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An Option Strategy Based On Momentum and Price Movement

An Option Strategy Based On Momentum and Price Movement

This strategy attempts to identify points in time when upside or downside price movement is likely to have run its course, based on the percentage of price movement over a given number of days. It looks for momentum to reach or exceed a given overbought or oversold “threshold”, and then to reverse for one day.

This strategy calculates a “Momentum” value and a “Volatility” value for each trading day. The Momentum value is the weighted average change in price. The Volatility value is the Standard Deviation of the Underlying index.

The “Momentum” model generates a “Buy Calls” signal when:

A) The Momentum value falls to or below the “Buy Calls Trigger” and then reverses for one day, AND:

B) The Volatility value is below the “Volatility Cutoff” level.

The “Momentum” model generates a “Buy Puts” signal when:

A) The Momentum value rises to or above the “Buy Puts Trigger” and then reverses for one day, AND:

B) The Volatility value is below the “Volatility Cutoff” level.

The “Volatility Cutoff’ acts as a filter and is intended to prevent trading signals from being generated when volatility is very high. Buying premium when volatility is high exposes a trader to the risk that option prices will decline, regardless of market movement, if volatility declines sharply.

Parameters

A) Buy Calls Trigger -In order to get a signal from the Momentum strategy to buy calls, the calculated Momentum number must fall to or below the “Buy Calls Trigger” value and then reverse to the upside for one day.

B) Buy Puts Trigger -In order to get a signal from the Momentum strategy to buy puts, the calculated Momentum number must rise to or above the “Buy Puts Trigger” value and then reverse to the downside for one day.

C) Momentum Days -This is the number of days used to calculate the “Momentum” value AND how many days are used when calculating prices changes for each of those days.

D) Volatility Cutoff -The Volatility value that is calculated each day MUST be less than this value in order for a signal to be generated.

E) Exit Days -The position will automatically be exited after this number of trading days.

F) Option Strike -Determines how money strikes in or out-of the-money the options that are purchased as a result of trading signals.

Examples Of Trading A Bear Call Spread

Examples Of Trading A Bear Call Spread

A bear call spread is a type of option trading strategy that is used when a decrease in the price of the underlying stock is anticipated. This strategy is implemented by selling call options at a specific strike price and at the same time buying the same number of call contracts at a higher strike price. Investors profit from a bear call spread when the price of the underlying stock decreases.

In order to properly build a bear call spread strategy correctly, there are a few things to keep in mind. Here is a list of tips investors should understand before implementing this type of strategy.

Buy Out of the Money Calls

Sell In the Money Calls

Underlying Stock – All options bought and sold must be for the same underlying stock.

Same Expiration Date – The contracts that are sold and bought should have the same expiration date.

Same Number of Contracts – It is important to buy and sell the same number of option contracts when building a bear call spread.

Bear Call Spread Example

Initiating a bear call spread is easiest to understand by looking at an example. Let’s assume an investor believes that stock XYZ is going to decline in the coming months. In order to profit from this possible decline in market value, the investor plans to implement a bear call spread strategy.

The current share price of the underlying stock is at $23.23. The stock also has the following call options available to trade, which will help to build the strategy.

July $24 Calls – This out of the money option has an option premium of $.57.
July $23 Calls – This in the money option has a premium of $1.00.

Here are a few details of this hypothetical trade.

Buy 5 Out of the Money Calls – The investor purchases 5 of the July $24 calls at $.57 per contract. The investor will pay $285 (plus commission) to own these out of the money contracts.

Sell 5 In the Money Calls – The investor will then turn around and sell 5 of the July $23 calls at $1.00 per contract. As a result of the trade, the investor will receive $500 (less commission) for selling these in the money options.

The end result of the scenario above is the investor receives a credit of $215 (less commission) for initiating the spread.

Possible Outcomes

There are a few possible outcomes of building a bear call spread strategy, like the example shown above.

Stock Price Moves Lower

http://www.finelineinvesting.com/deep-in-the-money-options-explained-properly/If the stock price moves lower, which is what the investor is expecting, then both calls should expire out of the money. For example, if the share price of XYZ fell below $23 when the contracts expired, then both contracts would be out of the money. This means that neither holds any value, therefore they would more than likely expire worthless.

This is the best case scenario for the investor as they get to keep the entire credit of $215.

Stock Price Increases

The worst case scenario using this strategy is when the underlying share price increases above the strike price of the call options which were purchased. For example, if the share price of XYZ increased to $24.25, both types of options bought and sold initiating the spread would be considered in the money.

This is the worst case scenario for the investor, but one that offers limited risk. The maximum loss can be calculated by subtracting the difference between the strike prices of the two different contracts and subtracting the original credit received.

If we were to calculate this scenario for our example above, the maximum loss would look something like this –
Maximum Loss = (($24 – $23) * 5 contracts) – Original Credit

Since the investor traded 5 contracts, we must take the difference between the two strike prices and multiply it by the number of contracts times 100 shares per contract. The result is the potential for a $285 loss ($500 – $215), plus any commissions.

Stock Price Closes in Between

The last outcome possible for initiating a bear call spread is when the underlying share price closes between the two strike prices. For example, shares of XYZ could end up closing at $23.50 which is right in the middle of the calls that were sold at $23 and those that were bought at $24.

In this scenario, the long call contracts that were purchased would expire worthless as they are out of the money. At the same time, the calls that were sold would still be in the money by $.50 per contract. In this case, we would need to take the difference between the closing share price ($23.50) on the strike price of the short call ($23).

Here is how we would calculate the return or loss in this situation –
Total Loss = $215 – ($.50 * 5 contracts * 100 shares)

If the stock price were to close at $23.50 on the expiration date, the investor would lose $35 on the trade.

All scenarios described above do not take into account any commission or brokerage fees.
Final Thoughts

Initiating a bear call spread allows an investor to take advantage of downturns in a stock while minimizing any potential loss. The option strategy is implemented when an investor sells a call option(s) and then purchases the same number of contracts at a higher strike price. While the potential profit of this type of trade is limited to the initial credit received, the maximum loss is limited as well.

Options Expiration Date Explained In Full

Options Expiration Date Explained In Full

The expiration date of a stock option is the day in which the contract is no longer valid. Once this date has passed, the contract no longer exists and becomes worthless. This date for all options traded in the U.S. are all set to expire on the third Friday during the expiration month. If this day falls on a holiday, then the third Thursday of the month is used.

Why are Expiration Dates Important?

Option expiration dates are important for a number of reasons. The most important thing to remember for investors who own options is that once the date has passed, the investment becomes worthless. The investor must either exercise the contract to buy (call) or sell (put) the stock at the strike price. If the option is not exercised, then the investor can place a sell to close order and collect whatever option premium remains.

The expiration date of an option also plays a major role in determining the premium of the contract. A perfect way to see the impacts that this date has on the premium is to look at out of the money options. Contracts that have a closer expiration date will be worth less compared to those further out. Take a look at a call or put option for the same stock with the same strike price. You will notice how out of the money contracts that are set to expire soon are worth much less than those that have more time till expiration.

Multiple Option Trading Strategies

There are numerous options trading strategies that use the expiration date in different ways. For example, investors who sell covered calls look for contracts that are set to expire within a month or two. This strategy is used to lower the risk of the contract being exercised so the investor can keep their stock and pocket the premium paid.

Options investors who sell deep in the money calls is another example of when traders use the expiration date in their analysis. This strategy uses time as a big part of the potential for profits. These investors want the calls they own to have plenty of time to increase in value so they can maximize their profits.

There are numerous other strategies that make use of the expiration date of an option.

Final Thoughts

In order to be a successful options trader, investors must factor in the expiration date in their analysis. We know that it plays a major role in calculating the premium of every option contract. It also lets us know when the contract is set to expire so we can make decisions on when to cut our losses or take profits.

What is the Intrinsic Value of a Stock Option?

What is the Intrinsic Value of a Stock Option?

The intrinsic value of an option is the difference between the underlying stock’s share price and the strike price of the contract. This amount is commonly referred to as the in the money portion of the option. If an option has a positive intrinsic value, then it is considered to be in the money. However, if the amount is less than zero, then the contract is considered to be out of the money.

Both calls and puts can be considered in the money depending on where the stock is trading in relation to the strike price (or exercise price). Options with a strike price that is close to the current share price often move in and out of the money many times before the contract expiration date. When an options’ exercise price and share price are equal, the contract is considered to be at the money.

The method for calculating this value is different for calls and puts but the results mean the same thing.

Call Options

The intrinsic value of a call option can be calculated by subtracting the strike price from the current share price. For example, if a call option has an exercise price of $20 and the share price is trading at $25, the intrinsic value is $5. On the other hand, if shares are trading at $18, then there is no intrinsic value since the difference is -$2.

Put Options

In order to calculate the intrinsic value of a put option, the current share price should be subtracted from the strike price of the contract. For example, if a put option has a strike price of $28 and the stock is trading at $25, the intrinsic value is $3. As soon as the share price increases above the strike price for a put, it becomes out of the money.
Final Thoughts

decayAny stock option (calls and puts) that is considered in the money is said to have intrinsic value. This value is calculated by taking the difference between the share price and strike price. In some cases, the results will produce a positive result which means the option is in the money. Other times the difference will result in a negative value meaning the stock is out of the money.

It is important for investors to understand that it is common for options to move in and out of the money, especially if the strike price is close to the share price.

Deep In The Money Options Explained Properly

Deep In The Money Options Explained Properly

Stock options that are considered to be in the money are contracts that have a positive intrinsic value. This includes any call option where the strike price is below the current share price of the underlying stock. It also includes any put option where the strike price is above the share price of the stock.

An option with a strike price that is significantly above (puts) or below (calls) the current price per share is considered to be deep in the money (DITM). A deep in the money option is usually at least one strike price above (puts) or below (calls) the current share price of the stock. These types of options generally are so far in the money that it is highly unlikely they will go out of the money before the expiration date.

Significance of Deep in the Money Options

optionsOptions that are deep in the money tend to carry less risk than those that are at or out of the money. As mentioned earlier, it is highly unlikely a DITM option will lose all it’s intrinsic value before it eventually expires. This means that regardless of what happens with the stock, the contract will continue to hold some value which isn’t always the case for an option contract.

Trading DITM options is significant because of the lower risk involved. Options can be very profitable investment tools but are riskier than more traditional types of investments like stocks. By trading only DITM options, an investor can reduce their overall risk and exposure to the market while maximizing their returns.

Another benefit of DITM options is that they tend trade in the same direction of the underlying stock – point for point. What this means is that investing in the option is similar to owning the stock. This is important because it requires much less capital to invest, has limited risk, and provides much greater profit potential.
DITM Example

An example of a deep in the money call option could look something like the following example. A popular technology stocks currently trades around $20 per share and offers a DITM call with a strike price of $15. The premium to own this call would run around $5.50 with an expiration date about 7 months in the future.

This example is not unlike many other DITM options. The intrinsic value of the contract is $5 ($20 – $15) and the time value is set at $0.50 ($5.50 – $5.00). It is highly likely that since this contract is deep in the money, it would trade point for point with the underlying stock. So if the stock price rose to $20.50, we can assume the option premium would rise by $.50 to $6.00.

On paper, this may not seem like a big deal if the option and stock move in tandem. Let’s assume investor A purchased 100 shares of this technology stock for $20 per share. Another trader, investor B, decided to buy 1 DITM call for $5.50 instead.

Here is the breakdown of the profitability of each trade assuming the stock went from $20 to $20.50 prior to the expiration date.

Investor A

Purchased – 100 shares of stock @ $20 per share.
Cost – $2,000 + commission
Sold – 100 shares of stock @ $20.50 per share.
Profit – $50 ($2,050 – $2,000) less commission
Return on Investment – 2.5% ROI

Investor B

Purchased – 1 call option at $5.50.
Cost – $550 (1 contract x 100 shares x $5.50) + commission.
Sold – 1 call option at $6.00 prior to expiration date.
Profit – $50 ($600 – $550) less commission.
Return on Investment – 9.1% ROI

The realized gain in both scenarios is exactly the same – $50. However, what is different is that the option investor did not have to come up with $2,000 to earn that kind of return. Instead, they only needed $550 (or 27.5% of the other investment) to earn the same $50 profit.

Caution – Investors must realize that options work the same way when the price decreases.
Final Thoughts

Deep in the money options are generally very profitable for investors. As an option becomes more and more profitable over time, the further deep in the money it becomes. However, as the strike price and share price move closer, the less in the money the option becomes.

Options, especially those that are deep in the money can provide excellent returns with limited risks if invested properly. These unique investment tools provide the opportunity for smaller investors with less capital to earn the same profits as shareholders.