The Option Strategist

THE OPTION STRATEGIST
Published by McMillan Analysis Corporation
P.O. Box 1323, Morristown, NJ, 07962-1323
CUSTOMER SERVICE: 1-800-724-1817
www.OptionStrategist.com
[email protected]
Dear New Subscriber:
Enclosed is a packet of materials that is designed to help you use and understand "The Option
Strategist Newsletter.”
PHILOSOPHY:
Recommendations will generally be of two types, strategic or speculative. Strategic recommendations
are spreads, neutral in nature, designed to take advantage of a perceived "edge" in the market place.
For example, if certain options are too expensive, a spread would be designed to sell those options (to
capture their overpriced nature), and that sale would be hedged with the purchase of other options.
Speculative strategies normally involve option buying. These recommendations would be based on
technical analysis or option trading patterns such as increased volume or a significant change in the
put-call ratio (see glossary).
New trading recommendations will be highlighted in yellow. Thus, you can quickly scan the
newsletter to see the new recommendations.
NEWSLETTER FORMAT:
While the format of the newsletter can vary, it generally includes the following sections:
1.
Stock market commentary based on various technical indicators including put-call
ratios, breadth, sentiment, price action, momentum, volatility and volatility derivatives.
2.
Featured articles, often of educational or informative value, that were either originally
published throughout the week or published that Friday.
3.
Specific trading recommendations based on various indicator. Each recommendation
includes follow-up action, trading stops and position analysis.
4.
Specific follow-up recommendations to all pertinent model portfolio positions.
There are some other information pieces designed to give you background on our products and
philosophy:
•
"The Oscillator" – an explanation of our advance-decline oscillator, along with a
description of the charts you will see in our publications.
•
"Some Random Thoughts On Option Trading" – trading philosophy.
•
"Which Option To Buy?" – thoughts on choosing the proper option for your strategy.
•
"Put-Call Ratios" – a brief explanation of this important technical indicator.
•
“When Is Trading Stock Superior To Buying Options?” - call buying vs. owning
stock.
•
“Position Delta” - how to construct positions that are neutral to the m arket.
•
“Measuring And Trading Volatility” - basic principles of volatility trading
•
"Option Glossary” – a glossary of option terms is also included for new subscribers.
This should be of use to less experienced traders who might not be familiar
with some of the terms used in the newsletter. While we attempt to give clear
explanations of all recommendations and ideas, it might be useful to have this
glossary available as well.
The model portfolio positions, except for those in the “Covered Write/Naked Put Sale” category, are
geared for the risk that a portfolio of approximately $100,000 should be taking. For example, each
outright call or put speculative buy risks about $1,500. The “Covered Write/Naked Put Sale” positions
are sized for another portfolio of $100,000 if using margin, or $200,000 if operating on cash.
Please let us know if there are any questions you have, or any ways in which you feel service could be
enhanced.
President, McMillan Analysis Corp.
Table of Contents
The Oscillator
1
Charts Used in The Option Strategist
2
Some Random Thoughts on Option Trading
3-4
Which Option to Buy 5-6
Put Call Ratios
7-8
When Is Trading Stock Superior To Buying Options?
Position Delta
12-13
Measuring And Trading Volatility 14-16
Option Glossary 17-20
9-11
THE OSCILLATOR
We occasionally make OEX recommendations, based upon our short-term overbought/oversold oscillator. If the
oscillator rises to +200 or higher, the market is overbought. We then look to short the market (i.e., buy OEX puts)
when it subsequently falls back below +180. Conversely, if the oscillator is below -200, then the market is oversold,
and we will buy calls when it eventually rises back above -180.
The oscillator is calculated with the following formula:
Today's Oscillator = 90% of Yesterday's Oscillator + 10% of (Today's Advances - Today's Declines)
For example, if the oscillator stood at 100 yesterday, and today there were 1200 advances and 900 declines,
then the today's oscillator number would be calculated as 120:
Today's Oscillator = 0.9 * 100 + 0.1 * (1200 – 900) = 90 + 30 = 120
The “Stocks Only” Oscillator
In the fall of 2001, several analysts were touting
the fact that the NYSE advance-decline was
making new all-time highs. At the time, we had
a bearish opinion on the market, and I could
scarcely believe that was true. But it was! Sure
enough, even though the stock market had been
struggling since the end of the tech boom rally in
early 2000, the NYSE advance-decline line was
indeed making new highs.
We have access to another good set of stocks,
though – all stocks with listed options. That is,
all optionable stocks. There is a large set of such
stocks, so we created our own advances and
declines (and our own advance-decline line),
using that set of stocks. It was remarkably
different. Figure 1 shows how much the “Stocks
only” cumulative advance-decline line had
differed from the NYSE cumulative advancedecline line.
Figure 4
This was mostly due to decimalization, for reasons that are too detailed to explain in this short piece.
However, because of this, we also compute a “stocks only” oscillator each day. Furthermore, we monitor both the
“stocks only” and the NYSE-based oscillators as potential market indicators and as measures of market breadth.
Buy and Sell Signals
A Buy Signal is generated when the oscillator drops into oversold territory and them emerges from it. A Sell Signal
is generated when the oscillator climbs into overbought territory and them falls from it.
For the NYSE oscillator: a Buy Signal is generated when it falls below –200 and then later rises above –180.
A Sell Signal is generated when it rises above +200 and then later falls below +180.
For the “Socks Only” oscillator: a Buy Signal is generated when it falls below –400 and then later rises above
–180. A Sell Signal is generated when it rises above +140 and then later falls below +120.
1
CHARTS USED IN THE OPTION STRATEGIST
The chart on the right is one of IBM. Our
price charts are always daily charts, unless
specifically noted otherwise. The stock
symbol is on the upper left (for futures
charts the symbol begins with '@' and for
indices it begins with '$'). Then, reading
from left to right across the top, we have
the price information for the rightmost data
bar on the price chart. This would
normally be the most current date. The
price information is high, low, and close,
for the date shown. In this IBM chart, that
date is Monday, January 22nd (960122),
and on that day IBM had a high of 103f,
a low of 101d, and a close of 102¼. The
rightmost number on the top is the "volume cut-off" figure — the maximum daily volume graphed
along the bottom of the chart. For IBM, this is 6,000,000 (6 million) shares. Look at the bottom of
the chart. You see that the stock volume is shown, but some of the volume lines have a circle on the
top. That circle represents the 6,000,000-share figure. Larger volumes are not graphed, for they
would interfere with the chart of prices, which is the most important data.
Finally, the daily price bars are shown in the middle of the chart. On this IBM chart, we have
surrounded the price bars with the "modified Bollinger Bands". These are similar to regular
Bollinger Bands, but we use a shorter volatility period, and draw the bands at 3- and 4-standard
deviations. Bollinger Bands, invented by John Bollinger (P. O. Box 3358, Manhattan Beach, CA,
90266) are a dynamic way of denoting overbought- oversold areas. They are dynamic because they
are based on the volatility of the stock — note how the bands shrink and expand (they are not always
equidistant from each other).
2
www.OptionStrategist.com
SOME RANDOM THOUGHTS ON OPTION TRADING
Reprinted from the 11/26/93 issue of "The Option Strategist"
I was recently asked what guidelines I generally follow in my
option trading. This is actually a rather thought-provoking
question, especially when it regards something one does
almost every day. In our feature articles, many useful general
strategies have been given, but not assembled all in one
place. After giving the matter some thought, it seemed like
it might be beneficial to list some of the "rules" that we
follow, either consciously or sub-consciously after all these
years. For the novice, they may be eye-opening; for the
experienced option trader, they may serve as a reminder.
These guidelines are not the path to easy riches, or some
such hype, but following these guidelines will generally keep
you out of trouble, increase your efficiency of capital, and
hopefully improve your chances of making money with
options. They are not presented in any particular order.
Buying an in-the-money call is often better than buying the
underlying instrument; buying an in-the-money
put is usually better than shorting the underlying
(if the underlying is stock). An in-the-money
option has a high delta, meaning that it moves
nearly point-for-point with the underlying stock or
futures contract. Furthermore, the option's price
contains only a small amount of time value
premium — the "wasting" part of the option asset.
Thus, the profit potential is very similar to that of
the underlying instrument. Finally, the risk is
limited by the fact that one cannot lose more than
the price he paid for the option, while one has
much larger risk when owning or shorting the
underlying instrument.
Trade in accordance with your comfort level and psychological identity. If you are not comfortable selling
naked options, then don't; even though such
strategies are nicely profitable for some traders, they
should not be used if they cause you sleepless
nights. If hedged positions drive you crazy because
you know you'll have a losing side as well as a
winning side, then perhaps you should trade options
more as a speculator — forming opinions and acting
on them accordingly. The important thing to realize
is that it is much easier to make money if you are "in
tune" with your strategies, whatever they may be.
No one strategy is right for all traders due to their
individual risk and reward characteristics, and
accompanying psychological demands.
Don't buy out-of-the-money options unless they're really
cheap. This is really a corollary of the above rule,
but it's important enough to state separately.
Obviously, you can't tell if the option is "cheap"
unless you use a model. If the out-of-the-money
option is expensive, then revert to the previous
rule and buy the in-the-money option.
Always use a model. The biggest mistake that option traders
make is failing to check the fair value of the option
before it is bought or sold. It may seem like a
nuisance — especially if you or your broker don't
have real-time evaluation capability — but this is the
basis of all strategic investments. You need to know
whether you're getting a bargain or paying too much
for the option.
Don't always use options -- the underlying may be better (if
options are overpriced or markets are too wide).
This is related to the previous rule. Sometimes it's
better to trade the underlying stock or futures
contract rather than the options, especially if you're
looking for a quick trade. Over a short time period,
an overpriced option may significantly underperform
the movement by the underlying instrument.
Don't buy more time than you need. The longer-term
options often appear, to the naked eye, to be better
buys. For example, suppose XYZ is 50, the Jan
50 call costs 2, and the Feb 50 call costs 2¾. One
might feel that the Feb 50 is the better buy, even
if both have the same implied volatility (i.e.,
neither one is more expensive than the other).
This could be a mistake, especially if you're
looking for a short-term trade. The excess time
value premium that one pays for the February call,
and the resultant lower delta that it has, both
combine to limit the profits of the Feb 50 call visa-vis the Jan 50 call. On the other hand, if you're
looking for the stock or futures contract to move
on fundamentals — perhaps better earnings or a
crop yield — then you need to buy more time
because you don't know for sure when the
improving fundamentals will reflect themselves in
the price of the underlying.
Know what strategies are equivalent and use the
optimum one at all times. Equivalent strategies
have the same profit potential. For example,
owning a call is equivalent to owning both a put
and the underlying instrument. However, the
capital requirements of two equivalent strategies
McMillan Analysis Corporation
3
(and their concomitant rates of return) can
vary widely. The purchase of the call will
only cost a fraction of the amount needed to
purchase the put and the underlying stock,
for example. However, the call purchase
has a much larger probability of losing
100% of that investment.
Naked put selling is equivalent to covered call writing, but
is generally a better strategy. We've mentioned this
often before, but it bears repeating because so many
option traders don't follow this rule, or don't believe
it. Both strategies — naked put selling and covered
call writing — have limited upside profit potential
and large downside risk. However, the naked put
sale involves less of an investment in terms of
collateral required, has a lower commission cost,
and allows one to earn interest on his collateral
while the position is in place. For these reasons,
naked put selling is the better strategy of the two.
The option positions that are equivalent to long stock (or
long futures) and to short stock (or short futures)
are perhaps the most important ones. Buying a call
and selling a put, both with the same terms (strike
price and expiration date) produces a position that is
equivalent to being long the underlying instrument.
Similarly, buying a put and selling a call with the
same terms is equivalent to being short the
underlying instrument. The next three rules deal
with these equivalences.
The equivalent option strategy may be better than
owning the underlying stock itself. If one buys a
call and sells a (naked) put, his investment is smaller
than that required to own the stock, and the
"investment" may be in the form of interest-earning
collateral.
The equivalent option strategy is better than selling
stock short, and of course is the only way to
completely short an index. The option strategy not
only has the advantage mentioned above, but does
not require a plus tick to establish the short position.
It theoretically might be possible to short an entire
index by shorting every stock in the index, but that
would be almost impossible because of the uptick
requirement.
The equivalent option strategy is mandatory knowledge for
futures traders, for it allows one to extricate
himself from a position that is locked limit
against him. When futures are locked limit, the
options will generally still be trading. The prices
of the options provide a price discovery
mechanism, in that one can see where the futures
would be trading were they not locked at the limit.
Furthermore, one can take an equivalent option
position opposite to his (losing) futures position,
and effectively close out the position at the current
loss without risking further limit moves on
succeeding days.
Naked combo selling in indices is usually less trouble than
selling combos in individual futures or equity
options. Selling both puts and calls is an
attractive strategy to many option traders, since
the benefits of the wasting asset are on your side.
Unfortunately, large or sudden moves by the
underlying instrument can create some nasty
surprises for the option writer. One way to
counter this is to concentrate the option selling in
index options. The broader the index, the less
likely it is to experience a gap opening. There
cannot be a takeover attempt on an index nor can
an individual earnings report, for example, cause
the index to move a great distance as it can for a
stock. For the index to gap, many of the stocks
that comprise the index would have to gap as well;
that might be possible in a very narrow-based
index, but is quite unlikely in a broad-based one.
These statements generally apply to U.S. indices;
indices on foreign markets (JPN or FSX, for
example) gap virtually every day since the actual
trading in those markets is occurring while the
U.S. markets are closed.
Trade all markets. There are strategic option opportunities
in all markets — equities, indices, and futures. To
ignore one or two of these just doesn't make sense.
The same principles of option evaluation needed
to construct a statistically attractive strategy apply
equally well to all three markets. Furthermore,
there are often inter-market hedges that are
extremely reliable, but in order to take advantage
of them, one has to trade all of the markets.
Trade in accordance with your comfort level and psychological identity. This is the first and last rule
and, ultimately, the most important one.
4
www.OptionStrategist.com
WHICH OPTION TO BUY?
Reprinted from The Option Strategist newsletter, October 28, 1999. Copyright McMillan Analysis Corp.
here are various trading strategies – some short-term, some long-term (even buy and hold). If one
decides to use an option to implement a trading strategy, the time horizon of the strategy itself often
dictates the general category of option which should be bought – in-the-money vs. out-of-the-money,
near-term vs. long-term, etc. This statement is true whether one is referring to stock, index, or futures
options.
T
In this article, we’ll lay out the basic types of option purchases that are dictated by the trading strategy being
applied to the underlying. The general rule is this: the shorter-term the strategy, the higher the delta should
be of the instrument being used to trade the strategy.
Day Trading
For example, day trading has become a popular endeavor – at least if we are to believe the media reports.
Statistics have been produced which indicate that most of these day traders lose money. In fact, there are
profitable day traders – it’s just more and harder work than many are willing to invest. Many day traders
have attempted to use options in their strategies. These day traders apparently are attracted by the leverage
available from options, but they often lose money via option trading as well.
What many of these option-oriented day traders fail to realize is that, for day-trading purposes, the
instrument with the highest possible delta should be used. That instrument is the underlying, for it has a
delta of 1.0. That is, day-trading is hard enough, without complicating it trying to use options. So, if you’re
using a day-trading system based on S&P futures, you are most likely only complicating things if you try
to trade it via S&P or $OEX options – trade the futures instead. For stock traders, this is equally true. If
you’re day-trading Microsoft (MSFT), trade the stock, not an option.
What makes options difficult in such a short-term situation is their relatively wide bid-asked spread, as
compared to that of the underlying instrument itself. Plus, since a day trader is only looking to capture a
small part of the underlying’s daily move, an at-the-money or out-of-the-money option just won’t respond
well enough to those movements. That is, if the delta is too low, there just isn’t enough room for the option
day-trader to make money.
If a day trader insists on using options, a short-term, in-the-money should be bought, for it has the largest
delta available – hopefully something approaching .90 or higher. This option will respond quickly to small
movement by the underlying stock, index, or futures contract.
Note that when we say “high delta”, we are actually referring to the absolute value of the delta. That is,
when buying calls we want to use ones with a delta of 0.90 or higher. But, if your strategy calls for shorting
the underlying – thus, buying a put if you are trading options – then the put’s delta should be –0.90 or less.
That is, put deltas range from 0 down to –1.0, so a “large delta” for a put means that the absolute value of
the delta is large.
Short-term Trading
Moving on to a somewhat longer-term oriented strategy, suppose you have one in which you expect to hold
the underlying for approximately a week or two. In this case – just as with day-trading – a high delta is
McMillan Analysis Corporation
5
desirable. However, now that the holding period is more than a day, it may be appropriate to buy an option
– as opposed to merely trading the underlying – because it lessens the risk of a surprisingly large downside
move. Still, it is the short-term, in-the-money option that should be bought, for it has the largest delta and
will thus respond most closely to the movement in the underlying stock. Such an option has a very high
delta – usually in excess of 0.80. Part of the reason that the high-delta options make sense in such situations
is that one is fairly certain of the timing of day-trading or very short-term trading systems. When the system
being used for selection of which stock, index, or futures to trade has a high degree of timing accuracy, then
the high-delta option is called for.
Intermediate-term Trading
As the time horizon of one’s trading strategy lengthens, it is appropriate to use an option with a lesser delta.
This generally means that the timing of the selection process is less exact. One good example is using putcall ratios to select what to trade. While the track record of put-call ratios as a contrarian indicator is good,
the timing of the forthcoming move is not exact, because it often takes time for an extreme in sentiment to
reflect itself in a change of direction by the underlying.
Hence, for a strategy such as this, we want to use something with a smaller delta – figuring that we will limit
our risk by using such an option, knowing that large moves are possible since the position is going to be held
for several weeks – perhaps even a couple of months or more. Therefore, an at-the-money option can be
used in such situations.
Long-Term Trading
If one’s strategy is even longer-term, an option with a lower delta can be considered. Such strategies would
generally have only vague timing qualities – such as selecting a futures contract to buy, based on the general
fundamental outlook for the commodity. In the extreme, it would even apply to “buy and hold” strategies.
Generally, I don’t espouse buying out-of-the-money options in any event, but for very long-term strategies,
one might consider something slightly out of the money. Or at least a fairly, long-term, at-the-money option.
In either case, that option will have a lower delta as compared to the options that have been recommended
for the other strategies mentioned above. In a similar manner, LEAPS options might be appropriate for stock
strategies of this type.
Summary
The estimated holding period of a system’s trades, and the exactness of the timing of the strategy, should
dictate what type of option purchase is best used for that system: from very high delta options for shortterm, exact timing strategies to low delta options for long-term, inexact timing strategies. If the options are
extremely overpriced, though, it may be wiser to buy slightly deeper-in-the-money options than indicated
above. Finally, note that this advice is for option buyers – if one is attempting an option spread, straddle,
strangle or premium selling strategy, different option deltas and time horizons might be more appropriate.
6
www.OptionStrategist.com
PUT-CALL RATIOS
ut-call ratios are useful, sentiment-based, indicators. The put-call ratio is simply the volume of all
puts that traded on a given day divided by the volume of calls that traded on that day. The ratio can
be calculated for an individual stock, index, or futures underlying contract, or can be aggregated – for
example, we often refer to the equity-only put-call ratio, which is the sum of all equity put options divided
by all equity call options on any given day. Once the ratios are calculated, a moving average is generally
used to smooth them out. We prefer the 21-day moving average for that purpose, although it is certainly
acceptable to use moving averages of other lengths.
P
The chart on the right above is a sample one – of IBM. Buy and sell points are marked on the chart. Note
that buy signals occur when the ratio is “too high” (i.e., near the top of the chart) and sell signals occur when
the ratio is “too low” (near the bottom of the chart). The chart on the left above is that of IBM common
stock, with the put-call ratio buy and sell signals marked on it. You can see that, in general, the signals are
good ones. In reality, we couple technical analysis – using support and resistance levels – with the signals
generated by the put-call ratios. The combining of the two methods normally produces better-timed entry
and exit points in our trades.
A dollar-weighted put-call ratio is constructed by using not only the volume of the various options, but their
price as well. The two are multiplied together, and the total of that product for all put options is divided by
the total of that product for all call options. That computation is the daily weighted put- call ratio. As with
the “standard” put-call ratio, this weighted ratio can be computed for individual stocks, futures, or indices,
or for aggregated groups of options. Formally stated, the weighted put-call ratio can be written
mathematically as shown in the box below. What this weighted ratio attempts to show, which the “standard”
ratio does not, is how much money put buyers are spending.
j (put price V put volume)
i
Dollar Weighted Put-call Ratio =
j (call price V call volume)
i
where the summation over i means that the product is summed over all
options belonging to this entity – whether it be an individual stock, or a group
such as “all equity options”.
McMillan Analysis Corporation
7
The thinking is that it is more important to know how much total money is being spent on puts versus calls,
than merely to know the volume. This point has some validity. For example, a person who is merely
hedging his position perhaps is not really all that bearish, but just wants to buy some puts as insurance. He
might buy fairly deep out-of-the-money puts. Thus, his dollars would be spent on rather low-priced puts.
On the other hand, a truly bearish speculator would most likely buy a put with a higher delta – something
that is at-the-money, or perhaps slightly in-the-money. Thus, this “true” bearishness would perhaps result
in a higher expenditure in terms of dollars.
The main difference between the “normal” and weighted ratios is that the weighted put-call ratio
generates more extreme readings – especially at major turning points. That is, during bullish periods the
weighted reading can dip down to 0.20 or below on a given day, even pushing the 21-day moving average
down to those minimal levels at times. The “standard” put-call ratio rarely gets that low, especially where
equity options are concerned. Furthermore, during extreme bearishness, the weighted ratio will easily rise
above 2.00 on individual days, and the 21-day average can rise to nearly 2.00 as well. Again, those kinds
of numbers are generally unheard of for the “standard” ratio.
As an example, let’s look at the big picture, via the equity-only charts. The two charts below show the
“normal” ratio (on the left) and the “weighted” ratio (on the right). The buy and sell signals are marked on
the charts. For these charts, the major buy and sell signals occur at relatively the same points in time.
8
McMillan Analysis Corporation
When Is Trading Stock Superior To Buying Options?
Reprinted from The Option Strategist newsletter, August 23, 2013.
he common perception among option traders is that option buying is the “best” approach to a speculative
situation because of the great leverage that the calls or puts provide. But in many cases, ranging from
extremely short-term holding periods to ones of more moderate length, where limited stock moves are likely,
one may be better served by trading the underlying entity than by buying options. In this article, we’ll try to answer
the question of which is better, an option position or a stock position. It turns out that the answer may be dependent
on what one’s objectives are. Also, we’ll reconstruct some trading from past recommendations to see the option
vs. stock results.
T
Call Buying vs. Owning Stock
The graph on the right (Figure 1) shows the profit graph of a simple call purchase vs. the purchase of the underlying
stock. The same graph would apply if the underlying were futures or an ETF, or anything else.
This is the profit graph of a Sept 100 call,
bought when the stock was at 100, with a
month remaining until expiration. The thick
red line is the dollars of profit or loss in the
stock. The straight black lines are the
option’s profit or loss at expiration. The
curved lines are the option’s profit or loss at
two dates prior to expiration: 9/01/2013
(pink line) and 9/10/2013 (blue line).
The “dollar breakeven” price is equal to the
strike (100) minus the cost of the call (4.60)
minus commissions.
Above the “dollar breakeven” price, the
stock purchase makes more dollars than the
Figure 5
purchase of one (100-share) option does.
Below the “dollar breakeven” price – shaded
in black – the option loses fewer dollars than the stock purchase does. So, over a wide range of prices, the stock
purchase of 100 shares makes more money than the purchase of one call does.
“Wait!,” you shout. The investments are completely different. Yes, they might be, but we’ll get to that in a minute.
Are there some traders who don’t really care about Return On Investment, but are rather just trying to make as many
dollars as possible? Yes, there are. These types of investors would generally be ones trading stocks with high
leverage. This would include accounts trading on portfolio margin, or professional traders who are working for
broker-dealers. Broker-dealers can trade their own capital with leverage of 6-to-1. Portfolio margin is similar, in
that one only has to advance 15% of the stock price. As we found out during the Financial Crisis of 2008, some
professional traders were trading with much greater leverage than that.
Almost anyone in this situation is most likely interested in profit dollars. The returns will take care of themselves
because of the leverage. When I first became a proprietary trader, in 1980, one of the veterans told me that he
wasn’t interested in comparing the expected returns of positions, but rather was just interested in making money.
McMillan Analysis Corporation
9
That statement is still true for many highly-leveraged accounts.
This type of trader would likely view Figure 1 and determine that the red line is where he wants his money. The
red line is the highest dollar profit line if the stock rises, or even if it falls slightly. The only time the option has a
better dollar return (actually, a smaller dollar loss) is if the stock falls rather sharply. Traders operating with high
leverage are usually fairly quick to take losses, so they would likely not even still be long if this theoretical 100dollar stock dropped to 95.
Figure 2 shows the same data, but the Y-axis is now graphed as Return on Investment, rather than dollars of profit
and loss, assuming that the stock and the option are purchased for cash.
Figure 2 shows why many speculators buy options
– for the large returns available because the
investment is so much smaller in the option. The
colored lines in Figure 2 (which are briefly
described in the enclosed box) are the same as
Figure 1 – red for the stock, black for the option at
expiration, pink for the option results on Sept 1st,
and blue for the option results on Sept 10th.
The black line (option rates of return at expiration)
crosses the red line at a gain of about 4.8%. (the
option cost 4.60). Above that point, the option
offers a greater rate of return than the stock does.
The other colored lines (blue and pink) cross over
the stock (red) line at even lower stock prices. Of
course, if the stock falls, the percentage losses on
the option are much greater than the percentage
losses on the cash stock holding.
What we can’t see from either of these charts is the
probability of the stock being at any of those points.
Without getting overly technical, suffice it to say
that since stocks generally adhere to a lognormal
distribution, there is the greatest chance that the
Figure 6
stock will be little changed at the end of a month.
Hence the extremely high returns for the option in Figure 2 are rare. Unfortunately, too many option traders are
envisioning those extremely superior returns when they buy the option, when in fact it is “pie in the sky.”
Another thing not shown in the above charts is what a change in implied volatility might do, but I don’t feel that
is really pertinent to our analysis. If volatility increases, that benefits the option trader, in theory (setting aside the
fact that usually it’s a stock price decline that is the cause for an increase in implied volatility). Conversely, a
decline in implied volatility hurts the option buyer. The stock holder is not affected by a change in the option’s
implied volatility, except perhaps for the residual effect of the stock itself potentially becoming more volatile. That
fact doesn’t change the stock’s returns at any price, but if the stock becomes more volatile, that makes the more
distant stock prices more likely to be attained.
–—––
Would any other type of trader be favoring Figure 1 over Figure 2? I would think that anyone who has a trading
10
McMillan Analysis Corporation
system that holds for relatively short periods of time might be more inclined to view Figure 1 favorably – especially
if he is trading stock with leverage. The reason I say this, is because in a fairly short period of time, the big rises
in stock price are less likely to occur.
When I first began publishing Daily Volume Alerts in 1994, the original research on the methodology had been
based on stock price movements. I have always felt that if one has a profitable stock trading methodology, he could
translate it to an option buying methodology, merely by using high-delta options (delta of 0.85 and above for options
positions that are likely to be held for two weeks or less) as a substitute for stock. But most retail subscribers are
not interested in high-delta options (for example, with the stock at 100, buying the 90 or 95 strike, instead of the
100 strike). So, in order to actually sell subscriptions, options with smaller deltas were often recommended.
In the modern markets, with striking price distances having shrunk to 1.0 or 2.5 points in many cases, the problem
isn’t as great as it was. Even so, the 0.85-delta option is still likely to be several strikes in-the-money, and that is
not attractive to many speculators.
In conclusion, one might find it a better approach to use the underlying stock or a synthetic version of stock. A long
call plus a short put is synthetic long stock, for example. Or one could use a “split-strike” approach: long an at-themoney call plus short an out-of-the-money put. This would reduce time value premium expense, while still
preserving upside profit potential.
McMillan Analysis Corporation
11
POSITION DELTA
All strategy recommendations made by "The Option Strategist" are approximately neutral to the market. That is, they
will not initially make or lose much money as the underlying instrument changes in price. When room permits, a graph
will be used to display how the delta of the position is expected to change as the stock moves up or down in price.
The delta of an option is the amount the option changes in price for a 1-point move in the underlying security. However,
the term "delta" may also refer to the exposure that a entire option position has with respect to movement in the
underlying common stock. This second usage of the term "delta" is sometimes referred to as the equivalent stock
position (ESP), or as the equivalent futures position (EFP). To differentiate between the two terms, the delta of the
option is generally referred to as "option delta" while the ESP or EFP is called "position delta". The position delta can
be computed according to the following simple equation:
Position delta = option's delta × shares per option × option quantity.
Shares per option is generally 100 for most stock options, except those affected by a previous stock dividend or stock
split. For futures options, the term "shares per option" would be replaced by "shares per contract", which is always 1.
By summing the above calculations for each item in a position, or even in an entire option portfolio, one can approximate
how much market exposure the entire option position has.
As a means of demonstrating the usage of position delta, the Archer Daniels Midland (symbol:ADM) straddle
recommendation in the first issue will be used as an example. The position is simple enough that the concepts can be
demonstrated without getting overly complicated.
When ADM was at 30, the recommendation was made to buy 10 Mar 30 calls and to buy 12 Mar 30 puts. The initial
recommendation was made at the following prices and deltas:
Option
Option Delta
Position Delta
Long 10 ADM Mar 30 calls
Long 12 ADM Mar 30 puts
0.56
!0.44
+560 shares
!528 shares
Net position delta:
+ 32 shares
Note that puts have a negative delta, indicating that they move in the opposite direction from the underlying security.
The total position delta of this straddle is equivalent to being long only 32 shares of ADM -- almost nothing -- and hence
the position is nearly delta neutral (a position is delta neutral if the position delta is zero).
Since the position is a long straddle (with a couple of extra puts), the delta grows larger as the stock rises and becomes
negative as the stock falls, thereby meaning that the position no longer remains neutral as the stock moves away from
the striking price. The strategist who is managing the above position knows that his delta will change in this manner,
but he should be aware, in advance, of how much change there will be in his position delta so that he can plan
appropriate follow-up action. There are mathematical ways to quantify this change in delta, but a simple way is to
12
McMillan Analysis Corporation
calculate the position deltas for various stock prices in advance. It is this type of calculation that is presented,
graphically, with each strategy recommendation made by this publication.
In order to see how to best use these graphs of position delta, again consider the ADM example. The two previous
graphs show the initial situation. The one on the left shows the profit potential of the position, while the one on the right
shows how the delta is expected to change as the stock price changes over the two weeks after the recommendation was
made. The overall position was destined to become long 500 shares with ADM at 32½, and to become short 500 shares
if ADM fell to 27¾. If the stock rose even farther, to over 39, the position would be long over 900 shares. On the other
hand, a massive drop in stock price to below 21 would have made the position delta short over 1100 shares. All of these
observations are readily discerned from the graph on the right above.
In order to avoid having too much market exposure, part of the recommended follow-up action was to place an order
to sell short 500 ADM at 32½, should the stock rise that far. In fact, ADM did trade at that price, and 500 shares were
sold. How did that sale affect the position? The graphs below display the situation after ADM has moved to 32½ and
500 shares have been sold. The graph on the left below shows the profit picture of the new ADM position, including
the sale of the 500 shares. Note that the new graph shows the effect of the sale of stock: the upside potential is lessened
(although it could still be substantial) and the downside potential is increased. The strategist has locked in some money
by having sold the 500 shares. Another observation can be made: the loss near 30 seems over the short-term is worse
than was projected in the above graph. That is due to two things. First, the projected "14-day" profit line is being drawn
three weeks later in time, and time decay takes its biggest toll near the striking price. Second, the market price of ADM
options has gotten even cheaper, so the new graph on the next page takes into effect the current market pricing of the
options. The profit and delta projections used by "The Option Strategist" will always be based on the current market
pricing of the options, unless otherwise stated. Part of the initial reason for buying this straddle was that the options were
cheap compared with the historic volatility of the underlying stock. Now they are even cheaper, even though the stock
jumped over 10% in just three weeks!
The graph on the right below shows the projected position delta of the current position, including the sale of the 500
shares of ADM. Note that it still has the characteristics of a straddle -- getting longer as the stock rises and shorter as
the stock falls -- but now the maximum position delta attained will be near 500 shares on the upside, while the position
could become delta short 1700 shares on the downside. Moreover, the strategist can plan further follow-up action, such
as covering the 500 shares should ADM fall back to 30 (see graph), for that is where the current position would be short
the equivalent of 500 shares of ADM. Covering the short sale at that point would return the straddle to a neutral
position.
In summary, the strategist should be aware of how his position delta changes over time and with changes in the price
of the underlying security. It is not necessary to be so aware of position delta in a speculative, option buying situation.
Of course, the follow-up recommendations that are made will be based, at least partially, on these projections of
position delta.
www.OptionStrategist.com
13
Measuring And Trading Volatility
Reprinted from a composition of several articles in The Option Strategist newsletter, as excerpted from the 4th
edition of the book, Options As A Strategic Investment, by Lawrence G. McMillan, President, McMillan Analysis
Corp.
The one thing that ties all option strategies together and allows one to make comparative decisions is volatility.
In fact, volatility is the most important concept in option trading. Oh, sure – if you’re a great picker of stocks, then
you might be able to get by without considering volatility. Even then, though, you’d be operating without full
consideration of the main factor influencing option prices and strategy. For the rest of us, it is mandatory that we
consider volatility carefully before deciding what strategy to use.
The information to be presented here is not overly theoretical. All of the concepts should be able to be understood
by most option traders. Whether or not one chooses to actually “trade volatility”, it is nevertheless important for
an option trader to understand the concepts that underlie the basic principles of volatility trading.
Why Trade “The Market”?
The “game” of stock market predicting holds appeal for many because one who can do it seems powerful and
intelligent. Everyone has his favorite indicators, analysis techniques, or “black box” trading systems. But can the
market really be predicted? And if it can’t, what does that say about the time spent trying to predict it? The
answers to these questions are not clear, and even if one were to prove that the market can’t be predicted, most
traders would refuse to believe it anyway. In fact, there may be more than one way to “predict” the market, so in
a certain sense one has to qualify exactly what he is talking about before it can be determined if the market can be
predicted or not.
The astute option trader knows that market prediction falls into two categories: 1) the prediction of the short-term
movement of prices, and 2) the prediction of volatility of the underlying. These are not independent predictions.
For example, anyone who is using a “target” is trying to predict both. That’s pretty hard. Not only do you have
to be right about the direction of prices, but you also have to be able to predict how volatile the underlying is going
to be so that you can set a reasonable target. In certain cases, the first prediction can be made with some degree
of accuracy, but the second one is extremely difficult.
Nearly every trader uses something to aid him in determining what to buy and when to buy it. Many of these
techniques, especially if they are refined to a trading system, seem worthwhile. In that sense, it appears that the
market can be predicted. However, this type of predicting usually involves a lot of work, including not only the
initial selection of the position, but money management in determining position size, risk management in placing
and watching (trailing) stops, etc. Thus, it’s not easy.
To make matters even worse, most mathematical studies have shown that the market can’t really be predicted.
They tend to imply that anyone who is outperforming an index fund is merely “hot” – has hit a stream of winners.
Can this possibly be true? Consider this example. Have you ever gone to Las Vegas and had a winning day?
How about a weekend? What about a week? You might be able to answer “yes” to all of those, even though you
know for a certainty that the casino odds are mathematically stacked against you. What if the question were
extended to your lifetime – are you ahead of the casinos for your entire life? This answer is most certainly “no”
if you have played for any reasonably long period of time.
Mathematicians have tended to believe that outperforming the broad stock market is just about the same as beating
the casinos in Las Vegas – possible in the short term, but virtually impossible in the long term. Thus, when
mathematicians say that the stock market can’t be predicted, they are talking about consistently beating the “index”
– say, the S&P 500 – over a long period of time.
Those with an opposing viewpoint, however, say that the market can be beat. That the “game” is more like poker
– where a good player can be a consistent winner through money management techniques – than like casino
14
www.OptionStrategist.com
gambling, where the odds are fixed. It would be impossible to get everyone to agree for sure on who is right.
There’s some credibility in both viewpoints, but just as it’s very hard to be a good poker player, so it is difficult
to beat the market consistently with directional strategies. Moreover, even the best directional traders know that
there are large swings or drawdowns in one’s net worth during the year. Thus, the consistency of returns is
generally erratic for the directional trader.
This inconsistency of returns, the amount of work required, and a necessity to have sufficient capital and to manage
it well are all things that can lead to the demise of a directional trader. As such, short-term directional trading
probably is not really a “comfortable” trading strategy for most traders – and if one is trading a strategy that he is
not comfortable with, he is eventually going to lose money doing it.
So, is there a better alternative? Or should one just pack it in, buy some index funds and forget it? As an option
strategist, one should most certainly feel that there’s something better than buying the index fund. The alternative
of volatility trading really offers significant advantages in terms of the things that make directional trading difficult.
So if one finds that he is able to handle the rigors of directional trading, then stick with that approach. He might
want to add some volatility trading to your arsenal, though, just to be safe. However, if one finds that directional
trading is just too time-consuming, or he has trouble utilizing stops properly, or is constantly getting whipsawed,
then it’s time to concentrate more heavily on volatility trading, preferably in the form of straddle buying.
There was an extremely interesting comment in an article on chaos theory, that has some application to volatility
trading. I don’t expect most readers to be familiar with that chaos theory of mathematics/physics. However,
anyone should be able to grasp the general theory, which states that a small change in a seemingly irrelevant place
can have great affects – perhaps even chaotic ones – later on in time. It applies to many areas of nature and some
have tried to apply it to the stock market as well, especially after the crash of ‘87 which didn’t seem predictable
by any “standard” branch of mathematics, but did seem possible under chaos theory.
In the article, it was pointed out that some systems just can’t be predicted. Chaos theory also aids in determining
that fact as well. For example, chaos theory provides some evidence that earthquakes cannot be predicted. Is this
a useful piece of information, or just some irrelevant trivia? In fact, it is quite useful and important. The article
quotes mathematical physicist Henrik Jensen as saying, “It’s pretty important if you can say you will never be able
to predict earthquakes. Instead you should concentrate on building quality houses.”
I thought that comment was very apropos to the stock market. If chaos theory says that we can’t predict the stock
market – and many say that it does – then perhaps we should stop trying to do so and instead should concentrate
on building quality strategies. Such a strategy would certainly be volatility trading – especially straddle buying
when implied volatility is low.
Volatility Trading Overview
Volatility trading first attracted mathematically oriented traders who noticed that the market’s prediction of
forthcoming volatility – i.e., implied volatility – was substantially out of line with what one might reasonably
expect should happen. Moreover, many of these traders (market makers, arbitrageurs, and others) had found great
difficulties with keeping a “delta neutral” position neutral. Seeking a better way to trade without having a market
opinion on the underlying security, they turned to volatility trading. This is not to suggest that volatility trading
eliminates all market risk – turning it all into volatility risk, for example. But it does suggest that a certain segment
of the option trading population can handle the risk of volatility with more deference and aplomb than they can
handle price risk.
Simply stated, it seems like a much easier task to predict volatility that to predict prices. That is said,
notwithstanding the great bull market of the ‘90's in which every investor who strongly participated certainly feels
that he understands how to predict prices. Remember not to confuse brains with a bull market. Consider the chart
in Figure 1 (below-right):
www.OptionStrategist.com
15
This seems like it might be a good stock to trade: buy it
near the lows and sell it near the highs, perhaps even
selling it short near the highs and covering when it later
declines. It appears to have been in a trading range for
a long time, so that after each purchase or sale, it returns
at least to the mid-point of its trading range and
sometimes even continues on to the other side of the
range. There is no scale on the chart, but that doesn’t
change the fact that it appears to be a tradeable entity. In
fact, this is a chart of implied volatility of the options of
a major US corporation. It really doesn’t matter which
one (it’s IBM) for the implied volatility chart of nearly
every stock, index, or futures contract has a similar
pattern – a trading range. The only times that implied
Figure 1
volatility will totally break out of it’s “normal” range is
if something material happens to change the
fundamentals of the way the stock moves – a takeover bid, for example, or perhaps a major acquisition or other
dilution of the stock.
So, many traders observed this pattern and have become adherents of trying to predict volatility. Notice that if one
is able to isolate volatility, he doesn’t care where the stock price goes – he is just concerned with buying volatility
near the bottom of the range and selling it when it gets back to the middle or high of the range, or vice versa. In
real life, it is nearly impossible for a public customer to be able to isolate volatility so specifically – he will have
to pay some attention to the stock price, but he still is able to establish positions in which the direction of the stock
price is irrelevant to the outcome of the position. This quality is appealing to many investors – who have repeatedly
found it difficult to predict stock prices. Moreover, an approach such as this should work in both bull and bear
markets.
Despite the neutral stance, there is risk in volatility trading. For example, if one decides to “buy” volatility, he will
generally be buying options. Thus, he is at risk of time decay and he also has a risk that volatility might decrease
while the position is in place. On the other hand, if one decided to sell options as his initial position (because
volatility was “too high”)_then he faces other risks: there is the risk that volatility could increase and thus cause
losses, and if the options are naked options, there is the risk that the underlying instrument could move sharply –
a gap move – and cause large losses. For this latter reason, we generally prefer to trade volatility from the long side
or as a spread – not with naked options.
Volatility trading has an appeal to a great number of individuals. Just remember that, for you personally to engage
in a strategy, you must find that it appeals to your personal philosophy of trading. To try to use a strategy which
you find uncomfortable will only lead to losses and frustration. So, if this somewhat neutral approach to option
trading sounds interesting to you, then we should talk.
16
www.OptionStrategist.com
OPTION GLOSSARY
The following is a list of terms that will appear in the newsletter with some frequency.
Assignment: the process by which a seller (or writer) of an option is notified that he is being required to
fulfill his obligation to sell stock (call assignment) or buy stock (put assignment).
Backspread: any spread in which in-the-money options are sold and a greater quantity of out-of-the-money
options are bought. In a more general sense, it may refer to any strategy that makes money when the
market becomes volatile.
Bear spread: a spread which makes money if the underlying stock or future declines in price. Typically
constructed by buying puts at one strike and selling a like number of puts with a lower strike.
Break-even Point: the point at which a strategy or position would neither make nor lose money (generally,
at the option's expiration date).
Bull spread: a spread which makes money if the underlying stock or future rises in price. Typically, one
would buy calls at a certain strike and sell the same number of calls at a higher strike.
Calendar spread: a spread in which one sells options at one strike and buys options at a longer maturity
with the same striking price. In a neutral calendar spread, one would not necessarily buy and sell
the same quantity of options. The spread may be constructed with either puts or calls, but they are
not mixed; that is, if one buys calls, he also sells calls to complete the spread -- puts would not be
involved in that case.
Cash-based: an option or future that settles for cash at its expiration date, rather than being converted into
stock or a physical commodity.
Closing transaction: a trade that reduces an investor's position. Closing buy transactions reduce one's short
position, and closing sell trades reduce an existing long position.
Collateral: the loan value of marginable securities; generally used to finance the writing of naked options.
Contrarian: one who thinks that the popular opinion of the masses is wrong, and will therefore go against
that opinion. If everyone is bullish, the contrarian will interpret that as a sell signal.
Cover: 1) to buy back an option that was written; 2) to sell an option against an existing position in the
underlying stock or futures.
Covered option: a written option is considered covered if the investor has an offsetting position in the
underlying security. Written calls are covered by long stock; written puts are covered by short stock.
Covered write: typically meant to denote the strategy in which one is long the stock or future and is short
an equal number of calls.
Credit: money received in an account. When a spread is done "at a credit", the dollars from the options sold
are greater than the cost of the options purchased.
Debit: money expended from an account. A debit spread requires an outlay of dollars to establish.
Delta: the amount by which an option's price will change if the underlying security moves one point in price.
See also 'position delta'.
Discount: an option is trading at a discount if it is selling for less than its intrinsic value. Example: XYZ
is 55, the Jan 50 call is 4½ : this is a ½ point discount, since the intrinsic value is 55 ! 50 = 5.
Early exercise or assignment: the exercise or assignment of an option before its expiration date. Not
allowed for certain options, which are known as European options.
www.OptionStrategist.com
17
Equity: see collateral.
Equity options: options which have common stock as their underlying security.
Equivalent positions: two strategies are equivalent if they have the same profit picture at expiration.
Selling naked puts is equivalent to writing covered calls; buying stock and puts is equivalent to
buying calls.
European exercise: a feature of some options which means that they are only allowed to be exercised at
expiration, but not before. Therefore, there can be no early assignment of a European option. Many
index options have this feature.
Exercise: to invoke the holder's right to buy stock (calls) or sell stock (puts).
Expected return: a mathematical estimate of the return that can be made from a position. It is technically
the return which an investor might expect to make if he were to make exactly the same investment
many times throughout history. If one consistently invests in positions with high expected returns,
he should, on average, outperform those who don't.
Expiration date: the date on which an option contract becomes void. For equity and index options, it is
the Saturday after the third Friday of the expiration month. For futures options, each one is different.
However, most commodity-based futures options expire in the month before the future expires.
Fair Value: a term used to describe the theoretical worth of an option or futures contract; determined
generally by a mathematical model, with volatility sometimes being a subjective variable.
Futures: a standardized contract calling for the delivery of a specified quantity of a commodity at a specified
date in the future. In some cases, the contract is cash-based, meaning that no actually commodity
is delivered; rather the contract is settled for cash.
Futures options: options which have futures contracts as their underlying security.
Gamma: the amount by which the delta will change when the underlying stock moves by one point. See
delta.
Historical Volatility: a measure of the volatility of the underlying stock or futures contract, determined by
using historical price data.
Implied Volatility: a measure of the volatility of the underlying stock or futures contract. It is determined
by using prices currently existing in the market at the time, rather than using historical data price
changes.
Index future or option: a future or option whose underlying entity is an index. Most index futures and
options are cash-based, meaning they settle for cash at their expiration, rather than for shares of the
index itself.
In-the-money: a term describing any option that has intrinsic value. A call is in-the-money if the stock or
future is trading higher than the striking price; a put is in-the-money if the stock is trading lower than
the striking price.
Inter-market spread: a spread involving contracts on two different markets, generally referring to futures
contracts. For example, one might be long Deutschmark futures and short Yen futures as a hedge.
Intra-market spread: a spread involving different contracts on the same underlying commodity. Example:
long July soybeans, short May soybeans.
Intrinsic value: the amount by which an option is in-the-money; it is never a negative number. For calls,
the difference between the stock or futures price and the striking price; for puts, the difference
between the striking price and the stock or futures price.
18
McMillan Analysis Corporation
Limit Order: an order to buy or sell at a specific price. A limit buy order is placed below the current market
price; a limit sell order is placed above the current market price.
Margin: the investment required by a brokerage firm. Long options must be paid for in full. Futures
contracts and naked options are margined. In this sense, one is not borrowing money from the
broker. Rather the margin is a deposit of collateral against potential losses from the position.
Moving average: an average of closing prices over a specific time period, which could be hourly, daily,
weekly, or even monthly. A 200-day moving average of a stock price is sometimes considered to
be significant support or resistance.
Naked option: a written option is considered to be naked, or uncovered, if the investor does not have an
offsetting position in the underlying stock or futures. See covered option.
Neutral: describing a position that does not have exposure to a certain factor of the marketplace. For
example, delta neutral means that the position is not affected by short-term market movements;
gamma neutral means that the position will not be affected by even larger market movements; vega
neutral means the position is not affected by changes in implied volatility.
Opening Transaction: a trade which adds to the net position of an investor; an opening buy adds more long
options or futures, while an opening sell adds more short stock or futures.
Open Interest: the net total of outstanding open futures or options contracts that have been purchased. Note
that for every opening buy, there is an opening sell as well, but the open interest only counts one
side, not both.
Out-of-the-money: describing an option with no current intrinsic value. For calls, when the stock or future
is below the strike; for puts when the stock or future is above the strike.
Parity: describing an in-the-money option trading for its intrinsic value. Also used as a point of reference -an option is sometimes said to be trading at a specific distance "over parity" or "under parity". An
option trading under parity is trading at a discount.
Profit Graph: a graphical representation of the profit potential of a position. Usually, the stock or future
price is plotted on the horizontal axis, while the dollars of profit or loss are plotted on the vertical
axis. Results may be plotted at any point in time. Generally, in The Option Strategist, profit graphs
will show results projected two weeks hence, as well as projected results at expiration of the nearestterm option in the position.
Position delta: a measure of the exposure of an entire option position to market movement. It is computed
by summing the following for every option in the position: quantity × delta × shares per option.
Premium: another word for price, when speaking of an option.
Put-call Ratio: a measure of option trading volume that is sometimes used as a contrarian technical indicator
to predict forthcoming market movements. The ratio is computed by dividing trading volume of puts
by the trading volume of calls. It may be used in a specific case, such as options on gold futures, for
example. It may also be used in a broader sense by dividing the total volume of all puts trading on
equities on all exchanges by all calls traded. If the ratio gets too high, that indicates too many people
are buying puts. Since this is a contrarian indicator, that would be a buy signal. Conversely, if too
many calls are being bought, the ratio will be too low, and that is generally a sell signal.
Ratio spread: a spread in which the number of options sold is larger than the number purchased. Hence
the strategy involves naked options. See also backspread.
Resistance: a term in technical analysis indicating a price area higher that the current stock price where an
abundance of supply exists. Therefore the stock or future may have trouble rising through the
resistance price.
www.OptionStrategist.com
19
Roll: to close an option and re-establish a similar position in another option on the same underlying security.
To roll a long call, one would sell the call he owns, and buy another call, generally with either a
higher strike or a longer time to expiration, or both.
Skewing: a term referring to volatilities of options at different striking prices on the same underlying
security. If the implied volatilities are different at each strike, there is said to be volatility skewing.
Spread: for options, any option position having both long options and short options of the same type (put
or call) on the same underlying stock or futures contract. For futures, any position involving both
long and short futures either with different months on the same commodity, or on two related
commodities.
Stop order: an order which becomes a market order when the stock or future trades at the price specified
on the stop order. Buy stop orders are placed above the current market price; sell stop orders are
placed below the current market price.
Straddle: any position involving both puts and calls on the same side of the market, with the same striking
price. For example, a long straddle involves buying both puts and calls with the same striking price.
Support: a term in technical analysis indicating a price area lower than the current price of the stock or
future, where demand is thought to exist. Thus a stock or futures contract would stop declining
when it reached a support area.
Technical Analysis: the method of predicting future price movements based on observations of historical
price movements; applies to either stocks or futures.
Theoretical Value: the price of an option or spread as computed by a mathematical model. See also fair
value.
Uncovered option: see naked option.
Underlying security: a broad term used to denote the stock, index, or futures contract which underlies a
particular series of options.
Vega: a term to describe the amount by which an option's price will change for a 1 percent change in the
volatility of the underlying security.
Volatility: a measure of the amount by which an underlying security is expected to fluctuate in a given
period of time. See also skewing.
Volume: the amount of trading of a stock, option, or future. Excessive trading volume in an equity option
may portend a move in price by the underlying stock. If one can spot unusually heavy trading in
calls, that may be a buy signal for the underlying stock.
Write: to sell an option. The investor who sells is called the writer.
McMillan Analysis Corporation
P.O. Box 1323, Morristown, NJ, 07962-1323
Customer Service: 1-800-724-1817
[email protected]
www.OptionStrategist.com