Butterfly Option Strategy » Investment

Trading Butterfly Option

admin — Wed, 06 Jan 2010 02:13:37 +0000

In stock trading, traders avoid spreads of any kind because limiting losses can also limit gains. It is a must to trade in a realistic way. If you trade a three-fold gain, which is the strategy that requires only little up-front capital, you strictly limit losses by neutralizing declining time value while opening the possibility of five to ten fold gains. This is done by holding the position to expiration, wherein it is part of any options players. The Butterfly option involves all these qualities. The butterfly option spread is the result from combined debit spread and credit spread, stuck over three strike prices. The butterfly option is basically the option position that is comprised of two vertical spreads with common price.

The butterfly option involves an opening position wherein options (Calls and Puts) are bought or sold at three different strike prices. This option is has both limited losses and limited profits. There are two basic types of butterfly option. One is the long butterfly that can be created by either employing call options or all put options. Because of put-call parity, the long butterfly that is generated from call options will behave like a long butterfly that is created using put options. In short, it doesn’t really matter whether you employ calls or puts to build the long butterfly option.

The long butterfly option can also be generated by buying an in-the-memory (ITM) call option or selling two at-the-memory (ATM) call options and or buying another out-of-the-money (OTM) call option. This is actually a combination of two opposing vertical spread options thus the name butterfly spread. Combining the profit profiles from the butterfly option, the stock prices will fall which in turn can cause limited losses. Also, if the stock prices jumps too high, limited losses can also be faced. However, in case the stock prices stay intact at the ATM option strike price, a limited profit will suffice in the butterfly option.

With that being said, the butterfly option is a good option strategy for low volatility. This is for the fact that betting on stock price that is not moving much so as to collect maximum profits. This butterfly option is also a low risk strategy because losses are limited when the stock crashes or creeps unexpectedly. The bad thing about this is that this can yield limited profits. In the long butterfly option, the trader can also use all put options rather than all call options.

Short butterfly option on the other hand is the exact opposite of the long butterfly. In this option, if the stock price falls, the trader receives maximum limited profits. Also, when the stock price is high, the trader receives limited profit. But here, the stock price doesn’t change much so the trader is faced with a loss, though this loss is limited as well. Short butterfly option is basically a strategy that is high in volatility but neutral in direction. A warning in both short and long butterfly option is that, they involve buying and selling options at three strike prices. This means that the investor needs to pay three commissions to open the position and another three commissions to close it. These extra commissions need to be considered when determining whether the butterfly will be profitable for any circumstance.

Financial Trading – so many markets, so little time

admin — Tue, 29 Dec 2009 03:52:28 +0000

Would you like to make money from trading but don’t know how to trade?
Have you heard of others making a killing on the markets and wished yourself in their position?
Trading covers a multitude of sins, or at least a multitude of markets. Mention “trading” to a non-trader and they’ll probably think of stock and shares but there are many other markets you can trade in. These include commodities, futures, indices, CFDs and options. They all have their pros and cons and some require specialized knowledge.
The most popular markets used by traders are stocks, commodities, futures, indices and forex. Some traders switch between markets, others stick to just one. Let’s highlight some of the similarities and differences between them.
Shares
In the USA there are over 40,000 shares so you have a lot of markets to choose from. You can’t deal in all of them so you need to home in on those that offer good trading opportunities using whatever trading methods you decide to use.
When buying shares you usually have to put up all the money at the time of sale. That might seem obvious but it’s not so with all markets. Some brokers offer a 50% margin with shares which means you can trade to the value of twice the amount in your account. This seems like a good deal but if your shares start to go down you’ll get a “margin call” and will either have to put more money in your account or sell the shares at a loss.
Shares are normally traded in lots of 100. If you want to trade an expensive share – and some shares are very expensive, particularly in the US markets – you need a considerable amount of money in your account.
It’s not easy to sell shares short. Selling short is a strange concept to many people who think of buying shares at a low price and selling then at a higher price. But it’s often easier to predict that a share will fall rather than rise so what you’d like to do is to sell it at a high price and then buy it back later at a low price. The net result is the same whatever the order of the deals – buy low, sell high.
However, you can’t sell something you don’t own so in order to sell shares short you must “borrow” them from your broker. This is not quite as straightforward as buying and not all shares are available for selling short.
Finally, share dealing takes place during market hours so if you don’t live in the country where they are being traded you must adjust your trading hours to suit.
Futures, commodities and indices
Commodities are goods such as corn, copper, crude oil, orange juice, oats, gold and wheat.
Technically, a futures contract is an agreement to make or accept delivery of a commodity on a certain day at a certain price. In practice this rarely happens unless you’re a manufacturer who actually wants the goods. The vast majority of futures traders are simply speculating on whether the price will go up or down and never take delivery of an item.
Futures contacts include commodities and also stock market indices such as the S&P 500, Dow Jones and the Russell. Indices are simply a composite of securities that provide an overall reading of the market or some section of it.
The S&P 500 (Standard & Poor’s 500) tracks 500 of the largest companies in the US market. The Dow Jones Industrial Average tracks only 30 of the largest and longest-established companies while the Russell 2000 is an index of smaller stocks.
Essentially, commodities and indices are futures and traded in much the same way although traders may use the terms interchangeably.
Unlike shares, futures can be sold short just as easily as they can be bought. Each futures contract has its own fluctuating price and many traders deal in just one lot contracts.
Brokers usually charge a flat fee commission per contract, often expressed as a “round turn” which is one buy and one sell transaction. This may be a few dollars, often less than the value of a point or two on the contract. If you’re trading a long time frame the commission is negligible but if you’re day trading and scalping for a few points here and there it becomes a considerable part of the cost.
Futures brokers usually offer a margin of around 20% of the value of the underlying instrument so you can control $10,000’s worth of a contract for maybe $2,000. However, the same rules apply – if you over-leverage your account you’ll receive a margin call or your positions will be closed at a loss. Margin and leverage are a two-edged sword.
Many brokers offer a demo account so you can get used to the trading platform and test your trading strategies before you put real money on the line.
Forex Currency Trading
Currency trading, foreign exchange or forex as it’s more commonly known, has fast become one of the most popular markets for private traders in recent years.
As its name suggests, it involves buying and selling foreign currency. The most commonly traded currencies are referenced against the US Dollar and are sometimes referred to as a “currency pair” even though you are only trading one instrument. For example, the GBPUSD is the UK Pound/US Dollar pair. A value of 1.7625 would mean that the one Pound is worth 1.7625 Dollars. Other popular pairs include the Euro (EURUSD), the Swiss Franc (USDCHF) and the Japanese Yen (USDJPY) although there are others.
So unlike shares and futures, you don’t have a mass of markets to choose from, but there is variety within forex currency trading to give you a range of markets to trade.
The value of each pair differs slightly but the minimum movement – called a “pip” – is worth approximately $10. The GBPUSD has been averaging 100-150 pips per day which would be $1000-1500. Many brokers let you trade half or even quarter-size lots which are useful when you’re starting out. Also, many brokers offer a demo account so you can practice before risking real money.
The total value of the forex market is worth trillions of dollars per day, far larger than shares or futures. It is also a truly international market with dealing taking place all around the globe 24 hours per day from Monday to Friday. You can, therefore, trade at any time of the day or night at times to suit you. It’s worth noting, however, that the bigger moves generally occur during the US and European trading sessions.
You can sell short forex just as easily as you can buy and brokers offer highly-leveraged accounts too – but the same warning regarding margins apply here as well.
Brokers tend not to charge a commission for trading forex and you will often see adverts for “commission free” trading. However, they make their money on the spread which is the difference between the buying price and the selling price. The spread is usually between 3 and 5 pips although some brokers may offer a 2 pip spread on some pairs, and some less-popular pairs may have a larger spread.
Paying on the spread is particularly useful when trading mini lots. A 3-pip spread on a quarter lot will be about $7.50 whereas on a full-size lot it would be $30. Again, the spread is more important when trading short time frames where you’re only aiming to make a few pips per trade. You need to build the spread into your trading system so you don’t overestimate the amount you might make per trade.
One interesting aspect of forex currency trading is that there is no central clearing house where absolute prices are quoted, unlike shares and futures. So it’s quite possible to see different brokers quoting slightly different prices for the same pair. As the market has become more efficient, this difference has reduced, in most cases, to a few pips but it highlights the importance of checking that the data you are using for analysis is the same – or close to – that used by your broker for placing your orders.
The market you decide to trade will depend on many things, not least of all, your budget, but also how many markets you want to look at and what hours you want to trade. There are trading vehicles to suit all preferences and pockets.

Options Trading in Extremely Volatile Markets

admin — Tue, 22 Dec 2009 15:34:02 +0000

The recent stock market crisis (2008) not only rocked the financial system and the world economy but also the pockets of countless options traders all over the world. Options traders who used to profit in the years prior to this market crisis broke their bank as none of their options strategies seem to work in this market anymore. So what is it about extremely volatile markets and how should one profit through options trading under such conditions?
Extremely volatile market conditions not only produce unpredictable short term stock price swings but also open up the bid ask spread of individual stock options due to a lower liquidity and profiteering by market makers. This combined effect not only made it doubly hard for options traders to make a profit. Volatile options strategies, supposed to be meant for such conditions due to their ability to make a profit when the market moves up or down strongly and their ability to profit from an increase in volatility, also failed to produce any consistent profits due to the higher premium outlay and wide bid ask spreads, soaking up most of the profits. Unexpected rallies also crunch volatility to the extent of producing losses through decaying the premium of long legs at express speed. Short term (weekly, monthly) directional options strategies fared even worse as it not only became almost impossible to predict short term price swings but the high premium and bid ask spreads also took most, if not all, of the profits away even if the stock did move in the expected direction.
So what works in an extremely volatile market condition such as this one?
First of all, let’s look at all the different ways to trade options. There are 3 main options trading methodologies; Swing Trading, Position Trading and Day Trading.
Swing trading is a directional options trading methodology that aims to pick stocks that will move quickly and strongly within a short period of time in a predictable direction and then execute bullish or bearish options strategies in order to profit from these moves. As mentioned before, trying to profit from directional swing trading in an extremely volatile market is like swimming against the tide. Not only is directions hard to predict in the first place but the high options premium along with gapping bid ask spread all work against its favor.
Position trading is more complex than Swing Trading as it aims to profit mainly (although there are also position trading strategies that are directional in nature) from volatility or premium decay through putting together several different options and / or stocks in order to produce a hedged, market neutral position. Position trading has produced some pretty profitable results for me in this market crisis as volatility soared and options premiums are high. This puts the disadvantages of an extremely volatile market condition in the favor of the options trader. Such positions include dynamically hedged delta-neutral as well as delta-gamma-neutral positions. Both of these position trading strategies aim to neutralize market movement such that unexpected swings do not affect the position significantly while the position safely takes the high options premium on the short legs into your pockets.
Day trading is an extremely dynamic options trading method where options are bought and sold very quickly within one day in order to profit from the slightest intraday price swing or change in volatility. This strategy was a pretty hard one to profit from in low volatility market conditions as prices doesn’t change enough within a day to produce significant profits. However, day trading becomes extremely profitable in the hands of seasoned options trading veterans in extremely volatile market conditions such as this market crisis as the Dow itself has produced intraday trading ranges of up to 10%! Yes, this is the kind of trading range and price range that cannot be realized in normal market conditions. Day trading often takes the form of simply buying or shorting call or put options and then quickly covering them when profitable. Day trading also avoids the extreme overnight uncertainties that so often catch swing traders by surprise in this market crisis. Sudden overnight good news can often gap the Dow up by a significant amount and closing it over 10% higher. This can wipe out all your profits if you had been betting in the opposite direction overnight. Day trading, however, is extremely risky for beginners in options trading as the price movement is so fast and dynamic that when things happen, beginners may not know what to do and be able to do it quickly. This is therefore not recommended for beginners.
So, there you have, 2 ways to profit from this market crisis through options trading which I have used profitably. Options trading (http://www.optiontradingpedia.com) is definitely profitable under any market conditions as long as you use the right method for the prevailing conditions.

Trading Options

admin — Wed, 25 Nov 2009 15:31:52 +0000

Option is a legal agreement between buyer and seller to buy or sell security at an agreed price in a certain period of time. It is quite similar to insurance that you pay an amount of money in order that your property is protected by the insurance company. The difference between these two is option can be traded whereas, insurance policy cannot be traded. There are two types of option contracts; call options and put options. We buy call option when we expect the security price will go up and buy put option when we expect the security price will go down. We also can sell call option if we expect the security price will go down and vice versa if we sell put option. Usually, option is counted by contract, one contract equivalent to 100 unit options. 1 unit option protects 1 unit share. So, one contract protects 100 unit shares. Before learning how to trade option, terminologies that you need to know are as follow:a) Strike price: Strike price is the price that is agreed by both buyer and seller of the option to deal with. That means if the strike price of the call option is 35, seller of this option obligates to sell security at this price to the buyer of this option even though the market price of the security is higher than 35 if the buyer exercises the option. Buyer of this option can buy a security with a price that is lower than the market price. If the current market price is $39, the buyer will earn $4. If the security price is lower than the strike price, buyer will hold the option and leave the option to expire worthless. For put option strike price, buyer of the option has the right to sell the security at the strike price to the seller of the option. That means if the put option strike price is 30, seller of this option obligates to buy the security at this price from the buyer if he or she exercises the option even though the market price is lower than this price. If the market is $25, the option buyer will earn $5. It looks like a lot of transactions have been involved; but actually, seller of the option will not buy a security and sell it to the buyer. The broker firm will do all the transaction but the extra money that has used to buy the security has to be paid by the seller. This means, if the seller loss $4, the buyer will earn $4. b) Out of the money, in the money and near/at the money option: Option price comprises of time value and intrinsic price.

Time Value + Intrinsic Value = Option Price

Time value is the amount of money that the option worth due to the time the option has until its expiration date. Longer the time the option has until its expiration date, higher the time value of this option. Time value of an option will become zero if the option has expired. Intrinsic value for in the money call option is the difference between current market security price and option strike price. Conversely, in the money put optionâ€™s intrinsic value is the difference between option strike price and current market security price. If the current security price is lower than the call option strike price, this option is an out of the money option. It only has time value. Call option with strike price that is lower than the current market security price is an in the money option. This option has time value and also intrinsic value. Near or at the money option is the option, which strike price is close to the current market security price. c) Delta value: Delta value shows the amount of the option price will change when the security price changes by $1.00. It is a positive value for call option and negative value for put option. It ranges from 0.1 to 1.0. Delta value for in the money option is more than 0.5 and out of the money option is less than 0.5. Delta value for deep in the money option usually is more than 0.9. If the option delta value is 0.6, meaning that when the security price goes up $1, option price will go up $0.60. If the security price goes up $0.10, the option price will goes up $0.06. Usually, $0.06 will round up to $0.10. d) Theta value: Theta value is a negative value, which shows the decay of the option time value. Option, which has longer time to expiry, has lower absolute theta value than option, which has shorter time to expiry. High absolute theta value means the option time value decays more than the low absolute theta value option. A theta value of -0.0188 means that the option will lose $0.0188 in its premium after passage of seven days. Options with a low absolute theta value are more preferable for purchase than those with high absolute theta value.e) Gamma value: Gamma value shows the change of the delta value of an option when the security price increases or decreases. For an example, gamma value of 0.03 indicates that the delta value of this option will increase 0.03 when the security price goes up $1. Option, which has longer time to expiry, has lower value of gamma than option, which has shorter time to expiry. The gamma value also changes significantly when the security price moves near the option strike price. f) Vega value: Vega value shows the change of the value of option for one percent increase in implied volatility. This value is always positive. Near the money option has higher vega value compared to in the money and out of the money option. Option, which has longer time to expiry, has higher vega value than the option, which has shorter time to expiry. Since vega value measures the sensitivity of the option to the change of the security volatility, higher vega value options are more preferable for purchase than those with low vega value.g) Implied volatility: Implied volatility is a theoretical value, which is used to represent the volatility of a security price. It is calculated by substituting actual option price, security price, option strike price and the option expiration date into the Black-Scholes equation. Options with a high volatility stocks are cost more than those with low volatility. This is because high volatility stock option has a greater chance to become in the money option before its expiration date. Most purchasers prefer high volatility stock options than the low volatility stock options.

Actually, there are twenty-one option trading strategies, which most of the option investors and traders use in their daily trading. However, Iâ€™m only introducing ten strategies as follow:a) Naked call or putb) Call or put spreadc) Straddled) Stranglee) Covered callf) Collarg) Condorh) Comboi) Butterfly spreadj) Calender spread

Naked call and put meaning buy call and put option only at the strike price, which is close to the market security price. When the security price goes up, the profit is the subtracting of the security price to the strike price if you buy call and the reverse if you buy put. Call and put spread is established by buying in the money or near the money option and selling out of the money option. When the security price goes up, in the money call option that you buy will generate profit and the out of the money option that you sell will loss money. However, due to the difference of the delta value, when the security price goes up, in the money call option price goes up with a higher rate compared to the out of the money call option. When you deduce the profit from the loss, you still earn money. The purpose of selling the out of the money option is to protect the depreciation of time value of in the money call option, if the security price goes down. However, if the security price continuously goes down, this will cause an unlimited loss. Therefore, stop loss has to be set at certain level. This strategy also has a maximum profit that is when security price has crossed over in the money option strike price. Straddle can earn money no matter the security price goes up or down. This strategy is established by buying near the money call and put option at the same strike price. The disadvantage of this strategy is the high breakeven level. The sum of the call and put option ask price is the breakeven level of this strategy. You only generate profit when the security price has gone up or down more than the breakeven level. If the security price fluctuates within the upside and downside breakeven level, you still loss money. The money that you loss is due to the depreciation of the option time value. This strategy is usually applied for the security, which has high volatility or before the release of the earning report. The maximum loss of this strategy is the total amount of call and put option price. This strategy can generate unlimited profit at either side of the market direction Strangle is quite similar to straddle. The difference is strangle is established by buying out of the money call and put option. Because both the options are out of the money option, therefore, both options have different strike. The maximum loss of this strategy is less than the straddle strategy, but difference between the upside and downside breakeven level is slightly higher than the straddle strategy. For this strategy, the upside breakeven is calculated by adding the total call and put option prices to the call option strike price. While, the downside breakeven level is calculated by subtracting the put option strike price with the total call and put option prices. The difference between the strike prices usually is about 2.50 or 5 depending to which stock that you select to buy with this strategy. If the security price fluctuates within the upside and downside breakeven level, you still loss the money due to the loss of the option time value. Application of this strategy is the same as the straddle strategy. Covered call is established by buying a security at the current market ask price and selling out of the money call option. Selling out of the money option has limited the profit that generated from this strategy. If security price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. When the option has comes to its expiry, if the security price is not moving up significantly, you still earn the total option premium that you have received. If the security price goes up, sure you will earn a limited profit. If the stock price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. Usually, stop loss is set at the security ask price after subtracting by the option bid price. If this security price goes down and passes over the price that you set as stop loss, the loss that is incurred to you is about half of the total option premium that you have received. This is because the delta value of the out of the money call option that you have sold is about 0.4 – 0.5. The out of the money call option strike price must be the closest strike price to the entering security price. Collar is also known as medium covered call. It is quite similar to covered call strategy. It is only added one more step in order that stop loss is unnecessary to be set in this strategy. This strategy is established by buying a security and near the money put option and following selling an out of the money option. Due to the put option that you have bought, it is unnecessary to set a stop loss because put option will protect the security if the security price goes down. However, out of the money option premium that you have collected has to be used to pay for the put option premium. If the security price goes down, you still loss about half of the total put option premium. This is because out of the money call option premium is less than the near the money put option premium. This strategy is for half or one year long term investment. Condor strategy has four combinations. Two of them are for stationary market and the other two are for dynamic (volatile) market. Long call and put condor are for stationary market whereas short call and put condor are for dynamic market. The former strategy involves four steps that are buying and selling in the money and out of the money call option with an equivalent amount of contract. With this strategy, profit can be generated as long as the security price does not fluctuate out from the upside and downside breakeven level. Short call and put condor are for dynamic market, which also involves four steps like the long call and put condor strategy. The difference is that in short call and put condor, the strike prices of the options that have bought must be within the strike prices of the options that have sold. For short call and put condor strategy, profit can be generated as long as the security price has fluctuated out of the upside and downside breakeven level. The upside breakeven level is calculated by adding the whole position total pay out or receive to the highest strike price in the strategy. The downside breakeven level is calculated by subtracting the whole position total pay or receive to the lowest strike price in the strategy. Combo strategy has two combinations that are bullish and bearish combo. Bullish combo strategy is for bullish market and the bearish combo strategy is for bearish market. This strategy involves two steps that are buying out of the money option and selling in the money option. If the security price goes up more than the higher strike price, profit can be generated. But if the security price goes down lower than the lower strike price, loss is incurred. If the security price fluctuates within the higher and lower strike price, you wonâ€™t loss anything. This strategy can earn an unlimited profit but also will cause an unlimited loss depending to the market direction and also which strategy you have used. Butterfly spread strategy is quite similar to the condor strategy. It has also four combinations that are long at the money call and put butterfly spread and short at the money call and put butterfly spread. Long at the money call and put butterfly spread are for stationary market and short at the money call and put butterfly spread are for volatile market. Steps that involve in long at the money call butterfly spread are buying in the money and out of the money call option and following selling at the money call option. At the money option means the strike price of this option is quite close to the current market security price. Number of contract of the at the money call option must double the number of contract of in and out of the money option. Profit can be generated as long as the security price does not move out from the upside and downside breakeven range. The upside breakeven level is calculated by adding the total pay out of this position to the highest strike price. The downside breakeven level is calculated by subtracting the lowest strike price with the total pay out of this position. The short at the money call butterfly spread is established by selling in and out of the money call option and following by buying at the money call option. Number of contract of at the money option must be double the number of contract of in and out of the money option. As long as the security price has move out the upside and downside breakeven range, profit can be generated. This strategy generates limited profit and also cause limited loss if the security price does not go to the right direction.Calendar spread is also known as horizontal or time spread. This strategy is solely used to earn money from the security, which price trades sideway. There are quite number of stocks have this kind of price trend. This strategy is established by selling at the money call or put option, which has a shorter time to expiry and buying at the money call and put option, which has a longer time to expiry. This strategy merely generates the money from the time value of the option. The option that has shorter time to expiry depreciates the time value faster than the option that has longer time to expiry. Usually, the option that has shorter time to expiry is left for expire worthless. The total money that you receive after closing this position will be more than the total money that you have paid out when opening this position. With these ten strategies, you can use to earn money from upside and downside market and also the market that trades sideway.