Saturday, February 15, 2014

my mom's micro account

a few years back, june 2011, i opened a micro account on behalf of my mother. by micro, i mean really small, $250. i posted back then some rules that i thought would be good for a micro account such as this. here's the current balance on this account: $274.19.  while that may seem a little dissappointing it is a 9.7% gain and more dollars than my mom is seeing on a much larger sum of money she has in savings earning 0.2%.

back in 2011 i advocated a no-stop type of strategy - buy and hold  and collect dividends but sell if a 10% gain can be obtained. while that is not wrong it does mean that there is at least 1 turkey (ewz) in this account dragging down performance and maybe some winners for which i left money on the table. so i am going to try to goose this account a little by allowing stop orders, so that the turkeys get taken out earlier and the winners left to run.

i have decided to pursue an investools type of strategy whereby there is a trio of indicators that guide the entry and stop adjustment. here's what i have in this account now:

Mkt Val
Maint Req








dboewa, ewx and ewu were purchased in the last 30 days so there is no sell-stop order on those yet. the others have a sell-stop that is 3% below a recent low. i will adjust the stop upward if the indicator trio goes to a sell condition. i have kept ewz to see if it can't improve its price a little but will shed no tears if gets taken out in the normal course of this strategy.

Monday, February 10, 2014

why stocks get pinned to a strike price at expiration

some stocks will pin an option strike price at expiration. by "pin" i mean they kind of get glued to a particular strike price on the afternoon of expiration friday, cycling between trading a little above the strike then a little below it. there's this mythology floating around the web that this occurs in order to inflict the most pain on option traders - the so-called max-pain theory. nothing could be further from the truth. the market has no emotions and does not care if you win or lose. pinning is a real phenomenon. it happens because a large population of retail traders wait til friday expiration to close their short options, counting on the accelerated time-decay to work in their favor.

firstly it is important to understand the actions of option market-makers. there are three roles that mm's play:
  1. counterparty locater. when you place an option order the mm will attempt to locate a counterparty willing to take the other side. if successful then the mm collects two commissions and the bid-ask spread and has no risk.
  2. default counterparty on open. if the mm cannot find a counterparty then he becomes the counterparty but he will hedge his position so as to take no risk.
  3. default counterparty on close. a party to an option contract can unilaterally close out his position without affecting the counterparty. if a new party cannot be located the mm will step in to take the place of the party but will hedge his position so as to take no risk.
the thread that is common to all these roles is that the mm takes no risk. the mm's cannot take risk and be put in a position where they might be biased or hurt by the moves in the market. thus the option mm's are always liquid, available and impartial facilitators of trading. this is possible due to the principle of put-call parity. in its simplest form put-call parity says that a covered-call is the synthetic equivalent of a shorted-put, given same strikes and expiration. this is typically expressed algebraically as:
+stock -call = -put     (1)
where the pluses and minuses indicate long and short, resp. this can be manipulated algebraically in many ways to obtain useful relationships such as:

-call = -put -stock    (2)
by subtracting stock from both sides of equation (1).

the mm uses put-call parity to neutralize risk on their side of a transaction. for example, if the mm is counterparty to your short-put then they acquire a long-put on their books. in order to neutralize the risk of being long a put they create a synthetic short-put by buying stock and shorting a call. thus their position looks like this:
+stock -call +put
this is a position called a locked trade, or a collar, in which the mm can neither make nor lose money because synthetically it adds up to zero.

if the mm is also making a market for shorted calls then they are locking the trade the other way 'round:
-stock +call -put
notice that this is just the negation of the collar hedge above.

so what happens if client A shorts a put then client B shorts a call? at the time client B shorts a call, the market maker simply flattens the hedge acquired for client A. in this situation the mm carries on his books that client A is short a put and client B is short a call and no hedge. likewise, a retail call buyer will flatten the hedge a market maker took to neutralize risk of a prior retail put buyer. thus, whenever there are balances between short puts and short calls or between long puts and long calls the market maker is unhedged.

now suppose in the above example that client A decides to close his position unilaterally by buying back his shorted put. this leaves the mm with an unhedged long call position because he is the counterparty of client B's shorted call. so the mm has to go out and hedge that position by creating a synthetic short-call, by shorting stock and shorting a put per equation (2). this is very much the idea of what happens on expiration friday when retail clients are liquidating their positions ahead of expiration. the mm's have to hedge their positions as retail traders liquidate positions.

there are various other mixtures possible. after client A shorts a put, client B might buy a put. in that case the market maker assigns B to be the counterparty of A and closes his hedge. similarly if client A shorts a call and client B buys a call then the market maker is left with no hedge. short-call then long-put and short-put then long-call both leave the mm with full hedges. however, i argue that there is a big tendency for long option traders to liquidate early while there is time-value left on their options. so most of the open-interest going into expiration friday is short-option traders waiting for the accelerated time-decay to work. thus, it is premium-sellers and underhedged market-makers running the show.

here's how this plays out: on expiration friday afternoon the price of a stock hovers a little above the big-strike and the price of puts drop to the level where a short-put holder decides to close his position. if the mm was the counterparty to that closed short-put then he now is net long one call as the counterparty to someone else's short-call position. to hedge that risk he creates a synthetic short-call to neutralize the risk the excess long-call position puts on his book. if another retail client was the counterparty to that closed short-put then the mm becomes the counterparty to the long-put holder's contract. in order to neutralize this new risk the mm creates a synthetic long-put position by shorting stock and buying a call (the negation of equation (1)). both of these transactions, synthetic long-put or synthetic short-call, are bearish for the stock, so if enough retail short-puts are liquidated the mm's will drive the price of the stock down as they hedge risk. the drop in price of the underlying reduces the price of calls and the short-call holders start buying back their positions. this, in turn, engenders new risk for the mm's so they start hedging the liquidated short calls and these hedges are bullish for the underlying. in this way the stock price circles around the big strike while retail option holders close out their positions. when this population of retail option positions is depleted then the stock can break the pin and the price moves unhindered by the option market.

so here's what i look for to suss-out pinning opportunities. first of all, the equity has to be high- priced (think aapl) because this is going to keep a big population of premium seller's around until friday afternoon. secondly, there needs to be a lot of open interest concentrated in select strikes, like tens of thousands of contracts. third, there needs to be relatively equal numbers of puts and calls in that concentration as any imbalance will be hedged already. lastly, the price needs to wander close enough to the big strike to get pulled toward the strike. this is like magnets - hold them far apart and nothing happens; close together and you can't pull them apart.

Sunday, February 2, 2014

super bowl and option spreads

today is the super bowl and all thoughts on this day turn to the "spread."  the spread is a fudge factor in a sports wager whose purpose is to balance out the betting on the outcome of the game. you see, often times, there is one team that is heavily favored to win an event like the super bowl and this becomes a problem for bookies because they would have to not offer the win side of that bet for fear of getting wiped out. and what is the fun of that? so to encourage more betting participation the bookies have created a system to even-out the odds of winning a bet on the heavily favored team - the favored team must win by a number of points in order to win the bet. this number of points is called the spread and sometimes it is called a line. in offering spread betting the bookie is operating more like a market-maker than an odds-maker, like the kind of bet one places on a horse-race.

you see, what determines the spread is the activity of gamblers, not so much the bookies. when the bookies see that their book is getting lopsided they change the spread to encourage more betting on the other side. an absolutely balanced book means the bookies simply transfer money from losers to winners - making their cut on transaction fees, low risk and really rather mechanical. the bookies, instead of exerting a house advantage (see, eponymous book by jeff ma in my brane fud section), function more like market makers, simply facilitating wagers for a fee.

one can check the spread online because sports gambling is legal in certain states and countries. as of 11am today the spread on tonight's broncos vs. seahawks game was 2.5 points in favor of the broncos, meaning, the broncos must win by 2.5 points to beat the spread. this is pretty narrow, less than a field goal, so tonights game is viewed by gamblers as being fairly evenly matched.

there is something very much akin to a betting spread in the options market that comes into play during market events. in the world of options the events that generate interest like this are earnings reports. now, one might think that the analyst expectations for earnings of a company would be a kind of spread but these really reflect the opinion of a small number of people who may or may not be biased by who is or is not paying them. instead, the spread on a company's earnings report can be determined by an option strategy called a straddle.

buying a straddle means purchasing a call and a put at the same strike and same expiration. usually the strike chosen is an at-the-money strike. here is what the risk profile of a straddle looks like for kors (last: 79.93), which reports earnings tuesday morning:
kors straddle expiring in 6 days
the current market price of this straddle is $7.5 which means that if you bought this straddle at this price you would need kors to move more than $7.5 up or down from the last price of 79.93, by next friday, to be profitable. so you would need kors to beat this spread by that much and, like a football spread, this is determined by market particpants bidding up the price of the options.

personally, i hardly ever initiate a transaction to buy a straddle because it is at best a 50/50 proposition. market makers recognize that particpants overpay for options near earnings reports and they actually have a rule of thumb that says that the expected move in the market is really about 85% of this straddle price or $6.38. so the better bet is to sell this straddle but that has unlimited upside risk and nearly unlimited (bounded by zero) on the downside. this 6.38 market-maker expected-move is important to us premium seller's when we construct trades to take advantage of the volatility crush after earnings. (see tastytrade's trade-small-trade-often segment for examples of such trades.)

good luck on the super bowl tonight and may the odds ever be in your favor!

Saturday, February 1, 2014

aapl butter

aapl is a well-known "pinner." that is to say, on some friday afternoons it seems to get glued to a particular strike, trading a little above, a little below, but always orbiting within a dollar or so of a strike price in the option chain. usually this happens on the monthly expiration fridays. so, i was a little surprised last friday, jan 31, when peter reznicek of shadow trader called-out a pin of the 500 strike on aapl. here's the chart:
aapl pinning the 500 level
so immediately i priced a trade that i call aapl butter. this is an option strategy called an iron butterfly, essentially an iron condor with the put and call strikes mushed together. in this instance i was evaluating shorting the 500 straddle while simultaneously buying the 497.5/502.5 strangle. the risk profile graph of this trade looks exactly like a butterfly but it initiates for a credit instead of a debit:
iron butterfly at aapl 500 strike
at 2:15pm, eastern, on friday, jan 31, this iron butterfly, expiring in less than 2 hours, was pricing for a credit of $1.35. i got in around 2:24pm, collecting a $1.30. since the strikes are $2.50 apart i had a net risk of $1.20.

children, be afraid, be very afraid.

now, this strategy is a bit hincky and absolutely not for newbie option traders and absolutely not for anyone lacking experience trading options in the final moments before expiration and absolutely not for anyone lacking experience with triggered orders. however, i have experienced high reliability with such trades as long as i trade them small, define the risk and follow the rules:

after getting filled on the entry, i manage this trade by immediately entering an order to buy back the "guts", the straddle of the butterfly, for 1/2 the net credit less commissions, which in this instance came out to 60cents.

  • the first rule of this strategy is: do not try to buy back the entire butterfly, you will not get filled. this is because one or both of the wing options defining the risk in the trade are/become zero-bid and the market makers will not fill that portion of a complex order (as they might with an option that has more time left on it) unless they can find a counterparty, which is not likely. one needs to leg out of these trades, buying the guts first and then selling the wings if they catch a late-day bid.
  • the second rule of this strategy is don't get too greedy by trying for overmuch time-decay. one or both of the short options might never trade down to a nickel for the tos commission-free buyback and there is a tendency of the underlying to break the pin in the last moments of the day.
  • the last rule of this strategy is to watch the trade into the close and be prepared to act if necessary.

as part of the exit strategy i create orders to sell-off the "wings", the strangle defining risk, for 10cents each, in two separate orders tiggered by the fill of the guts order. this is extremely important! after i have bought back the guts the underlying can break the pin and move to a price that pushes one or other wing in-the-money. it is gravy when one catches a wing-sale but one must have an order in place to dump that wing because this might be something that happens in such close proximity to the close that one cannot react fast-enough. one must monitor the wings into the close and if one of them is so much as 1cent in-the-money after the close one must immediately contact ones broker to tell them do-not-exercise. there is a 30 minute window of time after the close in which to do this, after which one becomes obligated to buy or short the shares, and your broker will do that regardless of your buying-power and margin-status (there are horror stories.) this is the reason one really needs to keep these trades small - contemplate what it might mean to be long or short n x 100 shares of aapl on monday morning. however, if you have the temerity to play with this particular kind of fire, as i clearly do, following the above rules will save you from the heartache of learning about this stuff the hard way.

in this particular aapl butter trade the guts order filled with 5 minutes left in the day. that was bit close but i was monitoring it closely. aapl broke its pin in the last minute of the day but did not challenge my wings.