deep in the money!what is ^time value? 23 •time value is the market makers estimate of what the...

Presents

DEEP IN THE MONEY!

With

Bill Corcoran

I am not a registered broker-dealer or investment adviser. I will mention that I consider certain securitiesor positions to be good candidates for the types of strategies we are discussing or illustrating. Because Iconsider the securities or positions appropriate to the discussion or for illustration purposes does notmean that I am telling you to trade the strategies or securities. Keep in mind that we are not providingyou with recommendations or personalized advice about your trading activities. The information we areproviding is not tailored to any particular individual. Any mention of a particular security is not arecommendation to buy, sell, or hold that or any other security or a suggestion that it is suitable for anyspecific person. Keep in mind that all trading involves a risk of loss, and this will always be the situation,regardless of whether we are discussing strategies that are intended to limit risk.

I am not subject to trading restrictions. Myself and other instructors could have a position in a security orinitiate a position in a security at any time.

Exciting Stuff!

• I am going to teach you how it may be possible to day trade INTRINSIC VALUE.

• This isn’t really unusual, we do it all the time, as BUYERS

• I am going to show you how it can possibly be done as a SELLER

But First…A Review

• First you need to understand what INTRINSIC VALUE is.

• Then we need to review the CALENDAR SPREAD

• Finally we will highlight the importance of reading the charts in compressed timeframes.

Do You Remember???

• How does stock price movement affect option price?

• How does time affect our options?

• What is Intrinsic Value?

• What is Implied Volatility?

• What is a CALENDAR SPREAD?

Does Mindset Matter?

• What if none of what I am going to teach you really mattered?

• Your success in trading is as much a reflection of your perspective as it is your application of skill.

• Understanding pricing is not enough.

• Two equally skilled traders may recognize the same opportunity and have very different results.

THE BASICS

Option Contract

• A call option buyer has the right to buy a specific stock at a set price if they choose to exercise that right on or before expiration of the contract.

• A put option buyer has the right to sell a specific stock at a set price if they choose to exercise that right on or before expiration of the contract.

• Allowing a contract to go to expiration assumes the buyers desire to exercise the option contract.

Option Price

• A contract strike price is static, it doesn’t move.

• The underlying stock price is always moving.

• A strike price is either “In the Money” or “Out of the Money”

• “At the Money” strikes are slightly “Out of the Money”.

WHAT IS “INTRINSIC VALUE”?

• INTRINSIC VALUE tells us how far the OPTION STRIKE PRICE is “IN THE MONEY”.

• INTRINSIC VALUE is the difference between the STOCK PRICE and the strike price.

• Notice that the INTRINSIC VALE will always move right with the stock price!

• The more Intrinsic value the more the option price tracks the stock price movement.

Stock Price $27.00Strike Price -$25.00Intrinsic value = $2.00

Example: The stock is trading at $27, we areinterested in the $25 strike call:

WHAT IS “TIME VALUE”?

23

• TIME VALUE IS THE Market Makers estimate of what the time left until expiration is worth.

• The Market Maker can add or subtract TIME VALUE whenever he feels the need to.

• TIME VALUE is the Market Makers “protection” from you.

• In the money (ITM) options will have some TIME VALUE and some INTRINSIC VALUE.

• At the money (ATM) and out of the money (OTM) options will be all TIME VALUE.

Stock Price $27.00Strike Price $25.00 Intrinsic value = $2.00

Example: The stock is trading at $27, we are interested in the $25 strike call. That call option is listed at $3/share:

Option cost $3.00Intrinsic value - $2.00Time value = $1.00

Out of The Money Option

OTM Option is all “Time Value”

OTM option has no “Intrinsic Value”

The time value will erode to zero at expiration!

In The Money Option

ITM Option has some “Intrinsic Value”

The ITM Options can also have some “Time Value”

If the stock price does not change in our favor, the time value will erode.

In The Money Option

This ITM Option has a lot of “Intrinsic Value”..

And very little “Time Value”

If the stock price moves at all, the option price will change at nearly the same rate!

Time

• Time Value is also called “Extrinsic Value”.

• Extrinsic value can decay rapidly or slowly and we have no control over that rate.

• Extrinsic value is how the market maker stays in business.

• Normally Covered call traders sell “Time Value”


Stock is trading at $95 a week before expiration-

You “Sell to Open” the 100 call option for

$5 (100% time value)


Two days later, your stock is trading at $97

The 100 call option lost $2 and is now worth $3 (100% time value) and represents a $2 gain for the seller.


Two more days later, your stock is trading at $99, it has gone up $4.

The 100 call option lost another $2 and is now worth $1 (100% time value)

A $4 gain for the seller.


At Expiration, the stock is trading at $99.99, it has gone up $4.99!

The 100 call option lost another $1 and is now worth $0 (100% time value)

The stock price moved $4.99 but did not move up above $100, the time value eroded to zero at expiration and gained no intrinsic value! YOU made $5!

But….• It took several days and almost went ITM.

• What if my short call option goes “In the Money”?

• If your OTM option strike should move ITM you may lose money on that trade as you will have to buy back the option to avoid an exercise, possibly at a higher price.

• The Market Maker has the right to “call” the stock from you at the short strike price.

• Our Long option price will have gained value, offsetting the loss!


Stock is trading at $95 a week before expiration-

You “Sell to Open” the 100 call option for $5 (100% time value)


A day later the stock is trading at $99!

Your 100 call option is only worth $4 (100% time value)

In The Money Option

A day later the stock is trading at $101!

Your 100 call option is worth $4 ($3 time value, $1 intrinsic value), you are still making $1

In The Money Option

At Expiration the stock is trading at $105, a $10 move!

Your 100 call option is worth $5 ($0 time value, $5 intrinsic value)

The stock price moved $10, taking it above $100, your option went from OTM to ITM but the option price is the same as when you sold it!

The Deep ITM

• Stock price movement ONLY affects the Intrinsic Value of the option price.

• Regardless of a long or short position we are typically trading INTRINSIC VALUE based on movement of the underlying stock as observed in the charts.

• Up to a point, the more Intrinsic Value we can SELL, the better the movement in our option price.

Breakeven Calculation

• We must know what our option will be worth at expiration!

• Doing so tells us how much extrinsic value the Market Maker has introduced over the options life cycle.

• This also allows us to determine whether the trade has a probability of success.

• Breakeven for a Call Option– Strike price + cost of the call

• Breakeven for a Put Option– Strike price – price of the put

THE GREEKS

Review

It’s All Greek

• Several factors affect an options price.– Underlying stock price movement

– Changes in implied volatility

– The passage of time

• The effect of these factors are evaluated through the “option greeks”.

• Option pricing models seek to determine extrinsic value pricing.

Basic Concepts

• The “Greeks” measure sensitivity of option pricing to four factors of the pricing model.• Changes in stock Price DELTA/ GAMMA

• Changes in Time THETA

• Changes in Volatility VEGA

• Changes in Interest Rates RHO• Least impact to option price

Black Scholes Option Pricing Model

• Fischer Black and Myron Scholes came to the formula in the late 1960s, published it in 1973 and received a Nobel Prize in 1997 for it.

C0 = S0N(d1) - Xe-rTN(d2)

Where:d1 = [ln(S0/X) + (r + σ2/2)T]/ σ √T

And:d2 = d1 - σ √T

And where:C0 = current option valueS0 = current stock priceN(d) = the probability that a random draw from a standard normal distribution will be less than (d).X = exercise pricee = 2.71828, the base of the natural log functionr = risk-free interest rate (annualized continuously compounded rate on a safe asset with the same maturity as the expiration of the option; usually the money market rate for a maturity equal to the option's maturity.)T = time to option's maturity, in yearsln = natural logarithm functionσ = standard deviation of the annualized continuously compounded rate of return on the stock

Binomial Tree Option Pricing Model• The binomial model was first proposed by Cox, Ross and Rubinstein in 1979

and is considered more accurate for long dated, American style options or on

stocks with dividends.

Sensitivity to Stock Price

• We can measure option “sensitivity” to price movement of the underlying stock with DELTA.

• DELTA helps determine how much an option price will move relative to the underlying stock price movement.

• The easy way to see this is:

• If the stock moves $1, the option price will move by the DELTA.

DELTA• DELTA is affected by movement in the price of the

underlying stock.

• DELTA is also affected by the time to expiration.

• DELTA can be affected by IMPLIED VOLATILITY.

• Call options have positive (+) DELTA

• Put Options have negative (-) DELTA

• Intrinsic Value always trades with a 1 DELTA

• As expiration approaches, the DELTA changes.

• ITM DELTA moves toward 1.00 (GAMMA increase)

• OTM DELTA moves toward 0.00 (GAMMA decrease)

DELTA ExampleStock moves DELTA Option Moves

$1 1.00 $1

$1 .50 $.50

$1 .25 $.25

DELTA Moves Too?

• DELTA is not constant, it will move:

• If the underlying stock price moves.– If the stock price moves up, the DELTA on the call options tend to also

move up, while the put option DELTA moves down.

– If the stock price moves down, the DELTA on the put options move up and the call option DELTA moves down.

• As Expiration approaches.– DELTA moves up

• If Implied Volatility changes– Higher Implied Volatility typically suppresses DELTA

• The rate of change of the DELTA is called the GAMMA

GAMMA

• GAMMA is displayed as the projected change in the DELTA given a $1 move in the underlying stock.

• GAMMA is also affected by time to expiration.

• The less time to expiration, the more pronounced the GAMMA

ATM GAMMA ExampleStock Moves ATM Call DELTA ATM Put DELTA

Moves Up Moves Down

(Gamma .10) (Gamma .10)

.60 .50

$1 .50 .40

*Numbers are examples only.

Time• Time is a diminishing resource.

• As expiration approaches, there is less time left.

• The price of an option can include “time value”.

• The time value component of an option price is reduced as expiration approaches.

• This time value “decay” is represented by the THETA.

• THETA can be affected by the IMPLIED VOLATILITY.

THETA• THETA is the measure of an options price

“sensitivity” to diminishing time.

• THETA only affects the “TIME VALUE” portion of an options price.

• At expiration, there is no more time left, hence there is no “TIME VALUE”

• Because there is no “TIME VALUE”, all OTM options have expired worthless.

• THETA increases as expiration approaches.

Theta Curve

Price

Time Expiration

THETA• THETA is represented as the amount that the

“TIME VALUE” will decay in one day.

• THETA is highest for ATM options regardless of time to expiration.

• ITM options have lower THETA due to decreased “TIME VALUE”

• OTM options have lower THETA due to reduced cost of the option.

• THETA can be significantly different for calls and puts

THETA ExampleTIME PERIOD THETA Option Moves

1 - .15 - $.15

1 - .65 - $.65

* numbers are estimates

** numbers are based on no movement in stock price

Theta Profile• Option buyers experience negative (-) THETA

• Option sellers experience positive (+) THETA

• THETA profile can potentially help balance risk

• Calculating THETA

– Calculate positive THETA (options that are sold to open)

– Calculate negative THETA (option that are bought to open)

VOLATILITY

Implied Volatility

• Implied Volatility is specific to the Option.

• Is an estimate of the stock’s volatility as determined by the Option Market Maker

• Represents the “risk premium” priced in by the Market Maker.

• Determines the “time value” (extrinsic) portion of the option price.

• Can change dramatically as market conditions change.

Vega

• VEGA measures the option price sensitivity to a move in Implied Volatility.

• It represents how much the option price will change based on a 1% change in Implied Volatility.

• It can indicate an INCREASE in extrinsic value in an environment of increasing Implied Volatility.

• High Implied Volatility will suppress DELTA and GAMMA

VEGA ExampleImplied Vol. moves VEGA Option Moves

1% .1 $.10

1% .65 $.65

* numbers are estimates

** numbers are based on no movement in stock price

Volume

• Options volume is the number of contracts that have traded that day.

• A spike in volume concentrated in one of a few strike prices can be important.

• Significant volume spikes can indicate institutional speculation on the movement of the underlying stock price.

Open Interest

• Options Open Interest is the number of ”open” contracts at any given strike price.

• A contract must be held overnight to be considered “open”.

• Significant accumulation of OI at one strike price can indicate institutional speculation on the movement of the underlying stock price.

The Traditional Way

Bullish Stock

If we found a bullish stock and we thought it may move higher, we could buy 10 Call contracts that expire in 6 months:

BTO 52.50 C Jan 2016, $3.40 x 10

ABC 52

That’s $3,400 invested.

We have the right to buy the stock for 52.50 if we need or want to between now and Jan ’16.

STO 52.50 C this week .25

BTO 52.50 C Jan 2016, $3.40 x 10

ABC 52

That gives us the right to sell the same or higher call option strike on the stock.

Selling Time

IF IT GOES DOWN OR SIDEWAYS.

If our stock does not move higher than 52.50 at expiration, the MM would not force us to sell him 1000 shares of the stock.

STO Sep 52.5 C @ $.25 x (100) x 10

ABC 52

We would keep the .25 for the contract. PASSIVE INCOMEThis could take days or even weeks…..

IF IT GOES UP….

If our stock moves higher than 52.50, the MM could buy 1000 shares of the stock from us:

STO Sep 52.5 C @ $.25 x 10

52.50 C Jan ‘16 $3.40

ABC 52

Since we don’t have the stock we would have to exercise our LONG option, and lose our initial investment.

IF IT GOES UP….

To avoid that we can buy back the option we sold before the expiration.

STO Sep 52.5 C @ $.25 x 10

52.50 C Jan ‘16 $3.40

ABC 52

Now we have no obligation to deliver the stock and we preserve our initial investment ☺

But we lost the opportunity to make a profit….

A More Powerful Way

Bullish Stock

• We find a bullish stock and we buy 10 call options contracts (or sell a synthetic long)

• We enter the long position ITM or we wait for it to move ITM.

ABC 52

BTO 50 C Jan 2016, $5.40 x 10

The Retracement

• Wait for a retracement to develop on the daily chart.

• Sell an ITM strike price that is at or higher than the long strike when a bearish signal shows up on the 5 min chart. DAYTRADE!

ABC 52

BTO 50 C Jan 2016, $5.40

The Retracement

• Wait for a retracement to develop on the daily chart.

• Sell an ITM strike price that is at or higher than the long strike when a bearish signal shows up on the 5 min chart.

ABC 52

STO WEEKLY 50 C FOR $2.50 BTO 50 C Jan 2016, $5.40

The Retracement

• As the stock price drops, the INTRINSIC VALUE will diminish.

• Buy the short position back when the selloff reverses or slows

ABC 52

STO WEEKLY 50 C FOR $2.50 BTO 50 C Jan 2016, $5.40

The Retracement



ABC 52

STO WEEKLY 50 C NOW $.50 BTO 50 C Jan 2016, $5.40

ABC 50



Sold for $2.50

ABC 52 Closed for .50

BTO 50 C Jan 2016, $5.40

The Retracement

ABC 50

IF IT GOES DOWN OR SIDEWAYS.

• The stock is higher than the $50 strike we sold.

• At or before expiration, the MM will force us to sell him 1000 shares of the stock.

• You MUST exit the short strike intraday!

IF IT GOES UP….

• The stock is higher than the $50 strike we sold.

• At or before expiration, the MM will force us to sell him 1000 shares of the stock.

• You MUST exit the short strike intraday as soon as the bearish move is over!

• Set a stop and get out, even at a loss!

But If I Sell ITM…….

• Many traders avoid selling ITM Calls because they assume they will receive an immediate assignment.

• The truth is that when done correctly an ITM option is unlikely to be assigned and if it is it will likely be at profit.

• It’s called MATH.


ABC 55

STO 50 C for $6

BTO 45 C for $7


• The Short Call is worth more than the difference between stock price and strike price.

• If the market maker chooses to exercise his right to force the sale of the stock, you would exercise your contract, at a profit….

• Again it’s just MATH.


ABC 55

STO 50 C for $6 (exercised)MM gets stock for $50 but paid you $6 meaning you are “delivering” the stock at $49

BTO 45 C for $7

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I am not a registered broker-dealer or investment adviser. I will mention that I consider certain securitiesor positions to be good candidates for the types of strategies we are discussing or illustrating. Because Iconsider the securities or positions appropriate to the discussion or for illustration purposes does notmean that I am telling you to trade the strategies or securities. Keep in mind that we are not providingyou with recommendations or personalized advice about your trading activities. The information we areproviding is not tailored to any particular individual. Any mention of a particular security is not arecommendation to buy, sell, or hold that or any other security or a suggestion that it is suitable for anyspecific person. Keep in mind that all trading involves a risk of loss, and this will always be the situation,regardless of whether we are discussing strategies that are intended to limit risk.

I am not subject to trading restrictions. Myself and other instructors could have a position in a security orinitiate a position in a security at any time.

deep in the money!what is ^time value? 23 •time value is the market makers estimate of what the...

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