Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

This is part of a series on option spreads, which are positions involving more than one option. Options can be combined like Lego blocks to create positions to fit varying market outlooks.

We can assemble the blocks into a position that will be most beneficial if our outlook on the outcome of the three main forces that change option prices is correct. These three forces are:

1. The actual price movement of the underlying stock. Rising stock prices push call option prices up, and put option prices down. Dropping stock prices do the opposite.
2. The expected future price movement of the underlying stock. The faster the movement option traders expect in the price of the stock, the more they will pay for options (both puts and calls). As these expectations change option prices inflate and deflate. This effect can happen very fast - in a matter of days or less. And changing expectations can even have a larger effect than that on the actual price movement of the stock. Changing expectations can either augment the effect of the actual change in stock prices or counteract it, sometimes more than cancelling out the effect of price movement. An untrained option trader can be left scratching his head wondering how his call options lost money when the price of the stock went up. In our Professional Option Trader class, we emphasize the importance of this effect, called implied volatility, and make it a central pillar of our option trading method.
3. The passage of time. This is a relatively easy one to figure. Every option loses a little of its value every day as it approaches its expiration date, and the rate can be easily calculated. This one too can get a little tricky, though, as the rate of decay remains pretty stable for a long time and then suddenly accelerates near expiration.

We can build an option position that is designed to take advantage of any one, or any combination of these three option forces. Here is an example of a situation where we have a strong opinion on the likely direction of stock price movement; but not on whether changing market expectations going forward are more likely to inflate or deflate option prices. We want a position that will make money if the actual price movement is in the direction that we expect; but we don't want to be hurt by changing expectations no matter which way they change.

Below is a chart of AFLAC, inc. (AFL) as of July 31, 2015.

Click on picture to enlarge

Aflac recently announced very good earnings and the stock popped up into a solid supply area around $64.63. We believed that this supply level was likely to hold and that AFL could drop back down toward its breakout level around $61.50 within a few days to weeks. This is a bearish trade situation.

The simplest kind of bearish option trade is to buy put options. A drop in the stock price raises the price of put options, all other things being equal.

The problem, of course, is that all other things are never equal. Those "other things," are changing market expectations and time decay.

In this case, note the ending position of the red line in the subgraph below the price chart. That red line plots Implied Volatility. This particular indicator is a proprietary one available to our students which is designed to make it clear at a glance that the current level is high, low or in the middle of its historical range. The raw implied volatility information is available in most trading platforms.

Here the current level of implied volatility is right in the middle of its range. If it were on the high side we would expect it to drop, and if it were low we would expect it to rise. Here it is neither.

If we simply bought puts in this situation, the value of those puts would be hurt if implied volatility drops - and there is a good chance of that. The second simple bearish option trade is just to sell calls short. That won't be a good idea here either. If implied volatility rises, then the value of all options will be pushed upward. This will hurt us if we have sold options short.

Here's how we can approach it. The trade is called a directional butterfly. It consists of three parts:

1. Buying one put option with its strike price above our supply zone, at the $65 strike. This is the moneymaker, the anchor of this position. This makes money if the stock goes down, if there is no impact from changes in implied volatility.
2. Selling two put options at a much lower strike price, one that is below our downside target price. In this case we could sell two of the $60 puts. Each of these puts, being farther out of the money than our $65 anchor put, has about half of the sensitivity to volatility changes as the $65 put. The point here is to neutralize any impact on the long $65 put from changing implied volatility. With volatility cancelled out, the trade becomes a leveraged pure price play. Only one of these two short puts is covered by our long put - the other is naked, which would mean unlimited risk. But we'll address that with one more Lego block:
3. Buying one additional put option at an even lower strike price than the target, at the $55 strike. This one is simply to cover our leftover naked short $60 put, so that this becomes a limited risk trade.
   When all is said and done we own a position that has three legs:

• Long one November $65 put
• Short two November $60 puts
• Long one November $55 put

The total cost of this position with AFL at the $64.63 supply zone was $1.20 per share, or $120 per contract. That $120 represented our maximum theoretical loss if we used no stop-loss on the position and left it alone until expiration. In fact, we would do neither of those things so our actual maximum expected loss is much smaller - around $10 after commissions. Our expected profit after commissions if AFL hit our $61.50 target would be about $48 all in.

So here is a summary of what we have here:

• Cost of the position: $120

• Profit if exited at target: $48

• Loss if exited at our stop-loss price: $10

• Effect of time decay: None

• Effect of changes in implied volatility: None

Options give us some great ways to fit our trading approach to the current market conditions.

In this article we have looked at a type of option spread called a directional butterfly. This trade is designed to make money if a stock moves in the direction we expect - no surprise there. What this spread does is to make it inexpensive to make the trade and limit our risk in case the stock moves against us.

The opportunity we were looking at involved the stock of AFLAC, Inc. on July 30. Its chart looked like this (repeated from above):

Click on picture to enlarge

We were looking at a bearish opportunity: we thought most likely that the stock would fail to break through its recent highs around $65.10 and could drop back to its recent breakout level around $61.50 within a few weeks.

As an alternative to selling the stock short, we considered a directional put butterfly which involved three components:

• Long one November $65 put - the moneymaker.
• Short two November $60 puts - the offsets. These reduced the cost of the trade and reduced our exposure to changes in volatility. They also nearly eliminated the effect of time decay that the $65 put alone would have suffered.
• Long one November $55 put - the protective unit. This very cheap option made this into a limited-risk trade.

The total cost of this spread was $120 per 100-share unit including all four options. This was our maximum loss on this trade if we used no protective stops and held it for the whole four months.  Our plan would cut down that $120 risk considerably.

• First, we would plan to exit the trade immediately if AFLAC traded above its recent high at $65.10. If that happened, it would indicate that our opinion about its inability to do so had been incorrect and there would be no more reason to be in the trade.

• Second, we would not hold the trade for the full four months. If AFLAC hadn't made its move within a month we would exit in any case.

Although setting stop-loss orders would not reduce the amount of cash required to enter the trade (it would still be $120 per 100-share lot), these two steps cut down our maximum risk from $120 to about $11 per spread. The profit potential if AFLAC hit our $61.50 target was over $44 per contract, four times the $11 risk.

Below is the Profit/Loss graph of this position:

Click on picture to enlarge

The horizontal axis is the stock price and the vertical axis is profit or loss on the position (given its $120 cost). The gray curved line shows P/L at any stock price if reached today. The green curved line shows P/L at any stock price in a month's time.

We used today's line (gray) to determine loss on the position at our $65.10 stop-loss price. The second row in the table above indicated that loss at $11.06 (in the "Theo P&L" column).

We used the green line, which indicates P/L a month from now, to determine our profit. This is because we believed it could take that long to reach our target. The first row in the table indicates the P&L at that price as $44.85. The profit could be a bit higher if AFLAC were to drop lower than our $61.50 target.

Although the directional butterfly has several moving parts, it can be a good solution to gaining profit from a stock move at a reasonable cost and with limited risk.

With the right education we can shape an option strategy to fit just about any market condition.