits to the downside are limited to the strike price selected and the premium received for the sale of the put. Just like a covered call there is risk to adverse price movement in the underlying, but now it is to the upside.
So, if you think that ABC stock won’t go any higher, you could short ABC say at $25. Then you could sell a $20 put say for $1. If ABC goes below $20 you’ll get assigned, buy the stock back at $20 and close out your position for a $6 profit. The percent return that you’d receive depends on the margin rate that you get from your broker.
Shorting stocks isn’t for everybody, but the covered put can be a viable strategy. As always it’s wise to do some thorough research and avoid stocks that could be potential takeover candidates or that could experience rapid price appreciation for some other reason like a new product announcement, lawsuit getting settled etc. Investors who rely on technical analysis alone should review the fundamentals to see if there are issues like that pending that could impact the price.
P/L Graph for a Married Put
