"Cost basis reduction" (CBR) is a simple but ignored concept when it comes to investing or trading. Consider a case of buying or selling anything in the non-trading world. Let's suppose you were trading baseball cards with your buddies; your prime objective would be to buy the product at the lowest possible cost and then sell it at the highest possible price (that the market would support) and thereby profit on the transaction. If you can't buy the product at a low cost you'd look for an avenue to get the product at the cost lower than what it is being currently offered to you at. If you were a deli store owner and your supplier is selling you vegetables or meat at $1 per lb, you'd always be on a look out to get the same elsewhere at a rate better than $1 per lb as that'll increase your profit margins (assuming your operating costs and selling price is not going to change). In your personal life, you are always looking for that deal to buy that latest gadget for a lowest price possible. If the store has lured you to their location to purchase it a specific discount, you'd always look up the price online to see if you can get a better deal there.
Now in terms of investing, if you had purchased a secondary home or property as an investment, you are most likely to rent it out. It's highly unlikely that you would invest a big chunk of your savings into a secondary home/property and hope that in, say, ten years the property would have appreciated and you'd have sold it for a profit. Imagine two property owners: Bob and Jane. Bob and Jane both invested some savings they had in a secondary home as an investment vehicle hoping that it would appreciate over the next ten years and they'd have some profit after selling it. They bought this property for $100K in late 2007 just before the financial crash. Given the market situation after the crash and the slow recovery, in 2017 the property is still worth only $50k or about half of what they each paid for their property. But, what if Jane had rented the property for $500 per month while Bob did not. Jane had collected about $60,000 in rent ($500/month for 120 months) and technically reduced her cost basis on the property from $100K to $40K. While Bob's still holding on to the property for $100K and hoping that the market will turn around. Of course, Jane's also hoping that the market will turn around so she too can sell the house for profit. But the difference is that Jane's cost basis on the house is just $40K and she'll already sitting on a $10K profit. Having this will help her sleep a lot better at night and will give her the freedom to sell the property a lot earlier than Bob who's currently hoping for a 200% turn in the market for him to break even and sell without a loss (not to mention a lost decade where his money did not appreciate while the cost of living and inflation did).
Now apply this principle to trading. People generally buy a stock and follow the 'buy and hold' approach which means that they'll buy and hold it as long as it takes to make a profit. You may have heard of tales as to how the best performing portfolios are of those who haven't touched their portfolio due to passive investing. Buying something and just hoping for years in hopes that it'll go up is not a likely-to-be profitable strategy, especially when there are options (pardon the pun) to reduce my cost basis so that I can make a profit a lot sooner. Poor Bob might be waiting years for his investment to allow him to rake in some money, while Jane is stress free.
Here's one of my favorite visualization of cost basis reduction courtesy of TastyTrade.com (segment: "Strategies in IRA" dated Jun 21st 2016)
Often two (or more) items might have a mutual relationship with each other. No we aren't discussing personal, professional, romantic or platonic relationships but rather one of mathematical and statistical nature which can be employed when trading or investing.
Take the clothing industry, for example. We often see that the behavior of seasonal clothing is dependent upon the season we approach. As the frost settles on our lawns, we see an increase in sales of winter coats and cozy mittens. As it becomes colder, demand for winter wear skyrockets, yet as sunny days approach, we begin to find ourselves more intrigued by the latest trends of spring season. If we were to plot these trends in dropping temperature against sales of winterwear, we would see an indirect relationship; as temperatures dip, sales increase but as temperatures rise, sales decrease. If we were to plot the trends of dropping temperatures against the sales of summerwear, conversely, we would see a direct relationship; as temperatures dip, sales dip and as temperatures rise, sales rise.
How can we describe this?
Direct Relationship -> Positive Correlation --> The two variables move in unison
Indirect Relationship -> Negative Correlation --> The two variables move in opposite directions
Can this correlation be measured mathematically? Absolutely! If we have the data points for the pair at different points in time, we can use the statistical formula:
The above formula is for the Pearson Coefficient Formula. We will discuss the formula further in depth in later posts, but for now it's important to understand the importance of formula yields. The formula can yield a number between 1 and -1. For the results above 0.3 through 1, there exists a positive correlation between the two items tested; that is, the two items move in unison or rise/fall together. The higher the number, the more positive and better the correlation. For results below -0.3 through -1, there is a negative correlation between the two items tested; that is as one item rises, the other falls or vice versa. The lower the number, the more negative the correlation. Results between -.3 and .3 generally do not matter to us traders as there is often not a strong enough statistical relationship between the items in that range.
If you use tools like Microsoft Excel, it is pretty easy to calculate correlation. In the image, correlations are calculated between the four major index ETFs:
So, how does this apply to trading, again? If we know that there is a high positive correlation between two underlyings and if we see a divergence in this correlation, we can assume that the historically positive correlation between the two has broken and we can place a trade that reverts back to the mean. This we will cover in detail when discussing "pair's trading".
While correlation is a great tool to place trades, not all correlations are tradable as numbers alone tell the whole story. Here's a link to site that lists some funny or spurious. Who knew that per capita consumption of chicken correlates pretty highly with total US crude oil imports!
Liquidity measures the ease with which an investor can buy or sell an asset. Think of liquidity in the scope of swimming. The more liquid the water, the easier it is to dive in without getting hurt. However, the less liquid, the less inclined you will be to dip your toes in the water.
By using the most liquid underlyings when trading and investing we can achieve a greater advantage in getting in and out trades. Most liquid tradable underlyings exhibit following characteristics:
Here's some of the most liquid ETFs and stocks with average daily volume (20 days) of over or just about 1 million shares per day:
What does vega measure?
Vega measures the rate of change of an option's price given a 1% move in implied volatility. Like delta, it measures the rate of change of an option's price, but this time in respect to IV.
Do we want vegas going from high to low or low to high?
It depends. Options vega have a direct correlation with implied volatility. This means as the IV rises, the vega rises and when the IV falls, the vega of a option falls. So for positions like debit call spread or calendar spread that you'd open in low IV environment, you would notice a rise in vega with the rise in IV. Conversely, if you have opened a short premium position under high IV environment, you would notice a decrease in vega with decrease in IV.
With passage of time, vegas decrease if there's no change in IV. So if you have long options position, you want the price of the underlying to move, and move fast in your favor. In short options positions, you want the vega keep falling with lowering of IV or passage of time for your position to profit.
How to Obtain High Vegas
As for theta, when the underlying price is ATM vega is at its highest. This is because ATM there is the most amount of extrinsic value. As the price of the underlying goes further ITM or OTM, the curve slopes downward forming our beloved bell curve. With longer expirations, the bell curve is shifted upwards, increasing the value of vega even more.
Here's a valuable trading tip from TastyTrade when it comes to Vega. We can infer the affect IV change will have on the change in price of our options position by considering the current vega:
What does gamma measure?
Gamma is the rate of change of delta, or the derivative of delta. If delta is the first derivative of the option price, gamma is the second derivative of the option price is useful for the measuring the stability of an option's probability of success.
Expiration and Gamma
A high gamma implies a high rate of change of delta and therefore a high rate of change of the option's price. In order to ensure a successful outcome, as methodical traders we hope to maintain a high probability of success. Yet, with high gammas, the location of our option price is unpredictable.
How to Avoid High Gammas: Rolling Options
As expiration approaches, there is less time for the option price to change. This causes for more fluctuation in delta as the contract approaches expiration, and therefore a higher gamma. In these instances, the options can be rolled in order to restore a longer DTE and therefore lower gamma.
W What does delta measure?
Delta measures the rate of change of an option's price given a plus or minus change of $1 in the underlying price. Delta answers, "If the underlying increases or decreases by $1, by how much will the option price increase or decrease?". For us math nerds, delta can be thought of as the derivative of an option's price.
Option Price Deltas
Option price deltas range form -1.0 to +1.0. If an option price has a delta from -1.0 to 0, it has a negative delta. If an option price has a delta from 0 to +1.0 it has a positive delta. Positive and negative deltas are important in assessing our directional assumptions regarding the options transactions. Let's take a look:
Options Transactions and Delta Signs
An option's delta is equivalent to the probability of being ITM. As established earlier, sellers want the options they've sold to expire ITM in order to profit. Therefore, sellers can use deltas to assess the probability of ITM. Similarly, buyers can use deltas to assess the probability of the option expiring OTM (where they profit). For example, if we sell a + 50 delta call, there is 50% chance the option will be ITM, and a 50% the delta will be OTM. What if the delta is negative? If we sell a -30% delta call, there is 30% of the option expiring OTM and therefore a 70% of the option expiring ITM.
You might often hear of the mysterious "16 delta". What does this even mean? If we look at a one standard deviation move on the traditional bell curve, the distance from the mean is 34% on either ends. The width is approximately 68%, leaving 16% percent flaps near each tail end. If we sell a -16% delta call, this means we have an 84% (16% flap we mentioned earlier + 68%) chance of the option expiring ITM (success!). This is usually the sweet spot we like to look for when trading.
What does theta measure?
Theta is the rate of decay of an option's price, all else held equal (including the fluctation in stock price and volatility). As you may recall from the Extrinsic Value post, the extrinsic value of a stock is determined by time and volatility. Theta measures how the rate at which the time value of an option price changes (or the time value aspect of the option's extrinsic value).
Theta in Conjunction with Buying and Selling Options
Sellers love theta. When selling options, as we've established, sellers sell premium to the buyers for the right to buy stock for the strike price at or before expiration. As time progresses throughout the duration of the contract, the extrinsic value, and therefore time value, of the option decreases. The seller can now profit by buying an option, with a now lower option price as a result of time decay ("Sell high, buy low"). The opposite is true for buyers, will are at a disadvantage as a result of time decay.
ATM, OTM, and ITM
The value of an option is always highest for ATM options, because here there is the most extrinsic value (0 intrinsic value). The curve of option prices slopes downwards as the underlying price goes further ITM and OTM because here there is more intrinsic value than extrinsic value. How does this principle relate to theta?
Because ATM options only have extrinsic value, theta decay increases faster than OTM/ITM options. When ITM or OTM, there is more intrinsic value, so there is not much left for the extrinsic to deecay by expiration. Contrastringly, when ATM, there is only extrinsic value so the option's theta decreases rapidly.
How can we apply this? Example:
If we know that theta decays rapidly for ATM options, we can sell an ATM options in order to buy back the option for an even lower premium and profit!
Greeks? Although I wish I could say that a plate of piping spanokopita would endow you with unbounded option trading knowledge, I can assure that the Greeks we will discuss are a formidable asset. In the world of options trading, the "Greeks" are crucial to the understanding of option prices. The Greeks are derived from the option pricing model. Typically the price of an option changes with time, or direction or time till expiration, implied volatility etc. All these can be quantified and measured using the various 'Greeks'.
The greeks provide very useful insight on how a specific options in your portfolio will affect the profitablity of your portfolio. You'll typically hear of traders saying that they are 'long delta' or 'short delta' in terms of direction. Or you'll hear of them say that they have positive or negative theta. What all these mean would be a bit more clear once we dive into this a bit more deeper.
In the next four posts, we will discover the relevance of the various options greeks like theta, delta, gamma, rho and vega.
Image Source: Options Playbook
The exact opposite of buying strangles! In this case, the investor sells an OTM call and OTM put. Let's take a look at the graph:
As mentioned earlier, in the selling straddle post, when we sell a put we profit when the price is above the break even price (strike-premium sold) and when we sell a call we profit when the price is below the break even price (strike-premium sold). The profits and losses for selling a strangle are as follows:
Price is above the put break even price and below the call break price: Profit! Maximized at premium collected from both sales
When the price is not in the aforementioned range: Loss is unlimited
Strangles are similar in essence to straddles--the thing that changes is the type of strike we purchase or sell them at.
When buying a strangle, the investor buys a call at an OTM strike price (above the current price) and buys a put at an OTM strike price (below the current price). Here is the graph:
When price is above the call break even price or below the put break even price: Unlimited profit!
When price is not in the aforementioned range: Loss! The maximum loss is constant at all prices in this range and is equivalent to the total premium paid for both options.
Eighteen-year old trader, future connoisseur of options.
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