Traders Expo New York How to Structure Your Trade for Maximum - PowerPoint PPT Presentation

! = ! − [ ! ! + ! ! ! − ! ! ] Traders Expo New York How to Structure Your Trade for Maximum Profit 12-March-2019 MARK W. GUTHNER, CFA @Mguthner web site: TheOptionsEdge.Com @The_OptionsEdge MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Table of Contents ¯ Traditional Approach to Directional Option Trading ¯ Index Options Returns ¯ Why Options Are Different From Stock & Bonds ¯ Alternative Approach to Directional Option Trading ¯ Buy or Sell? ¯ Other Issues ¯ Track Record 2 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Traditional Approach to Directional Options Trading 3 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Most Investors Trade to an Anticipated Price Buy July 2018 165/185 Call Spread Apple Inc. (AAPL) $174.98 1-Mar-2019 $250 Sell 1 $200 @ $1.73 (20.4%) $230 Buy 1 $180 @ $7.35 (22.1%) $210 Target Cost = $5.62 $190 $170 $150 Stats assuming a random walk $130 q $185.62 = Breakeven (up 6.1%) $110 q 30% Chance of a Gain $90 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Apr-19 Jun-19 Jul-19 Aug-19 Sep-19 Mar-19 May-19 q 13% Chance of Maximum Gain q 61% Chance of Maximum Loss Risk $5.62 for a chance to earning $14.38. Payoff = 2.6:1 Is this really the best way to structure a bullish trade? 4 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] To Answer That Question, We Ask This One First… Are options fairly priced? 5 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Many Practitioners Argue That Puts are Overpriced Most Investors Lose Money Buying Puts Negative Beta Assets Should Produce a Negative Rate of Return. 16%' Market'Index' 12%' Annual'Return' 8%' Minimum'Risk' 4%' 0%' 130%' 120%' 110%' 0%' 10%' 20%' 30%' 14%' Risk('Stdev)' 18%' 112%' 116%' 120%' Negative <--------------- Beta ---------------> Positive What Does the Data Say? 6 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Put Options Should Generate a Negative Rate of Return Median Returns/Mo for Put Options on the S&P500 (SPY) Out of the Money <-----------------------> In the Money 1-Month 2-Months 3-Months 6 Month 12 Month 18 Month 10.0% 0.0% 90% 95% 100% 105% 110% -10.0% -20.0% -30.0% -40.0% -50.0% -60.0% -70.0% -80.0% -90.0% Data Source: Bloomberg, Time Period Studied: 1/2005 to 1/2018 -100.0% Put Options Have a Negative Beta => Negative Expected Rate of Return 7 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] What About Calls? Median Returns/Mo for Call Options on the S&P500 (SPY) Out of the Money <-----------------------> In the Money 1-Month 2-Months 3-Months 6 Month 12 Month 18 Month 20.0% 0.0% 90% 95% 100% 105% 110% -20.0% -40.0% -60.0% -80.0% -100.0% -120.0% Data Source: Bloomberg, Time Period Studied: 1/2005 to 1/2018 ü In-the-Money Call Options Generate a Positive Rate of Return ü Long Dates Calls Generate a Positive Rate of Return ü Out-of the Money, Short Dated Options Generate a Negative Rate of Return 8 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] For the buy & hold investor, returns are path dependent Underlying Days to Expiration Probability Cum Price 30 27 24 21 18 15 12 9 6 3 - of Event Prob 0.1% 0.1% 3355.80 |- ----- $499.80 ------------------ ------------------ Take S&P500 | 3295.59 |- ----- $439.52 | 0.5% 0.5% | 100.0% | for Example 3236.45 |- ----- $380.33 | |- ----- $380.45 ------------------ ------------------ | 100.0% | | 3178.37 |- ----- $322.24 | |- ----- $322.33 | 2.2% 2.7% S = $2,800 | 100.0% | | 100.0% | 3121.34 |- ----- $265.44 | |- ----- $265.27 | |- ----- $265.34 ------------------ ------------------ | 99.2% | | 100.0% | | 3065.33 |- ----- $211.15 | |- ----- $209.63 | |- ----- $209.30 | 7.1% 9.8% | 95.8% | | 98.7% | | 100.0% | 3010.32 |- ----- $161.73 | |- ----- $157.72 | |- ----- $154.84 | |- ----- $154.32 ------------------ ------------------ Call | 87.8% | | 92.4% | | 97.9% | | 2956.31 |- ----- $119.46 | |- ----- $113.16 | |- ----- $106.54 | |- ----- $100.87 | 15.6% 25.5% | 75.7% | | 79.7% | | 86.1% | | 97.1% | Assumptions 2903.26 |- ----- $85.44 | |- ----- $78.03 | |- ----- $69.45 | |- ----- $58.91 | |- ----- $47.26 ------------------ ------------------ | 61.6% | | 63.6% | | 66.8% | | 73.5% | | 2851.16 |- ----- $59.46 | |- ----- $52.18 | |- ----- $43.75 | |- ----- $33.37 | |- ----- $18.31 | 23.4% 48.9% K= $2,856 | 47.7% | | 47.6% | | 47.5% | | 47.2% | | 45.9% | 2800.00 $40.45 | |- ----- 34.08 | |- ----- 26.99 | |- ----- 18.86 | |- ----- 9.15 | |- ----- 0.00 ------------------ ------------------ 35.4% | | 34.0% | | 32.0% | | 28.6% | | 21.6% | | Vol. = 20% 2749.76 |- ----- 21.87 | |- ----- 16.43 | |- ----- 10.69 | |- ----- 4.86 | |- ----- 0.34 | 23.8% 51.1% 23.5% | | 20.8% | | 17.0% | | 11.1% | | 1.8% | 2700.41 |- ----- 9.91 | |- ----- 6.09 | |- ----- 2.66 | |- ----- 0.36 | |- ----- 0.00 ------------------ ------------------ 13.2% | | 10.0% | | 5.9% | | 1.4% | | 2651.96 |- ----- 3.49 | |- ----- 1.48 | |- ----- 0.26 | |- ----- 0.00 | 16.5% 27.3% 5.8% | | 3.2% | | 0.9% | | 0.0% | Price: $40.45 2604.37 |- ----- 0.84 | |- ----- 0.17 | |- ----- 0.00 | |- ----- 0.00 ------------------ ------------------ 1.8% | | 0.5% | | 0.0% | | 2557.64 |- ----- 0.11 | |- ----- 0.00 | |- ----- 1.46 | 7.7% 10.9% Zeta = 36% 0.3% | | 0.0% | | 0.0% | 2511.74 |- ----- 0.00 | |- ----- 0.00 | |- ----- 0.00 ------------------ ------------------ 0.0% | | 0.0% | | ZetaEver = 72% 2466.67 |- ----- 0.00 | |- ----- 1.46 | 2.5% 3.1% 0.0% | | 0.0% | Option Price & 2422.41 |- ----- 0.00 | |- ----- 0.00 ------------------ ------------------ 0.0% | | 2378.94 |- ----- 0.67 | 0.5% 0.6% Probability of expiring in the money 0.0% | 2336.25 |- ----- 0.00 ------------------ ------------------ 0.10% 0.10% The buy & hold option investor needs the appropriate directional move (autocorrelation) of sufficient magnitude to capture value. 9 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] How Options are Priced & How they are Traded Usually Differs Option Price Price Predicted by Delta Gamma Effect $10 Not Explained by Delta $8 At the Money Strike & Initial Option Price $6 Share Price Not Explained by $4 Delta $2 $0 $15.00 $20.00 $25.00 $30.00 $35.00 -$2 -$4 In a fairly priced option, what is gained by “Gamma,” the bend in the curve, is lost by “Theta”, the rate of time decay 10 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Options have value because of the potential for price changes ¯ Traditional financial assets are a claim on a real asset ü Bonds = 1 st Claim ü Stocks = 2 nd Claim ¯ Options are a different kind of asset all together ü Value is derived, at least in part, because the price of the underlying assets changes or is expected to change ü If the price of the underlying is fixed, a properly priced option will not have time value Value of an in-the-money option would have intrinsic va lue § Value of an out-of-the-money option would not have any § value 11 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Options have value because of the potential for price changes ¯ Using options for directional trades ü Value is created when the price of the underlying moves enough (up for a call/ down for a put) to overcome time decay ü Value is lost rapidly when underlying price moves down for a call and up for a put ¯ Options are volatility instruments ü Captures value when price moves in either direction ü Arbitrage condition trades off price movement with time decay 12 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Implications: Alternative Approach to Directional Options Trading 13 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Trade to where price is not going Apple Inc. (AAPL) $173.80 Sell July 2018 170/150 Put Spread 1-Mar-2019 $250 Sell 1 @ $6.75 (30.0%) Don’t Buy $230 Buy 1 @ $1.85 (31.0%) This $210 Credit = $4.90 $190 $170 $150 Sell this instead $130 Stats assuming a random walk $110 q $165.10 = Breakeven $90 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Mar-19 Apr-19 May-19 Jun-19 Jul-19 Aug-19 Sep-19 q 65% Chance of a Gain q 56% Chance of Maximum Gain q 14% Chance of Maximum Loss Risk $15.10 for a chance to earning $4.90. Payoff = 0.3:1 14 MEMBER FINRA | SIPC | NSCC | OCC

! = ! − [ ! ! + ! ! ! − ! ! ] Use Shorter Expirations When Possible 19-July-2019 Expiration 20-May-2018 Expiration Stats assuming a random walk Stats assuming a random walk q $166.01 = Breakeven q $165.10 = Breakeven q 68% Chance of a Gain q 65% Chance of a Gain q 59% Chance of Maximum Gain q 56% Chance of Maximum Gain q 8% Chance of Maximum Loss q 14% Chance of Maximum Loss q 78 Days to Expiration q 138 Days to Expiration q Collect $399 In Premium q Collect $4.90 in Premium Profit Potential Potential Profit ü $490/138 = $0.036 per day ü $399/78 = $0.051 per day ü Higher Chance of Success 15 MEMBER FINRA | SIPC | NSCC | OCC