Reading Price Action - The Analytical Approach

In the chart above, one can figure out that price will collapse after candle B, for the following reasons:

1. Prior to candle B, price showed weak attempts to rally above the upper channel line (red). Previous bull candles all have relatively long upper wicks.
2. Imagine how candle B looks like when price is at the high of the candle… At that moment, price probably looked very bullish… Unsuspecting bulls may jump onto the trade, believing that price is due to rally.
3. In fact, candle B is a nice bull trap… Its high is slightly above the high of candle A, and will thus trap bulls who buy on breakout.
4. Candle C is another confirmation that price is weak. A nice price to sell will be one pip below the low of candle C.

The Zigzag Pattern

The chart above shows a common pattern that leads to a trend continuation. I don’t know what is the actual name for this pattern, so I’ll just call it the zigzag pattern. This pattern starts with a strong uptrend, followed by a reversal that is significantly less steep. When the green downtrend line is breached, the previous uptrend resumes.

The pattern is stronger when it is combined with other price action. If we zoom into the chart above, we can see that a cup-with-handle pattern formed before the downtrend line is breached (refer to chart below). The shallow handle is further proof that bears were not strong enough to push the price down.

Cup with Handle

1. Reading Price Charts Bar by Bar (by AL Brooks), and
2. Trade What You See (by Larry Pesavento and Leslie Jouflas)

Received them yesterday morning… The postman came when I was still sleeping… Luckily he knocked loud and long enough to wake me up… Managed to catch him before he went off…

Anyway, I’ve started reading the first book… It is really a difficult book to read… there’s loads of information in it… The author is obviously an experienced trader who’s passionate about sharing his knowledge… However, because there’s so much information presented on each page, it makes it hard to digest and retain the information… it would be better if the author added more headings, sub-headings, bullet points and charts…

Initially, I gave myself two days to complete the first chapter… Now I’ve decided to give myself a month to complete and MASTER the chapter… It’s easy to finish reading the chapter, but to fully absorb what’s taught will require much more effort… I’ve decided to read and re-read multiple times and make my own notes to fully master the book… This is a good book… and the author definitely deserves such effort from his readers….

Let’s start with an example… Suppose you are a big iPhone fan and are extremely bullish about Apple (AAPL). You looked at the chart and identified strong support at $148.28. You believe that there is no way AAPL is going to fall below $148.28. In that case, you can choose to sell the nearest OTM Put, which is the $145 Put. In order to protect yourself from any unexpected plunge in the stock, you buy an even lower OTM Put, which is the $140 Put.

Example of a AAPL Bull Put Spread

Let’s just suppose you sold the $145 Put for $2.70 and bought the $140 Put for $1.20. What you’ve done is you’ve just sold a Bull Put Spread. Since the $145 Put that you sold is more expensive than the $140 Put, this spread is actually a credit spread; you earn premium upfront (($2.70 – $1.20)*100 = $150 per lot in this case).

If you are right and AAPL never trades below $145 for the entire period till expiry day, both the $145 and $140 Put options will expire worthless and you are a few hundred bucks richer.

However, if you are wrong (say Steve Jobs is suddenly ousted from AAPL again) and the stock price plunges to $100 on expiry date, your lose is limited. This is because although you will be forced to buy AAPL stock at $145 now, you can turn around and sell that same stock at $140, since you bought a $140 Put to protect yourself. Thus, your loss is only limited to $500 for every Put you sold.

But wait! Remember you earned a premium of $150 on that fateful day when you decided to sell the spread? This means your loss is actually $500 – $150 = $350 per lot (excluding commissions). That’s not half as bad as if you had not bought the $140 Put. In which case you would have lost ($145 – $100)*100 per lot… Even after deducting the premium that you earned, you would still have lost $4500 – $270 = $4230 per lot…

That’s the merit of doing a credit spread, as opposed to selling a naked option (i.e. selling an option without buying another to protect yourself)… Better safe than sorry.

For those Physics experts out there, we can say that
“Delta is to Velocity, as Gamma is to Acceleration”…

For Math experts, Delta is actually is the First Derivative of the Option Price (w.r.t. to Stock Price), while Gamma is the Second Derivative.

For everyone else… let me try to explain gamma with a hypothetical example

Suppose AAPL is currently trading at $190. Let’s look at how the price of a $205 CALL option will likely change when AAPL’s stock price changes

Understanding Gamma

From the table above, you’ll notice that the delta of an option changes at a different rate depending on how far the current stock price is from the option’s strike price. The further it is, the less the delta will change.

For instance, when the current stock price changes from $190 to $195 (a $5 change), the delta increased by 0.3. In contrast, when it changes from $200 to $205 (a $5 change as well), the delta increased by 0.15. This is because the delta of an option changes at the greatest rate when the option is at-the-money (highlighted in yellow).

Since the delta of an option changes at a different rate, the gamma is a measure specifically designed to measure this rate of change of delta.

As a tool, gamma can tell you how “stable” your delta is. A big gamma means that your delta can start changing dramatically for even a small move in the stock price. Personally, I don’t really worry too much about gamma when I trade… This may not be the best way to trade… but it has worked well for me and I really love to keep things simple… So… gamma? What gamma….????

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The last option greek to discuss is Rho…

Rho is an estimate of how much the theoretical value of an option changes when interest rates move 1.00%. For example, suppose a call option of stock ABC has a value of 2.1 with a Rho value of .19. If interest rates increase from 5% to 6%, then the price of the call option, theoretically at least will increase from 2.10 to 2.29.

Among all the Greeks, Rho is the least used… and it has the least effect on options price… so, naturally, I never looked at Rho when I trade…

Volatility is a measure of risk / uncertainty in the underlying stock price of an option. It reflects how likely the underlying stock price will fluctuate up or down. Some stocks tend to move wildly from one trading day to another, and thus have high volatility (and risk). Other stocks barely move for an entire week and have low volatility.

In options, there are 2 types of volatility:

1) Historical Volatility (HV), or sometimes called Statistical Volatility, is a measure of the fluctuations of the stock price over the past 30 trading days. If there is a sharp move in the stock price (up or down) during that period, the historical volatility will increase drastically. HV is obtained by calculating the standard deviation of historical daily prices over the period.

2) Implied Volatility (IV) is an estimate of the volatility of the stock price for the next 30 trading days.

This estimate is obtained by comparing the actual market price of an option with the theorectical price of the option calculated based on an options pricing model (e.g. The Black–Scholes Model). It is the volatility that, when used in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option.

For instance, let’s consider a HYPOTHETICAL options pricing model.. Suppose

Theoretical Options Price = 0.09823*IV + 10.2

If the current market price of the option is $12, then to calculate what IV value will cause the theoretical price of the option to be equals to the actual market price, we have

12 = 0.09823*IV + 10.2

Thus IV = (12 – 10.2)/0.09823 = 18.32

In other words, IV is the volatility “implied” by the current market price of the options.

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Now, let’s get back to our options greek: VEGA…

Vega measures the sensitivity of an option’s price to changes in Implied Volatility (IV). It estimates how much an option price would change when implied volatility changes by 1%.

For instance, let’s assume the current price of AAPL Oct 190 Call is $3, with Vega 0.20 and the volatility of AAPL stock is 35%. If the volatility of AAPL increases to 36%, the AAPL Oct 190 Call’s price will rise to $3.20. If the volatility drops to 34%, the Call’s value will drop to $2.80.

An increase in IV will increase an options’s price for both Calls and Puts options. This makes sense, since the higher the volatility, the greater the probability that an option will move into your favor by expiration.

As an options seller, I love to sell when volatility is high, since I can sell the options at a higher price. However, honestly, although some traders trade purely based on options volatility, I’m not too concerned about it. What I normally do is simply check that the IV of the options I’m buying is lower (or at least not much higher) than that of the options I’m selling. Other than that, I do not really worry too much about volatility… As long as I can sell the iron condor (or other combinations) at my target price, I’m fine… If you are interested in finding out more about options volatility, you can check out this book  by Sheldon Natenber: Option Volatility & Pricing: Advanced Trading Strategies and Techniques

Just for Laughs: The Unfortunate Consequence of a Sudden Rise in Volatility of Belt Prices

According to the definition in my previous post, What are Options Greeks? – Part 1: Delta, Theta is the change in option price due to time passing. I’m not sure if this definition makes sense to you, so I’ll provide an example below:

Suppose I bought a $190 AAPL Oct Call Option last Fri, on 25th Sep 2009… That would have cost me about $2.70…

A $190 AAPL Call Option grants me the right to purchase the AAPL stock at $190.. however, as of last Fri, AAPL was trading at around $182, which means that the CALL option is fundamentally worthless… if that’s the case, why do I need to pay $2.70 for the option?

This $2.70 is what is known as the time value of the option… In other words, it is what the option is worth because of the time left before it expires… As long as the option has not expired, there is a chance that AAPL will rally above $190, say to $200… In which case, I can exercise my option and buy AAPL for $190, and sell it immediately on the market for a profit of $10 per share…. Thus, I often refer to “Time Value” as the “Price of Hope”… As long as the option has not expired, there is still hope that the option will become profitable…

If time value is the price of hope, then theta is measure of hopelessness…. It measures how the option price will decrease for every passing day…. For instance, the theta of the AAPL $190 Call Option is currently -0.13, which means that if all things remain unchanged (e.g. if AAPL stock price does not move at all), the option price will decrease by $0.13 everyday… As an option buyer, your theta will always be negative… In contrast, as an option seller, you’ll enjoy positive theta because with every passing day, the option will lose money, allowing you to buy back the option at a cheaper price if you so decide…

Source: http://www.funnytimes.com/playground/img/121330972131185.png

In fact, time decay is the greatest enemy of all options buyer… because even if you are right in predicting the stock’s direction, if the stock does not move enough to counter time decay, you will still lose money.. For instance, if AAPL only moves to $191 when my Oct option expires, I will still lose money because I paid $2.70 for hope…

In contrast, option sellers absolutely love time decay…. Even if the stock does not move at all, time decay will continue to make money for them with every passing day…

Simply stated, greeks are just measurements that help us estimate how the price of an option will change in response to changes in the underlying stock price, interest rate, volatility and time passing.

The table below shows the five options greeks… and what they measure:

Options Greeks

The best way to explain is through an example… In this post, I’ll concentrate on the delta, leaving the other greeks for my future posts….

The chart shows the deltas for AAPL Nov 09 Options… The current price of AAPL is $184…

Delta

The left side of the chart shows the Call Options… Look at the row that is highlighted… It shows that the Nov 09 AAPL CALL option, with a strike price of $190, has a delta of 0.45. What this means is that when AAPL’s stock price increases by $1 (with all things being equal), the $190 Call option will rise by $0.45. Since the current bid price of the option is $8.50, we’ll expect the price to rise to $8.95 when the AAPL stock increases by $1.

In contrast, look at the Put Options on the right of the chart… We can see that all the deltas are negative… Look at the row that is highlighted… It shows that the Nov 09 AAPL PUT option, with a strike price of $150, has a delta of -0.10. What this means is that when AAPL’s stock price increases by $1, the Put $150 option will increase by -$0.10 (in other words, fall by $0.10). Since the current bid price of the option is $1.61, we’ll expect the price to fall to $1.51 when the AAPL stock increases by $1.

There are a few things to highlight about an option’s delta

1. CALL options will always have positive deltas while PUT options will have negative deltas (i.e. their value decreases when the underlying stock price increases)
2. An option’s delta does not stay the same throughout its lifetime.. The $190 CALL option, that currently has a delta of $0.45, will have a different delta as the stock price changes. For instance, if AAPL suddenly plunges to $100, we’ll expect the delta of the $190 CALL option to drastically decrease…
3. The absolute value of a delta can also be viewed as the probability of the option expiring in-the-money…You’ll notice that for CALL options, the $130 option has a delta of 0.97.. This means that the option price will increase by $0.97 for every $1 increase in the stock price… It also means that there is a 97% chance that the option will expire in-the-money.. In other words, it is almost a certainty that the option will expire in-the-money… (That makes sense, since the option is already so deeply in-the-money at present…)In contrast, the $260 Call option has a delta of 0.02, indicating a 2% chance of expiring in-the-money. That is because $260 is very far from the current stock price (which is about $184).. so it is almost impossible for the $260 option to finish in-the-money…

Here’s Part 2 of the animation explaining options trading…. this time for PUT Options… Quite well explained… but I need to correct the definition of PUT option mentioned at 2:02…

It was stated that
Put Option = Buying the right to sell an underlying option…

That’s confusing… what is an underlying option??? You do not buy an option for the right to sell another option….. The correct definition for Put Option should be “Buying the right to sell an underlying SECURITY or ASSET“…

so, if you bought a AAPL Stock PUT option, you bought the right to sell the underlying security(in this case, the AAPL stock) at the pre-determined strike price…

I think this was just an oversight on the author’s part, cause his definition for CALL option was correct… Anyway, other than this mistake, the rest of the animation is pretty cool… enjoy

Found this video on youtube… it gives a very entertaining introduction to CALL options… in the form of an animation… very nice drawing… and it explains CALL options in very clear layman terms… You can fast forward to 1:25 to go direct to the animation if you want…

However, because this animation is meant to be a preparation for a seminar… it does leave out some details…

Firstly, it left the “Option Clearing House” out of the picture… In the animation, it shows the options transaction between Ali and Abu.. In reality, an option transaction is not done directly between a buyer and seller… Instead, the Options Clearing Corporation (OCC) acts as a middle man, the buyer actually pays the clearing house, which then pays the seller… In addition, the OCC acts as guarantor, they ensure that the obligations of the contracts they clear are fulfilled….

To keep things simple, the animation also does not state the terms commonly used in options trading… In the animation, Ali pays $1 to Abu for the right to purchase Microsoft at $20 one month later….

$1 is known as the Options Premium, $20 the strike price.. Suppose the current month is September, then if the option expires one month later, Oct is known as the expiry month… All options will expire on the third Fri of the expiry month (except when it falls on a holiday, in which case it is on Thursday)