Put Call Ratio
The put call ratio can be used to measure market sentiment. It is frequently used as a contrarian indicator. The way it’s calculated is very simple it’s just the number of puts traded divided by the number of calls traded. You’ll see it quoted a couple of different ways, one is the open interest or OI ratio and the other is volume or VOL. The OI ratio uses the open interest on the option contract and the VOL measure uses the volume over a given time frame.
The dollar weighted put-call ratio is the sum of the put volume times the put price divided by the sum of the call volume times the call price.
Contrarians use the put call ratio under the assumption that the public is usually wrong. So when the public is buying a lot of calls, they’ll short the stock and when the public is buying a lot of puts, they’ll buy the stock.
As with any strategy it won’t work 100% of the time and there have been many times when there has been heavy call buying on a stock and the stock ends up getting taken over. A takeover candidate is not a suitable short sell candidate.
Below is a chart of the AGG ETF as of 11-9-2012, the IShares Core Total US Bond Index. The red line below shows the put call OI ratio at 226.00.
Ten Often Repeated Misconceptions about Option Trading
#1- Options should only be used by professionals
Not true, the use of options has become more widely accepted over the last several years. Today’s modern retail brokerage platforms and tight option spreads put individual investors on the same playing field as the pros. It has been shown in numerous studies that using options can enhance return and lower risk in your portfolio.
#2- Options should only be used in an IRA or tax deferred account
Some people think that due to possible high turnover from using options can create a tax headache. That also is not true. Options can be bought or sold long term and the portfolio turnover is something that can be controlled. Today’s tax reporting software make it very simple to report even if you do have high turnover, like from a strategy of selling covered calls on a monthly basis. The IRS will allow an investor to attach a realized gain/loss statement from a brokerage instead of completing the schedule.
#3- Individual investors get taken advantage of in trade execution
In the old days the market makers controlled the game and the bid ask spreads were wide. Today’s electronic markets are very efficient and competitive. Many issues now trade in penny increments. Investors no longer get taken advantage of by the market makers.
#4- Option trading only works when markets are volatile
Options can help enhance the return on your portfolio regardless of whether the volatility is high or low. There are different strategies that can be used to profit or protect your portfolio when the volatility is rising or when the volatility is falling.
#5- Option trading is not for young investors
Some people say that option trading is good only for highly sophisticated investors with years of experience and a high net worth. That is another misconception that is not true at all. Younger investors with a growth objective may want to purchase long term options on the market or an individual stock to participate in the upside of the market, but limit their downside risk to the amount of the premium paid for the option.
#6- The trades are hard to execute and require experience
Another common falsehood, today’s modern platforms and options chains make it quite simple to enter trades with very little room for trade errors. It only requires a little learning to be able to execute option trades.
#7- Brokerages that are good for options are not suitable for equities or ETFs
Not true, today the main stream brokers all have pretty good option platforms and the firms that specialize in options also have some very good platforms for stocks and ETFs.
#8- You need to spend a lot of time and money on options trading education
That’s another one that may have been true at one time, but does not apply anymore. Most of the brokerages have some good educational materials. The Options industry Council, OIC, has some excellent free education on their website. The Chicago Board Options Exchange, CBOE, also has a wealth of free information. There are many books worth studying as well.
#9- Options traders are greedy short term speculators
Nothing could be further from the truth. Options can be employed by long term investors to reduce risk and produce income. Cash secured puts can be sold to target an entry price on a stock or ETF for a long term hold and the returns can be favorable. Covered calls can be used for income generation in today’s record low interest rate environment.
#10- Options trading popularity will die off
The volume in options trading has been expanding recently. The ETF explosion has led to more and more options volume. The use of options is becoming more widely accepted than ever and will continue to increase.
One of the keys to success in trading options or in using options to enhance return on a portfolio is have some flexibility in your strategy selection so you can adapt to rapidly changing market conditions. I have talked with many traders over the years that have a strategy bias and they get good results for awhile only to eventually experience a period where they have heavy losses and have a substantial drawdown of capital.
What strategy bias means is that is that the trader will learn one strategy and use it on a regular basis regardless of market conditions. A strategy like the iron condor is a good example. People learn about the iron condor, understand that it can have a high probability of success, but may not have much experience with dynamic delta hedging and learn the hard way that iron condors also have a poor risk/reward ratio.
The market goes through cycles knows as “regime changes” where the market moves from a period of relative quiet, through a period of high volatility. Iron condor traders can have losses when the market moves from low volatility to high volatility. In 2008 when the volatility spiked to extreme levels iron condor positions would have hit their maximum loss.
If you are forecasting rising volatility, you’d want to consider trade like a long straddle. Long straddles can be effective when there is a know event approaching that could move the market. On Thursday May 31st the SPY closed at $131.47. The monthly jobs report was released pre-market on Friday June 1st and the SPY opened at $129.41 and hit a low of $128.16. A long straddle bought before the close on Thursday could have produced some nice profits and we knew the jobs report was coming. An iron condor held through that would have had an adverse movement.
To be successful over time, master several different strategies and learn how to employ them in changing market conditions.
Dynamic Delta Hedging
Dynamic delta hedging is a term used for adjusting the delta of an option position due to price changes in the underlying security. One of the beauties and challenges of options trading is that there are so many different combinations to consider for any market outlook. Say you’re an income oriented investor and you have just established a delta neutral iron condor. In order to receive the maximum profit, you want the underlying security to stay between the two strikes and the entire position to expire worthless. As the stock or ETF begins to move your position will start taking on delta. The gamma of your position is the rate of change of the delta. If you were delta neutral when the position was initiated, check your gamma, the gamma is how much the delta will move with a one point move in the underlying. By knowing the gamma you can be prepared to make adjustments to your position to remain delta neutral. Complex positions that have a high positive theta will also have short gamma, meaning that you have to be prepared to adjust according to price movement in the underlying. In the case of a delta neutral iron condor, if the underlying makes an upward price move you have the choice of adding some long calls, more short puts or some long shares of the underlying stock. If it makes a downward move, you can add long puts, short calls or short some of the stock. Instead of just adding you can also look to reduce some contracts, so in the case of an upward move you’d want to buy back some of the short calls, or in the case of a downward move you could buy back some of the short puts, or you could consider any combination of the above.
One thing that you need to consider is how often you want to adjust, do want to check your position daily or several times during the trading day? Another consideration is how you choose to define delta neutral. Of course the strict definition is that delta neutral means zero deltas, however when it comes to trading you should establish a guideline so that you’ll allow some flexibility. It’s impossible to stay at exactly zero, so a good rule of thumb might be to say that you’ll allow a range of plus or minus 50 deltas. Allow the position to range from -50 deltas to +50 deltas and don’t make any adjustments until those levels are exceeded.
The final consideration is how to make the adjustments and that is where the fun comes in. Because there are so many different possibilities to evaluate for each position, it is wisest to use an expected return calculator and see which adjustments have the best mathematical expectancy. Remember if you want to add delta and want to add to the position you can buy stock, buy calls or sell puts. If you want to subtract delta and want to add to the position you can buy puts, sell calls or short stock. You can also adjust delta by closing out part of the existing position. Evaluating all of the possibilities is what makes options trading so flexible and challenging.
One of the advantages of trading options is their virtually unlimited flexibility. For any strategy or position considered there are numerous possibilities. If one is to consider all of the different strike prices and expirations to choose from the universe is huge. Now consider for a moment that for every option position there also exists a synthetic equivalent.
Say for example that you are considering purchasing a long call. Hypothetically, there are ten strikes for that option and also ten different expirations that could be used. That means that there are 100 different call options to evaluate to see what fits your market prognosis the best.
Now consider that there is also a synthetic equivalent to a long call. The equivalent is long stock plus a long put. There is only one long stock position to consider, but hypothetically assume that there are also ten strikes and ten expirations to consider for the long put. That means that in addition to the 100 call options to evaluate, you can also evaluate 100 long put positions to combine with the long stock. So now you have 200 different positions to consider.
That’s the beauty of using options, the possibilities are virtually unlimited and there is is no limit to the amount of creative thinking that can be applied.
Remember for each position there exists a synthetic equivalent. Here’s a table of the basic ones.
Long Stock = Long Call + Short Put
Short Put = Long Stock + Short Call
Long Put = Short Stock + Long Call
Long Call = Long Stock + Long Put
Short Call = Short Stock + Short Put
Short Stock = Long Put + Short Call
Since there are many complex option strategies to use, it makes sense that a synthetic equivalent could be used for any of the legs of a normal option strategy if it is advantageous.
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.
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.
The uncovered or naked put is sold when an investor wants to produce income and is willing to accumulate shares of stock. The key difference between an investor and a speculator when it comes to naked put selling is that the investor is targeting a stock or ETF for a long term buy and has set a price that he is willing to purchase that stock at. The speculator is trying to profit by selling the put and hopes it will either expire worthless or he can buy it back later for a profit. The investor is satisfied with either outcome having the put expire worthless or getting assigned and purchasing the underlying shares at pre-determined price. Income is produced by selling out of the money put options at a price lower than the current price of a stock, when the investor would be willing to buy the stock at that price. For example, if XYZ stock is trading at $25, the investor is willing to purchase XYZ at $20. Therefore, she sells a $20 put for $1. If the stock stays above $20, the investor retains premium. If the stock goes below $20, it will be put to the investor at $20. However, the investor already has collected $1 in premium so her cost basis is $19. There are many sources that consider naked put selling to be a risky strategy. However, selling an uncovered put is not as risky as outright stock ownership. If an investor owns a stock that goes to 0, like General Motors, the investor has a total loss. If the same investor sold a put and was assigned on that put to purchase those GM shares, the investor would have retained the put premium even though the shares eventually went to zero. Naked put selling is riskier to the brokerage house because they fear that the investor may not meet the margin call if shares are put to her. If the investor utilizes proper position sizing relative to her portfolio and is using the strategy for stock accumulation uncovered put selling is not a high risk strategy and in fact has the same risk profile as the covered call strategy which is generally considered to be low risk. When stock prices decline, implied volatility has a tendency to rise making the options more expensive. If you’re targeting an entry price for a stock and see it decline rapidly, check the option quotes for a rise in the implied volatility and high prices for out of the money puts. When bad news comes out on a stock that you want to own, that can be a good time for selling out of the money puts. Say you’re willing to accumulate 1000 shares of XYZ over time. You could sell 10 out of the money puts and wait for the shares to get put to you or you could use a fraction of the total, say 2 puts per month and repeat the process until you’ve accumulated the full 1000 shares. When selling naked puts we target investments to accumulate, a price below the current market that we’re willing to buy them at and try to find puts that are relatively expensive. If you’re accumulating shares of a stock, puts will have a tendency to be priced high every quarter prior to the earnings release. This can create an opportunity for the put seller as the implied volatility rises to account for a substantial move in the stock. Out of the money puts can have a higher price at this time and provide an attractive entry point. For investors wishing to accumulate shares in a commodity based ETF such as USO, the oil ETF, the volatility can be higher before the weekly release of the petroleum report. Stock index ETFs can have higher implied volatility prior to major releases of
economic data like the monthly employment numbers or scheduled Federal Reserve meetings. When selling a put you can use the delta to approximate the probability of getting assigned at expiration. An at the money put will have a 50 delta, so if you sell an at the money put you have a 50/50 chance of ending up owning the shares. The at the money puts also have a relatively high premium and will have high theta. As the puts move out of the money the delta is lower so the probability of getting assigned also gets lower as you move out of the money. If you sell 20 delta puts the premium may not be that high, but you’ll only get assigned 20% of the time and your entry price into the underlying will be substantially below the current market price. If you are targeting individual equities with this strategy, you will only get assigned when the stock drops significantly, and you may decide you don’t want to own that stock anymore. It’s very critical to be sure you’re willing to purchase a stock when selling puts. When the strategy is used to accumulate ETF shares in a broad based index like the S&P 500 for example, by selling far out of the money puts on the index, you’ll only buy shares on dips and it can be a good dollar cost averaging strategy for share accumulation in an index fund.