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Options Pricing & The Greeks

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A good explanation of the option greeks from optionsalpha.com

Transcript:

Hey everyone. This is Kirk here again at Option Alpha.com and in this video we are going to go through Options Pricing and The “Greeks”.

Now, I can tell you honestly that this is actually one of my favorite parts about trading. I’m just a numbers guy by nature and I can tell you that this is by far the number one distinguisher between those people who are successful in this business and those who aren’t is understanding how options are priced, understanding the Greeks, how implied volatility and time decay and all of that stuff impacts an options price.

Because if you understand that, then you’ll understand where we get our edge in trading. We are going to be going over this a little bit more in some other video tutorials further down in track 1 but today we’re going to dive really really deep in options pricing so that you guys have a clear clear understanding of it.

So first of all, trying to predict what will happen to the price of a single option or a position involving multiple options as the market changes can definitely be difficult as an undertaking.

So, it’s really hard, it’s easy with stocks right, as you know what’s going to happen with the value of the stock because you can see it visually right? The stock value goes up or the stock value goes down.

With options there are so many different components that factor in. It’s hard to understand that sometimes what is really impacting that value of that option.

So if we said because the option price does not always appear to move in conjunction with the price of the stock, it’s important to understand what factors contribute to the price of an option and the effect that they have.

Option traders often refer to delta, gamma, vega and theta of their option positions. This is collectively called the “Greeks” and they provide a way to measure the sensitivity of an option’s price to quantifiable factors. Now, its really important that you realize immediately that the greeks do not determine pricing and this is a big misconception that people have. Greeks don’t determine pricing, they just reflect what could happen in option pricing changes for moves in stock, implied volatility, time, etc.

Okay! So greeks are forward looking, they are not a determinant of options pricing. They basically tell you that if this happens then the price of the option should go down or up by X.

Okay? So they are like little levers, so if you push this level then you’ll get this reaction, if this happens in the stock you’ll get this reaction and its a big misconception that some people have. So again, before we talk about the greeks, let’s dive a little bit deeper into the overall options pricing which builds on the concepts that you already learned earlier in this course and track 1. All right, so here’s the deal.

In the way that I always think about it is like this and this is what we kind of created here for you guys is that options pricing so the price of the option is basically broken down into couple different categories and then we’ll kind of go further and deeper into the Greeks. Now, we’ve already talked about intrinsic verses extrinsic values. I think we did that in our last video or the previous video.

Inside of track 1 here, talking about in the money, out of the money and at the money options but basically you can break down the options price into two broad components and that is intrinsic value and time value. Intrinsic value again being the value of the option right now if it were to be at expiration so does it have any value right now based on the spot price or the stock’s price and your strike price.

Meaning if you have a 50 strike call option, so your strike price is at 50 and the stock right now is at 55, you know that you have 5 dollars of intrinsic value in that option right now because you can buy it at 50 and immediately sell it at 55. Okay? So that’s the first component in option pricing is this intrinsic value and again that’s just simply looking at the difference between the stock price and the strike price whether you’re at the call side or the put side. Now the other component of options pricing is time value. Now this is the one that always trips people up.

Most people get intrinsic value but this time value aspect really has a lot to do with how options pricing fluctuate in addition to the movement of the underlying stock. Because we know that the intrinsic value is going to move as the value of the stock of the value goes up and down. That’s just the straight linear relationship but they extra component here this time or extrinsic value that’s a little bit different. So, that factors in things like time to maturity so how long is it before expiration. Typically options that have a long time before expiration are more highly valued because there is a long time for that contract to be out there. Options that have a low time until expiration are typically lower valued, all things being equal. Volatility! Again this is the key right here. I can tell you right now, if you’ve watched any of our videos here or if this is the first video that you are watching here at option alpha, I am telling you right now that volatility is the key to everything that we do here as a trader and trading options.

It is the number one most important thing that you can master and volatility, when it comes to options pricing just basically means that when the markets are more volatile so when there’s high volatility then option pricing is high as well across the board. Calls, puts, everything on both sides when there’s high volatility, options pricing goes up as well because a rising tide raises all ships meaning that when the markets are very volatile and swinging back and forth wildly then each strike price has a better chance of being hit. When volatility is really low or dropping, then options pricing as a result goes down and when markets are really low in volatility means they are just moving sideways and not really making those huge moves like a high volatile market.

In low volatility markets like that, the option pricing is low because then those further out of the money strike prices don’t have a high chance of being hit. The market just doesn’t move all too much. Then the last thing that really effects the value of an option is the rate of interest or interest rates. This is rho. We don’t usually talk about this one but kind of briefly cover it right here, but we don’t usually talk about this kind of like the mane for Greeks and rho really effects options that are really far out end dates.

So just like time to maturity and just like volatility, as of contract expiration is further and further out we’re talking six months a year two three years out then interest rate impacts will have a bigger impact on the value of that option. For what we do here at option alpha and what most traders do, trading inside of 60 days, the impact of interest rates is non existent almost. So, we don’t really cover it as a kind of main Greek but it is there just so you guys know. Okay, so that’s kind of like the basics for options pricing. Now let’s dig a little deeper into the actual Greeks and we’ll kind of relate this back to the things we just talked about.

So, again options pricing broken down into those two main categories, then all the ones below now we have the Greeks, okay?

Again, we have basically the four major Greeks: Delta, Gamma, Vega and Theta and then we have Rho which is the interest rate one as well, okay! We don’t want to discount that, don’t want to assume its not there, it is but it doesn’t really impact shorter maturity options.

Delta:

So again, delta is now going to give you and show you that relationship for intrinsic value okay. This is basically what delta does. It gives you the relationship that how much money you’re going to make for that particular strike price based on any particular movement in the underlying stock and again we’ll go over each of these individually with a lot of examples too, okay.

Gamma:

Gamma doesn’t really have a connector here but Gamma is related to Delta. So gamma is considered basically, the rate of change or the acceleration amount of delta. So basically it shows you that next dollar amount, how much more are you going to make from that next dollar and then the next dollar and then the next dollar.

Vega:

Vega is very easy to remember. Vega and theta are very easy to remember because I always think V-Vega, V for Volatility. So, Vega is going to tell you what the impact is on that option for a one person change in volatility. And again, all things being equal, what happens to the value of that option should volatility go up or down by one percent.

Theta:

T for Theta is time to maturity. This is basically going to tell you how much the value of that option decays every single day as it gets closer to expiration. Remember, options are wasting assets. As they approach expiration the Theta decay as its called or the time decay starts to accelerate as it gets closer to expiration, time is running out, the clock is running out and so the value of the options go down dramatically as we get closer to expiration.

And then again we have Rho which is the rate of interest, okay. So let’s go a little bit deeper here and talk a little more about delta and we’ll go through Delta, Gamma, Theta and Vega and go through some really cool examples using some live pricing at the time I’m doing this video. Hopefully that really helps kinda clear things up for you guys. So, lets talk about Delta. Delta is one of the biggest ones you’ll probably hear. We talk about it here generally, not to often, but we will talk about Delta a lot and you’ll definitely see it on your local platform. Now Delta is the amount an option price is expected to move based on a $1 move up in the underlying stock. Now the key here is that the Delta is always based on an upward movement of the stock.

It’s always based on a $1 move no matter if it’s a $500 stock or a $2 stock, it doesn’t matter. It’s always based on a $1 move and a $1 move up. Now naturally then, call options have positive delta, between 0 and 1 meaning that if the stock moves up that is always good for wrong call options and then vice versa. Put options always have a negative delta between 0 and -1. That doesn’t mean that they are bad, it just means that when the market is moving up, then it negatively effects Put options. But, when the market moves down by a $1 then it would positively impact a Put option okay.

So that’s basically the text book definition if you will of Delta. Let’s really dig deep here and look at some examples. So this is my live broker platform. Right now we are looking at GDX. Why GDX, because I just typed it in and then we’re just looking at it okay. The stock right now is trading, live trading at okay, this is ETF for gold. So, it’s live time trading at and I’ve got two contract months open. I’ve got April expiration and I’ve got the May expiration. April expiration has about 24 days to go and May expiration has 9 days to go okay.

So this going to help us to show the differences of how these numbers are going to shift and change and move as we go further out into expiration or closer into expiration okay. And then again we kind of have the weekly contracts that are in between here as well. All right, so let’s actually go in here and start looking at some Delta’s. One of the first things I want to do is I want to look at these 21 strike call options for both April and for May expiration. Again, I am just highlighting it here so you can see it a little bit more clearly and focus in on it. But, inside of our platform or at least something or in most broker platforms you have all the different groups here: Delta, Gamma, Theta, Beta and you can changes these things. Again, we are working on just the call side right now.

Now remember, Delta is going to tell us how much money we make or lose based on the $1 move up in the stock. So right now, the Delta of the 21 strike call options is and what this means is that if the stock goes $1 higher from where its at right now, so from to all else being equal, all things else being equal, then this value of this option contract is going to go up by $46. And the current value of this contract is about $74. This is a big spread here. So, its currently valued at $74 so if the stock goes up by $1 then this option contract should go up by $46, okay. So again, we can see the impact that Delta has. It kind of gives you a barometer for how much money do I make for every $1 move up in the stock. Again now, as we look out towards the May expiration, you can see that there is a bigger impact in May for the same underline move because there’s a little bit more time left until expiration. So again, still the same $1 move up in the stock from where it is right now, up to 21.60.

That gives you a $49 increase in the value of the option okay. Those options out in May are little bit more expensive because of a bunch of different factors which we will continue to talk about. But those options have a lot more time decay, a lot more volatility baked in and are going to profit a little bit more from a quick move up in the underline stock. They cost more upfront but they’re going to profit a little bit more, couple dollars more, for a $1 move up in the stock. Okay, so that’s on the call side. Now, let’s look on the Put side of the trade at the same 21 strike Puts. So the same 21 corresponding strikes but now on the Put side and you can see here for Delta that all of the Delta’s are negative. Now that doesn’t mean that you’re always going to lose money, it’s just remember that Delta is telling you how much money you make for $1 move higher in the underlying stock. If you owned the April 21 strike Puts and the stock moved up by a $1, the value of your contracts would go down by 54 cents.

So right now they’re valued at about a $1.12, $1.13, they would go down by $54. Now, that also means that in the reverse you would make money so if the value of GDX actually went down by $1 instead of up, if the value of GDX went down from to then you would actually make $55 okay. So just the complete opposite. If the value of the stock goes down with Put options then you make this Delta which is okay. On the call side again the same relative thing is going to happen here. You can see the Delta is -51 on the 21 strike Puts for May. That means the value of GDX the stock itself goes up by a $1 or lose $51 and if it goes down by a $1 we make $51. Okay, so hopefully you can see how that relationship starts to interact with each other. Now one thing that I want to point out is that obviously the value of in the money options is always going to have a higher Delta than out of the money options okay.

And again remember that Delta is more of your intrinsic part of options pricing and basically bakes in the intrinsic value of those options that are already existing meaning how much money could you make if the expiration was today and you can see that any options that are in the money both in the call and put side, any options that are in the money have higher Delta’s whether they’re higher negative or higher positive.

They generally have higher Delta’s approaching 1 or negative 1 which is basically parity with the options. Any options that are out of the money usually have lower Delta’s because they’re not going to be as responsive to a $1 move in the stock as something that is in the money. So if you bought a 23 strike let’s say call that’s way out of the money and $1 move up, it’s still not going to be in the money. So the $1 move up from the stock of up to 21.60, you’re still not going to have your stock price above your strike price or have an option that’s now in the money so that option is going to be less responsive and is going to profit less than something else that is a little bit closer in. These options are always cheaper so the market is always fair and efficient with how it prices its options. All right, so let’s move on here and talk about Gamma.

Now Gamma’s a little bit different. Remember, Gamma is going to be related and tied into Delta. Gamma is the rate if change in delta based on a $1 change in stock price. Again, so if delta is the “speed” at which option prices change, or how much you make or lose, and you can think of gamma as the “acceleration”. So, options with the highest gamma are the most responsive to stock price changes in the underlying security. The way that I think about gamma, because I know its hard and I’m trying to give you guys as much information as possible. The way that I think about gamma is I think about gamma as the additional profit or additional loss for the next dollar.

That’s how I think about it. And so lets go back here to GDX and kind of use an example here okay. So, if we were looking at these options now, and move around here to challenge you here on option pricing. So if we were looking at the 22 strike call options in April, the delta for these options is basically 30 right. So let’s round that so we have round numbers here. Its 29 something so that’s basically 30 okay. So that means that if GDX goes up by a $1, the first $1 from to you make $30 okay.

If it goes up another $1 from there so from to you’ll make another $30 plus the additional $1 is going to get you another $15 a profit. So the first $1 that you make or the first $1 up in GDX you basically take in $30, the second $1 or $2 higher you take in an additional $45 for that move higher, okay. So you can see that as the stock rallies your profit potential at least with call options, as the stock does rally in your favor you have an opportunity to kind of compound a profit here in a small snowballing fashion.

Again, it can work in the complete opposite so if the stock moves down by a $1, so again let’s use this example here, it works complete opposite. If the stock moves down by a $1 you lose $30 and if the stock moves down another $1 so now it goes from down to down to then you lost another $30 plus another $15 so now you’re losing even more money as the stock goes down as well okay. Now I don’t want you to think that it only works in one direction, its definitely a two sided mark obviously and it works in both directions. And again, the rate of change is just showing the incremental impact of the delta in the underlying stock move. Now, in this case with gamma, gamma is always positive and it just means the additional money made or lost.

So on the put side if you’re looking at say the 22 strike puts, if the stock moves down by a $1 you make $71. Remember on the put side you want the stock to go down and that means we make money. If the stock goes up we lose $71 but if the stock goes down we make $71. If the stock goes down by another $1 on top of the first $1 then we’ll also make another $71 check, and we make an extra $15 on top of it okay. So that’s how you want to think about that. Gamma is the additional money made or lost for each incremental dollar higher and lower. Now notice, what’s really important about gamma is that gamma is always highest when its centered around at the money strikes okay. So generally speaking gamma’s highest when its centered around the at the money strikers. As you go further out on each end notice how gamma goes down. That’s because you’re getting away from being either in intrinsic value or extrinsic value right.

So that’s why gamma is lower at the further extremes because its not going to have as much of an impact on the actual options price which really is going to have big impacts is when the options is trading right around its strike price okay. So hopefully that makes sense and hopefully that kind of clears that up. All right, the next option group that we want to talk about is Theta. Theta is time decay or is really the enemy number one for option buyers. On the other hand its usually the option sellers best friend and there’s option sellers here at Option Alpha. It is one of our best friends to have theta or time decay working to our advantage. Now, theta is the amount the price of calls and puts will decrease every single day as the option approaches its expiration. Remember, option contracts are wasting assets. They decay in value until they reach their intrinsic value at expiration. That means that every day they are wasting away. I think about it like a bucket of water with a slow drip and slowly over time that slow drip is going to empty the value of those options.

That’s why we prefer to be option sellers because of this wasting approach to option selling. So again lets go back here to our GDX example and we can look at some theta inside of here and I always do that … so open up garage bands instead of my marker. So you can see here that this is theta and again its negative in all cases for all options out of the money, in the money options, everything.

Theta is always negative for options because options is always a wasting asset. There’s no example of option theta would not be negative. But remember theta is going to be really really small far out because the options have a lot of value as we get closer and closer to expiration, theta really speeds up. So just to give you like a really good example of this we can look at a couple different contracts here. These are the March contracts that expire in two days from now and you can see that the 21 strike call options have a theta of -4.

When I go out to the 21 strike call options on the April contract which have 24 days to go, you can see that those are only losing $2 per day wherein theta of -0.02. So again this is the every single day decline in the value of the option regardless of what happens in the underline stock because its getting closer to expiration. So when I look at these April expiration options and this 21 strike call you can see that every single day no matter what happens this option is losing part of its value, $2 per day to time decay okay. Again, this is going to happen every single day and that’s going to accelerate and speed up because you can see here as it gets closer to expiration, now its losing $4 a day and probably somewhere in between here around the 17 or so or 10 days you can see now its starting to lose $2 to $3 per day okay.

So that time decay aspect is really really crucial and you have to understand that if you are trading to close in, that theta decay means that your option neither has to be make it or break it. Its either going to make money or not because if it doesn’t you’re going to lose a lot of value from those contracts purely on the decay in the options as they near expiration.

Now same thing goes on the reverse obviously the further out that you go the theta decay is really limited. You can see these options only in May. There’re losing just about a $1 a day okay. That’s pretty much the lowest that they can lose and the least amount. That means that the value of these options are going to pretty much hold up until they start getting really under 45 days that’s when it really starts to speed up. All right, so the last option Greek that we’re going to talk about is Vega. Vega is my personal favorite. I believe that this where we make all our money as an options trader and its understanding the relationship between implied volatility, historical volatility and how options are priced okay. We’ll get deeper into this as we go through our edge training here in a couple of sessions on the beginner track here at Option Alpha. So vega is the amount that a call or put price will increase or change for every 1% change in implied volatility of the underlying stock okay. So again its always based on a 1% move up in implied volatility and it basically shows you how much money you’ll make or lose if all else stays the same, everything else stays the same and implied volatility goes up.

Now, vega does not have any impact on the intrinsic value of the options because again it can impact the kind of like the further out stretches because it doesn’t really matter if the stock moves its all based on implied volatility in the market. So it doesn’t have any impact on the intrinsic value of the option and and only affects the “time value” of an options price. Now that said, IV is the most critical element of an option and the options pricing model because its the only unknown component.

So when you really think about this, okay, the options market knows almost everything to determine the price of an option. So going back to this options pricing chart here, to determine the price of an option we know almost everything. We know the current stock price, check, we know the strike price in relation to the current stock price. That’s a given. So we know intrinsic value immediately. We know how much time is left till maturity, we would know what the interest rates are, right, and the only thing we do not know is how volatile this stock is going to be in the future. This unknown becomes our edge. This is the one component as I mentioned numerous times before if you’ve listened to anything we’ve done here at Option Alpha or read anything that we’ve published, you know that this is the number one component that you have to understand if you want to be successful at trading.

Because its the unknown and therefore its our opportunity to make money, its our edge in the market. So again all these other factors can determine options pricing except for volatility. So how does implied volatility work? So basically without getting too much into it in this video because we got a lot of other videos that we can go through.

But implied volatility basically works by assuming how far a stock will move in the future. So basically what happens is that the options market basically determines its own implied volatility or the market participants based on how active and how much they want to price an option or how high or low they want to price it, they determine how volatile they expect the stock to be in the future or the ETF to be in the future. You can see here down below with GDX back here in November or at least at the time we were doing this video, there was pretty low volatility in the market. So market participants were not expecting GDX to make a really big move and as a result over the last you know couple of months as it headed toward a really big move, market participants got that part right for couple of months.

You’ll notice they started to shift and change there perspective and you’ll see this big jump in implied volatility and this is again is all based on current market participants. Its not based on any necessary you know formula or relationship to the stock price, the expiration or any of these other things. Its based on how active people are buying, how aggressive they’re buying options on either end, how far out they’re doing it, the prices that they’re paying but you can notice that there is a meaningful jump in implied volatility meaning the market participants expected GDX to be fairly volatile sometime soon in the future and you can see once that jump happened exactly that the GDX basically doubled over in the matter of two months or so from around $10 to around $21. You can see the market participants kind of fairly and accurately predicted that move. Its this implied volatility factor that is unknown so we don’t know exactly what the stock is going to do but we do know that market participants can expect a big move out of the stock or can expect a little move out of the stock and having high implied volatility basically gives all option prices a higher value, having low implied volatility gives all option prices a lower value.

So going back to our trade tab in GDX, when we look at vega again which is volatility we again see that vega is pretty much is a constant on both sides and is positive. Because its always looking for that one percent move up in implied volatility okay. It doesn’t just like delta its always looking for a $1 move higher, vega is always looking at the next 1 percent higher in volatility. So if we look at again the 21 calls and with a vega of 0.2, if volatility in GDX increased by 1 percent regardless of where the stock moved, regardless if its closer to expiration or not, just a 1 percent move up in implied volatility causes the value of this option to go up by $2. Now in most cases volatility moves up by a couple percent, usually 5 or 10 or 20 percent in a given week. So if we’re looking at a 10 percent move in volatility, we’re looking at a $20 increase in the value of this value in this option and nothing else had to happen. The stock could stay exactly the same, we could be in the same day between now and the expiration as in the same time.

Everything else being equal just a rise in implied volatility or the market expecting the stock to be more volatile to be more volatile than before causes an increase in the value of these options. Now again, just like time decay the value of these options will be more dramatically impacted the further we go out because as we have more time till expiration volatility going higher creates a bigger opportunity for the market to swing into a zone that we could make some money in.

So again if we go back here in GDX and if we’re looking at these expiration dates, this is the April expiration date and this is the May expiration date out here. If the stock market is really volatile we only have option until May, there’s not too much time for the stock to swing into profitable range but if we have options all the way out until April we don’t have too much time. If we have time all the way out to the May expiration, you can see that we got a lot more time for the stock to move into profitable range. So in this case volatility is going to dramatically impact those options that are a little bit further out in time okay. We’ll be going through a lot more case studies and looks at volatility especially in the coming up videos when we talk about historical volatilities that actually happens verses implied because that’s really how we kind of gain our edge as option sellers. Remember that the Greeks like we said before are snapshots in time.

What’s more important to realize about options pricing, is the impact of future time decay and volatility can have a huge impact on option pricing more so than the underlying position and how it moves. We’ve proved time and time again and posted many live training videos that showed where the stock moved completely against us where we did not get the directional assumption right meaning we thought that the stock was going to go lower or higher and we were totally wrong but the impact of time decay and volatility and understanding those components or put us in the position where we could take a profit in the trade even though we had the underlying direction completely wrong okay.

So Greeks are just snapshots, they move every single time the market moves, the Greeks are basically recalculated and always moving as we get closer and closer to expiration. So I know this has been a long video. Hopefully it was incredibly helpful to understand options pricing. If you have any comments or feedback, I’d love to know. Add them in the comments box right below this video. If you love this video and thought it was helpful, please share online and spread the word on social media.

Help us help you by getting other people involved in options trading. It’s one of the ways we grow here through organic referrals from people like you. Until next time happy trading. .

As found on Youtube

How to Generate Consistent Income Trading Options

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Another great video from options alpha – a good overview of consistent income generation via options.

Transcript:

Hey everyone. This is Kirk here again at optionalpha.com and in this video I want to go trough, hopefully, the entire process and lay the foundation for how you can generate consistent income trading options.

My goal in this video is to basically bring everything that we learned in track 1 together and kind of lay the foundation for now going out and doing more tutorials in track 2 about how we can find trades, placing orders, things like that. I think it is important that we first cover the broad strokes.

We have to understand where we’re going so we know what the path is to get there. For something to be powerful and profitable it doesn’t have to be complicated. Yet, more often than not, when I present this system that I’ll be presenting to you right now to new traders and even experienced traders, they believe that making money with options must mean crazy systems and thousands of indicators.

But the reality is it’s just not that case. You see, I love this chart because it’s so clear that effectiveness and simplicity are on a linear path together. Meaning for something to be extremely effective, it also must be very simple. Options trading definitely has its complicated parts. It’s not as easy, as black and white, as buying stock and selling stock. That doesn’t mean that it’s extremely complex and that you have to have all of these different indicators and all of these different ways of thinking about trading.

You do have to learn a little bit. You do have to put in a little bit of effort and work at it, but it is a very simple process when we talk about it at the high level. Some of the things I’m going to say below in this video you may not like or won’t be what you envisioned this game to be, but regardless, it’s what you need to be doing to be successful. So here they are.

The five things I believe you have to do to be successful in the options trading space.

1. You have to trade small positions. It kind of goes without saying, but if you trade too large, you’re just going to blow up your account.

2. You have to trade with a high probability of success Again, just to use a completely opposite example of this, if you invest in lottery tickets, they don’t have a high probability of success.

The likelihood that you’re going to win is really, really low. You have to invest in something that has a high probability of success. We’ll help you figure out how you can find that in this video.

3. You have to be in liquid stocks and options I think it goes without saying, but if the market is not liquid, I mean there’s no other participants in there, you’re the only person, or you and five other people in the entire world are the only participants in there, then you’re going to lose a ton of value to slippage and you may not even be able to get in or out of a trade.

That’s obviously a critical component.

4. Probably one of the most important, is using the right strategy We’ve talked about how implied volatility is our edge in trading. If you believe that implied volatility is our edge in trading then you have to also believe that you should be generally selling options when implied volatility is high and, if you ever do buy options, you should be buying them when implied volatility is low. You have to play that volatility game. We’ll prove here in the video in a very different way than we have before how that’s the case where direction is meaningless compared to implied volatility.

5. You have to be doing it as many times as you can This gets down to the number of occurrences, the number of times that you trade. Creating a large frequency of trades so that over time you hit your expected probability level, whatever you’re targeting.

Most traders do one or two, that’s the reality, but they don’t do all 5. You can’t pick or choose. It takes all of them to win long term in this game. Let’s take an example. If you trade small positions in liquid stocks using the right strategy as many times as you can, but you didn’t have a high probability of success, you would not win. That’s just the reality. You can choose any of these things and you throw one out and it crumbles the whole thing. This would be like lottery tickets. Lottery tickets are liquid. It’s the only strategy you can use. You can do it as many times as you want. It’s a really small investment, $1, but it has low probability of success. You’re never going to win.

You could trade in something that has a high probability of success in liquid stocks and options using the right strategy as many times as you can, but your position size is too big and one bad trade that comes along wipes out your entire portfolio. You can’t do one or two or three or four. You’ve got to do all five.

Finally, just to drive home the example even more, you could trade small positions with high probability of success in liquid stocks and options using the right strategy, but if you only did it one time, how often are you going to win? If you only did it one time or two times, heck, even ten times a year, how often are you really going to win? How often are ten trades actually going to work out in your favor? It doesn’t work. You take one of these building blocks away and the whole thing crumbles. This is what most people miss in this space, in my opinion. They do one or two or three of these, but they don’t do all of them.

Let’s dig in a little bit deeper here and start talking about trade size. This is something we’ve covered before in depth, but at Option Alpha we firmly believe, and I’ve believed this for a long time, that your trade size should be no more than 1-5% of your account balance. If this is your account balance on the left hand side, meaning how much capital you have in your account, this should be your sliding scale of trade allocation size.

Obviously, in my opinion, I think most of the time you should play in this sandbox, meaning the 1-2% region. Even at a $250,000 account, which is a large account, 1% is $2500 of risk per trade. You can do a lot with $2500 of risk per trade. You don’t need to be going up to the $12,000 of risk per trade. That also means that if you have a small account, say you’re trading under $5,000, you may need to increase your position size because of the small account so that you can get some trades across.

You may need to move up to the 2% or 3% level. There are definitely trades that you can place out there for $100 or $150 risk. Are you going to make enough money to quit your job and sail away on a cruise ship or yacht or whatever? No, you’re not, but you have to be realistic with your expectations. If you trade too large with a small account, don’t make the assumption that making or having more money in your account is magically going to make you a better trader. I can guarantee that if you can’t make money with an account $15 – $5,000, there’s no way you’re going to make money if you had an account of $100,000.

You’re just going to lose money a lot quicker with more money. Focus your time, if you do have a small account, on making small high probability trades, like we’re going to discuss, because that’s how you win in this game. It’s a long term game of slowly building up capital and profits. Obviously the next part of that is high probability of success. This is something that we’ve talked about because we know what the probabilities of winning on trade are or not. We can show you here in a second. Remember, markets move in a more or less normal distribution pattern. We actually showed in one of the previous videos here on track one. We went back all the way to 1990 and tracked the Dow Jones daily move and it was almost exactly a normal distribution from 1990.

Are there times when you’ll have five or six days of up moves? Yes. But, generally, over time markets move in a normal distribution pattern of percentage up or percentage down moves. If we take that normal distribution pattern, we know that over time, as a stock moves, we can figure out what the percentage range is that the stock might move 68% of the time. We can take this stock. If this stock was at $50, we could look on our charts and on our broker platform and see that there’s a 68% chance it moves between $60 and $40. Those are known numbers. This is how we can then determine what types of high probability trades we want to get into. At that point it’s just a matter of choosing which direction you want to go.

It really doesn’t even matter at that point. Here’s the deal. Here’s a high probability example of a trade that you can make in SPY. SPY, at the time that I grabbed this chart, was trading at 203. The April options, which are about 22 days away, you can see exactly what the probability of each and every strike price being in the money is at expiration. Remember, this is calculating based on the entire trading history of the S&P, or whatever stock you’re looking at. Every move it’s every made, up or down, the magnitude of every move, how fast it’s moved in a given time period, and then implied volatility. All of those numbers are then populated into a broker platform where you can see what the probability that each and every strike is going to be in the money at expiration. In this case, if the stock right now is trading at 203, we know that in the next 22 days, there is a 31% chance that the stock goes from 203 up to and above the 2call strike. We know that that’s the probability.

So if there’s a 31% chance that it goes above that level, that means that there is basically a 70% chance that it never goes above that level. If we’re option seller, which we usually like to be, then we would sell these 2calls and basically take in a credit of $152 knowing that we’ve got about a 70% chance that the stock never gets to our strike price. Again, these numbers are know. You can basically pick what likelihood of success you want to have. The field is open. The buffet is open. You choose how often you want to be successful. At Option Alpha, we usually choose around the 70% probability of success range. It works in the same way in the opposite direction with puts. Down below the market we also know that if the stock is trading at 2that in the next 22 days there is only a 30% chance that the market goes below 198.5. We know these numbers. They’re known numbers. That means that there’s a 70% chance that the stock market doesn’t go below 198.5. 70% chance that it stays above this level at any point between now and expiration. If we were to sell these put options, we could see these put options for $122 and have basically a 70% chance of success.

Notice, it really doesn’t matter. There’s a slight difference in pricing here. In most cases there’s going to be a slight difference in either direction one way or another, but generally speaking you’re collecting about the same amount of money for the same probability of success on either end. So really direction is meaningless compared to making high probability trades and being on the right side of volatility. We’ve got more video tutorials on that here at Option Alpha. We don’t have time to go into every possible strategy and how you can figure out the probability of success, but this is a great example. I just want to show you guys that it’s known.

You can choose your probability of success, however successful you want to be in the trades that you make. Here at Option Alpha we choose about the 70% level. We find that that’s a good risk reward for what we try to do. Next, it’s important we focus on just stocks and ETFs with really great liquidity because slippage can literally rob you of your potential profits. Here’s the deal, here’s SPY. This is not the time that I did the other screenshot here, although it’s very similar pricing, but completely different time. That tells you the market’s been completely sideways since then. That’s pretty interesting. When I took this screenshot of slippage, it’s important to note that SPY is one of the most highly traded ETFs and options that are out there. You can see the volume and open interest category for both the calls and the puts side here is insane. There’s a lot of people who are trading these options. As a result, the options have very very narrow slippage, or very tight bid ask spreads.

You can see even far out of the money, around 2and even at 204.5, the slippage is down to around a penny or two pennies per trade, very very tight slippage. Apple, another great example. Highly liquid stock, highly liquid options. Look how many people are trading. The volume in open interest for each of these contracts in Apple, there’s a lot of liquidity in these markets. What that means is that there’s very minimal slippage.

There’s not a lot of slippage in the difference between what you can buy an option for and what you can sell it for, the bid ask spread. Even with these incredibly tight bid ask spreads, we’ll still lose a little bit of money to slippage trading options in these super liquid options. Here’s how the math works out. If you have an option that has a one penny wide bid ask spread. I want to get you to the full value here. You times that penny by 100, which is the contract multiplier. Remember, each option contract controls 100 shares of stock. So one penny times 100 times one contract, if you just buy one contract, times two sides to every trade, meaning you’re basically going to lose this slippage as soon as you get into a trade and as soon as you get out of a trade. Most people don’t cover that part of it.

They only assume slippage happens once and then it’s done, but you lose it twice, effectively. So you lose that slippage twice. That means that every time you trade just one option in Apple or SPY, we’re losing $2 per trade. Again, every single time that we trade Apple, just one contract, you lose $2. If we traded each stock one time each month for a year, we’d lose $48 just in slippage. That’s little slippage, that’s minimal slippage, the least amount of slippage you could possible have. Let’s not deter you though. The profits we can generate, just trading one spread each time, cover slippage and commissions each year.

But what about other stocks? This is the important part here about choosing liquid underlying stocks and options. Here’s an example of Nike. Nike is kind of middle of the road. I wouldn’t consider this to be insanely high slippage. I think there’s things that are even wider than this, they’re $.50 to $1 wide. Nike is not necessarily a very liquid underline. In this case you can see that the slippage, even for at the money options, is pretty wide.

We’re talking about $.10 – $.12 wide of slippage between the bid price and the ask price. It’s reflective in the fact that there’s not a lot of volume and open interest for these contracts, generally. There’s a couple people trading, and that’s okay, but there’s not a lot of volume and open interest for Nike contracts at the time. Here’s how the math work out on Nike.

You’ve got a $10 bid and ask spread. Times the 100 contracts multiplier. Times one contract if you just get into one contract. Two sides, because you’ve got to open and close it. That means $20 per trade you’re losing just in slippage. We didn’t even talk about commissions. Every single time that you trade just one contract in Nike, we’re losing $20 to slippage. Talk about starting out in the hole. You get into a trade, you’re down $20 immediately. And you wonder why most traders don’t make money in this business. If we traded Nike one time each month for an entire year we would lose $240 in total. That’s 1 stock and 12 trades. You wonder why people don’t make money in this business. It’s because they’re not focused on highly, highly liquid underlines. Thankfully for you guys, we did build a watch list here at Option Alpha that pre screens all of the possible stocks and ETFs out there for liquidity.

We update this list on a rolling basis to make sure that these options and stocks both have a lot of liquidity and fairly tight bid ask spreads. We focus here at Option Alpha on around 80-100 stocks and ETFs depending on how we screen them out. We built this watch list software into our platform. It’s totally proprietary for us that we built. It’s really cool because now you can focus. I just want to focus on, let’s say, EFTs only. Now you can scan and filter between ETFs or earnings trades. You can say I want to see the highest implied volatility stocks first or the lowest implied volatility stocks first. Whatever you want to do. It’s all prebuilt into this platform. We don’t give you the ability to search for any stock here because we’ve already scanned the entire universe and we’ve basically chosen the top 80-100, depending on the month cycle that we’re in. We’ll constantly update and monitor this.

We’ve basically given you the list of 80-100 of the most liquid underlying, ETFs, stocks, everything, so that you have the ability to focus on just those that work for you. It’s a way that we help kind of get you to where you need to go here at Option Alpha. The next part of this is choosing the right strategy. Now that we’ve focused on highly liquid underlyings, which we can do here for you. You don’t have to do on your own. Now we have to focus on the right strategy. Remember, our edge trading options is the ability to consistently sell high implied volatility setups that we have already proven are historically over priced and gives us the widest possible margin for error while still being able to make money. What that basically means is that as volatility expands, all option prices go up, It we want to profit, we need to be selling implied volatility when it’s high because that means we’re selling options when their prices are already high.

As volatility contracts, all option prices go down. That’s all options on both sides in both cases. As volatility drops, all prices go down. That means that if we are going to be an option buyer, we would never want to buy options when implied volatility is high because if implied volatility drops, we would lose value in those contracts that we bought just purely on the drop in implied volatility. Right now I want to prove this point here with a quick example in EWW. You can do this on most broker platforms. On thinkorswim it’s really great because you can basically go in here and simulate what would happen for different movements in either volatility or the stock price itself.

In this case what we’ve done here is we’ve basically built out a simple call credit spread. We’ve sold the 59 calls. We’ve bought the 60 calls. The stock right now is trading at 56.08. We’re selling options above the market. Stock’s trading at 56.08. We sold the 59 calls and bought the 60 calls and we’re taking in a credit of $.18 on the trade. Just to kind of set the foundation here. At this point, we haven’t made any adjustments to the stock or to the options. This is just the current value of that spread. You can see that there’s no adjustment to volatility. There’s no adjustment to the stock. This is kind of like the open and available price of the security right now. What would happen if we just simulated a 10% rise in implied volatility? The stock gets more volatile, but doesn’t more. Look at this. The stock never ever moved from 56.09. Just adding that increase in volatility of 10%, which is a small increase across the board, you see that the value of these options goes up to $26. So a 10% increase in volatility, no movement in the stock at all, and the value of these options go up.

These 10% move up in volatility caused a 44% increase in the price of the spread. If we were selling this spread, that would be a loss in this case because we sold the credit spread and IV went higher. That goes against what we’re trying to do. We’re trying to make money if implied volatility drops by selling options. We try to make money by buying options and hoping that implied volatility rises. You have to be on the right side of volatility. This is assuming the stock doesn’t move, which likely won’t happen. Let’s do this now.

Let’s assume that the stock actually dropped in value to $55.09. It basically went down $1, which is exactly what we wanted it to do. But, implied volatility still rose by 10%. This is the classic case where traders will email me and say, “Hey Kirk, the stock went the direction that I wanted it to. It moved the direction I wanted it to, but I still lost money”. You still lost money because implied volatility is still a bigger factor than the stock price. In this case, that implied volatility move still caused the value of this option to go up even though the stock went the direction that we wanted. Even after a $1 move down in EWW, which is exactly what we wanted, the price of the spread still increased because of volatility expansion by more than 22%. Now let’s do this. Let’s look at a drop in volatility of 10%. Let’s assume that volatility foes the right way, the way that we want it to go, and the stock price goes against us by $1. Remember, the stock was originally at $56.09. Now the stock goes against us.

Remember we sold the credit call spread. We don’t want the stock going towards 59. We want to stock going away from 59. Let’s assume that the stock goes up by $1, but in that time period implied volatility dropped 10%. Notice that the value of this option now decayed just to $.08. It went down and we now have a profit on this trade. With a $1 move higher, against our position, and a 10% drop in implied volatility the spread made a profit and dropped to a value of $8 per spread. Do you see now why most traders lose money even if they get the direction right? I still am blown away every time I go through this example that this is the case and most people don’t get it. You must be on the right side of volatility. The right strategy in the wrong market, meaning the right position in the wrong market where you don’t get the direction right can still win. How do you know if something has high implied volatility? Here at Option Alpha, what we teach is to use IV percentile or IV rank.

You can use it on your charts and basically you can track a graph of implied volatility and you can see where the spikes are in implied volatility. All the red circles here, these are spikes in implied volatility. These are the time periods where you want to be selling options, where you want to be a net seller of options. You want to use strategies like credit spreads, iron condors, strangles, straddles, etc. When implied volatility is really low, you don’t want to be selling options. You don’t want to sell options because remember if implied volatility rises, then even if you get the directional move in the stock right, you’re going to lose money based on that rise in implied volatility. It’s actually fairly easy. This is a concept that most people don’t understand, but it’s fairly easy to see visually where implied volatility is on the charts. If you don’t have thinkorswim or you can’t get this, we do have it here at Option Alpha inside of our watch list.

We have all of these filters here that basically help you scan and filter out high implied volatility and sort by high implied volatility rank. Now you can go in here and you can say I just want to look at ETFs. I want to sort by highest implied volatility. Now you can see here that these are the implied volatility ranks, 0 to 100, for each and every security in this chart. You can see these are the different implied volatility ranks. Right now, EWZ, at the time we’re doing this video, has the highest possible implied volatility of ETFs that we’re looking at right now. UNG, not as high. It’s in the 60’s. GDX is below 50 so we probably wouldn’t do anything in GDX because it’s just too low. If you wanted help in just understanding what strategy to used based on implied volatility, what we’ve also built into the platform, which nobody else has out there, is the ability to actually look at and give you suggestions on the best possible strategies for this current implied volatility rank in every different scenario.

You can see here with a 61 IV rank, you want to be trading credit spreads and butterflies and iron condors. With a 70 IV rank, you want to trade strangles and straddles and iron butterflies. With a 46 IV rank, you want to trade debit spreads and calendars and diagonals. We’ve basically done the heavy lifting for you and given you a pre screened liquid watch list that tells you exactly which stocks and options have the highest implied volatility and then tells you what the best option strategies are so that you’re always on the right side of volatility.

As a special bonus, we have also added the one day, one week, and one month expected ranges. Meaning, we know that the stock will move 68% of the time in these ranges. We already pre-calculate them for you. If you wanted to make a monthly trade in EWZ and you wanted to have a 68% chance of success, you’ve got to be selling options around $19 and above $32. Remember stock right now is trading at 25.67. It already pre-calculates what the likelihood is that the stock will move so that you know exactly how far out you want to sell options to have about a 70% chance of success.

Insanely helpful. Now that we’ve covered one through four, the final piece is just to realize that your chance for success increases with time and frequency. Remember that in order to get long term consistency we have to remember the law of large number which states that as a sample size grows, or the number or trades that you make, the mean will get closer and closer to the expected value of the population. In real English terms, what this means is that if you are targeting a 70% chance of success, you might not hit a 70% chance of success on your first trade or your first two trades or your first ten trades. But if you make a lot of trades, say 1,000 or even 10,000 trades, over the course of your career, not necessarily in one month or one year. The longer you stick with it and the longer you target that 70% level, the more consistent you’ll be. Consistency over time is just a numbers game.

Just to use that head and tails example that we’ve used before in previous videos, if you start flipping a coin heads and tails, your first three results of flipping that coin might be all tails. Like your first three trades might be all profits or your first three trades might be all losers. That doesn’t necessarily mean that you’re going to have that same trajectory or that same path.

If you keep flipping the coin time and time again, you toss the coin four times, 100, 1,000, 10,000 times, the more you toss that coin, the closer you’re doing to get to your expected result. Whatever you target, that’s where you’re going to get. This is why casinos have table limits because they want people to play more so they have more spins, more rolls, more chances at making money. They realize and they recognize that their success is directly tied to the number of times that people play their game. They play their game on a small scale. If a casino has one spin and they’re playing a game where the odds are stacked against them, players are behind 51% of the time after one spin.

It’s probably their best opportunity to make money. But after 100 spins, or after 1,000, or even after 10,000 spins or plays at a casino game, there’s almost a 100% chance that you’re going to be behind to the casino or the casino’s going to win because their edge is going to have played out over hundreds and thousands of different spins. This is why casinos try to get you back to them. That’s why they offer free meals and free drinks and free hotel rooms. They know the more times you come, the more plays that you have at black jack or roulette or whatever the case is, the better and better their chance of success are.

The more that they can get you to play, the higher their probability of winning is. You’re going to hit what you’re aiming for. This is why trade size and high probabilities are so important for smaller accounts. You have to be able to place enough trades so that over time the numbers work out in your favor. They will. Just like the coin flip. One thing that I didn’t mention that we were going to talk about but I want to introduce here is the concept of stacking or laddering trades on a consistent basis. I wanted to do this because as we get towards the end of track one here and as you complete track one, it’s really important to understand this concept because oftentimes what people will say to me is, “Kirk, I don’t know how often.

I don’t know how to space my trade. What should I be looking for”? We’ve covered most of that but I think this concept of stacking or laddering is going to be really helpful to you. It’s just purely meant to get the juices going between your ears. There are many ways to do this, but the concept is very much the same. What most people do when they get out and start trading is they start making these one off monthly trades. They don’t do enough of them. So they make four trades a year or five trades a year.

When you look at it, if this is the market right now, if this is the time period you made a trade back in Apple, you might have sold a call option here at 124 and then you sold a put option here at 110 or any combination of strategies that included selling that call and that put. But you basically draw a really hard line in the sand that’s one trade.

Maybe it’s a big trade position size, maybe you do 10% of your account balance in that one trade. It’s still a high probability trade, but you end up pigeon holing yourself to the market move because you have one spot to get in, one opportunity to make that play. It doesn’t mean that it’s not going to work. It just means that if you make one trade here, one trade here, that’s your second trade all year. Then you make three trades so now you’ve made three trades all year. You have a low likelihood of actually seeing a profitable result at the end of the year because you just didn’t trade enough and your initial position size was probably too large. You can still move and be flexible with the market, depending on where the market is every single month. On the other hand, what we favor here at Option Alpha, are smaller incremental trades throughout the month and throughout the year. Instead of placing one big trade, we’re going to place these little trades.

Here would be a strike price, but this might only be 1% of your account balance. This trade right here might be a different trade or a different call option that is 1% of your account balance. Now we’re spreading the risk and averaging around where the market’s trading. For example, if the market’s trading here, we sell a call option here and we sell a call option here. Then a couple days later when the market’s a little bit higher, we sell another call options and adjust our strike prices so that we’re trying to stay neutral and even and balanced around the market. As the market trades we continue to adjust our strike prices and follow the market wherever it goes over time. Each trade that we’re doing is small, slow, consistent, and high probability. We’re just spacing out the trades over time and I think that’s a better way of going about it. This is called stacking or laddering trades. A lot of these things look like little stairsteps or little ladders that you can put on a chart.

It’s visually how I think about it. This doesn’t mean that we’re moving away from monthly options into weekly options. We’re still placing a monthly contract every single time. Sorry, weekly fans. We’re spreading our entry out over one to two plus weeks in the same security. For example, if we wanted to sell six iron condors in Apple, rather than enter all six today, maybe split up your order to three today and three next week. It’s that type of concept because it increases your occurrences. You’re still doing six, but now you’re spreading the trades out over time. You’re giving the market a little bit of time to move and you’re giving yourself a little bit of opportunity to be flexible with the market.

A simple schedule for you would be something like this. Calendar dates don’t matter. Let’s say for you getting started, you would come in every single Wednesday and come in and try to make a trade. On Wednesday you’d make a trade in something that has high probability, a high implied volatility, make a trade. The next Wednesday you come in, make another trade. The next one, you make another trade, etc. etc. etc. You get on a consistent schedule. As long as you’re starting out, this is a good way to do it. Get on a consistent schedule to make trades because you don’t want to just make trades necessarily when the market is high or low because you don’t know when that is. How do you know when the market is high or low. I feel like the better way to go about it, the mathematical approach that you should be taking, is making a consistent schedule of getting in and making trades.

You could also take the approach, if you want to be a little more consistent, instead of making five trades every month you come in and make ten trades every month. On Tuesday you make a trade then on Wednesday you make another trade then the next Tuesday you make another then the next Wednesday you make another etc. etc. etc. As long as you realize that this idea of stacking or laddering can basically be your key to slowly getting into positions. Keeping a neutral portfolio and keeping that balance and increasing the number of occurrences so that you hit your targeted probability of success, that’s what’s really important here. The key here with stacking or laddering is that it gets you into a consistent pattern of selling options in small chunks versus one big positions each month. More importantly, you are reacting to the market much quicker. If you enter a trade on Tuesday and Thursday of every week, you can average into whatever the market’s doing.

Just to wrap up here, as far as generating consistent income with trading. The game plan should include these five things. If you don’t have one of these five things, there is no way you can be successful long term. You have to believe in each one of these five aspects because it’s insanely important to your ability to generate money. It means you have to trade small positions. They have to be with a high probability of success in liquid stocks and options using the right strategy and you have to do it for a long time. Hopefully this has been really, really helpful and kind of lays the foundation for what we’re going to talk about further in our training in track two and track three here at Option Alpha. Congratulation on completing track one. If you’ve made it this far in this video and you’re watching all the way to the end you’ve really done an amazing job going through all of this training. I can definitely tell you that you’re probably at least ahead on 90% of the other people out there who don’t get even this far.

I can tell you right now, you don’t want to quit. You don’t want to give up. Continue on to track two and three. We’re going to get even deeper and deeper into strategy, order entry, managing trades, and everything that goes along with being successful in trading options. Hopefully you’ve seen now the opportunity that options have to give you a very reliable and stable income base in your portfolio. It is a little bit of a tough trek ar some points, but I can tell you honestly that it’s completely worth the journey if you’re willing to take it. I’d love to get your comments, your feedback. If you love this video or any of the stuff that we’re doing here at Option Alpha, please share this online.

Help spread the word about what we’re trying to do. Until next time, happy trading.

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