Lessons from the Pros


Dynamic Premium

In this article we will explore how premium can change. First we will look at how premium can lose value after only one day due to lack of price action. Secondly, at the end of an option’s contract, near expiry, one would expect to see very skinny premium on out-of-the-money options, yet exactly the opposite might be the truth.

Although some of the volatility traders blindly sell premium even without looking at a chart, in the Online Trading Academy’s Professional Option Traders course, we teach that the real edge comes from the technical application of the knowledge of supply and demand combined with implied volatility readings; hence the chart below.

Figure 1

The above daily chart of the Russell 2000 cash settled index shows the price action contained within a range between supply and demand. For several days the RUT was hugging the 800 level and simply going sideways. One of the option strategies for a sideways market is the Iron Condor. In this strategy the trader is simply anticipating that the underlying will stay within a range until expiry. In the case of the particular trade we will discuss, the August regular weekly options were used that had an expiry date of the third Friday in August.  The two horizontal lines on the chart represent the supply zone (red 815 line) and demand zone (green 775).  The exact price of RUT at the time of entry was 801.25.

The strike prices of the trade involved the following: BTO (buy to open) +820 call and STO (sell to open) –815 call. This segment of the Iron Condor is known as a short vertical call spread, or simply a Bear Call. The bottom line is that the premium sold can be kept if the underlying stays below the sold 815 strike price. As can be seen from the figure above, RUT could even go up $13.75 before the 815 supply zone is crossed, not that the seller of premium would want that rally to take place.

On the down side the strike prices traded were BTO the lower leg 770 put and STO the higher leg 775 put. From RUT’s price at entry, $801.25 to the 775 put there is $26.25 of downside protection. The reason why the 815 call and 775 put are not equidistant from $801.25 is simple. The market tends to go down faster than it goes up, so we left more room to the downside.

The trade was entered with a foot-solider for the initial credit of 1.35 or $135 leaving us with maintenance of (5.00-1.35) $365. After getting filled so quickly at 1.35, I knew that I could get a better fill for a higher price. So the next contract was sent for 1.36 and was filled at that price.  As previous articles have pointed out, it is sometimes wise to scale into a position gradually. Some traders tend to put all the trade on at once. There are various reason for such an approach, the commission often being one of the motivating factors. Anyhow, an additional eight contracts were placed on Friday, with again a foot-solider leading the way. What was trading for a credit of 1.35 to 1.36 on Thursday AM, was trading for forty cents less by Friday’s close, while RUT had not fluctuated much at all. On Thursday the RUT was at $801.25 and on Friday it closed at $800.66. The foot-solider on Friday received only 0.95 for the sold Iron Condor and on the other seven, exactly $1.00 was obtained. In hindsight, one could state that it would have been better if the whole thing, meaning 10 contracts, were entered at once. For that reason the article named, Should I Sell on Thursday Morning or Friday’s Close?, was written.  You can read that here: Should I Sell on Thursday Morning or Friday’s Close?

An additional point that ought to be emphasized about the RUT is that its last trading day is Thursday and the actual settlement is at Friday’s open.  Bottom line was that this trade worked out well.  RUT stayed contained in between the two sold strike prices, the two lines on the chart. However, something quite interesting took place on the last trading day of the RUT. Figure 2 shows that the price had rallied all the way up to above 812.

Figure 2 – The high of the day was 813.57

The last trading hour of that Thursday the premium of the 815 call was trading for 1.36. One would wonder why the premium was so rich so close to expiration. The answer is simple – due to the possibility that RUT could close above 815.  So, a Bear Call spread was entered within the last hour of that day by buying the 820 call and selling the 815 call, for a credit of 1.13.  See Figure 3 below.  All that needed to happen to keep this premium was for the RUT stay below 815 at the open on Friday.

Figure 3 – RUT 815-820 Vertical Call Credit Spread Sold for $1.13, Thursday Just Before Expiration

Figure 4 – RUT Settled at $811.65 Friday Morning

The last chart shows the 15 minute candles and how the RUT failed to rally above 815. On Friday’s open, the RUT settled at $811.65 and not only did the 10 sold Iron Condors work out, but also the single contract Bear Call spread did too. Why was a single contract Bear Call spread selected? The reason is that even if wrong, the Bear Call loss from a single spread  would not wipe out the gain of ten ICs. There was the slight possibility of having both trades turn into losers. Yes, but that is the risk each individual trader must decide upon making prior to placing a second trade on. Be accountable for your own mouse clicking.

In conclusion, option premium is a dynamic thing that changes based on the movement of the underlying, as well as volatility, and time among other things. Due to the fact that the RUT did not go anywhere during the first two days when the IC was entered the premium diminished. However, once the RUT moved volatility kicked in and instead of having a poorer premium the premium became richer. Hence extrinsic value is not just Time Value; more than anything else it is the volatility.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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