Seeking Alpha

Chris Vermeulen's  Instablog

Chris Vermeulen
Send Message
Chris Vermeulen the founder of AlgoTrades.net Algorithmic Trading Systems. This automated investing system is designed for individual investors and traders. He is also the editor of the TheGoldAndOilGuy newsletter which is designed for gold market traders providing quality ETF Trade Alerts,... More
My company:
AlgoTrades Algorithmic Trading Systems
My blog:
TheGoldAndOilGuy - Gold Market Traders
My book:
Technical Trading Mastery - 7 Steps To Win With Logic
View Chris Vermeulen's Instablogs on:
  • How to Trade Gold Options Using Theta

    In the previous article, “Learning How to Profit from Theta When Trading SPX Options,” I discussed the basics of the famed option Greek, Theta. A fundamental knowledge of Theta is imperative in order to understand the mechanics and construction of option strategies. In many cases, Theta is either the profit engine or the means by which experienced option traders reduce the cost of opening a new position. Theta can even take an ETF that pays no dividend and create a monthly income stream utilizing a technique known as a covered call write.

    The most exciting thing about options is their versatility. You can trade them in so many different ways. A trader can define a positions’ risk with unbelievable precision. When traded properly utilizing hard stops, options offer traders opportunities that stocks and futures simply cannot provide. Theta allows option traders to write spreads which generally offer nice returns with very limited risk.

    Theta is the fundamental reason behind the slow and relentless deterioration of option values over time. As a series of options gets closer to expiration, Theta becomes a very powerful force. As stated in the previous article, the final two weeks of option expiration put Theta into overdrive. Courtesy of Optionsuniversity, the two charts listed below illustrate the rapid decay of Theta.

    These charts illustrate effectively that option contracts which are out of the money and consist entirely of time premium decline rapidly in value on their way to 0 potentially. While Theta must be respected, it is Theta’s relationship with implied volatility that really makes it a force that must be monitored closely.

    While I will not discuss implied volatility in this article, in future articles it will gain considerable attention. Implied volatility is paramount in every decision that an option trader makes. Ignoring implied volatility and Theta is a recipe for disaster, the kind of disaster where an entire trading account is wiped out in less than 30 days. In most of the trades that I place, Theta is regularly a profit engine. I never purchase options naked, in every option trade that I construct I am utilizing some form of a spread in order to mitigate the ever present wasting away of time premium. In many cases, Theta is the driving force behind my profitability.

    In any other case, Theta decreases the cost for me to purchase options allowing me to minimize my risk to an acceptable level. Vertical spreads come in two variations: debit spreads and credit spreads. A vertical spread is a multi-legged option trade which involves more than one strike price. As an example, we will assume that GLD is trading around $119/share. If I were to have placed a call credit spread trade at the close on Thursday I could have sold the GLD August 120 call strike and purchased the GLD August 121 call strike, thus receiving a credit in my account.

    At current prices as I type, the August 120 call strike would have resulted in a credit to my trading account of $53 dollars while the August 121 call strike would have resulted in a debit in my account of $29 dollars with a one lot position size. If I were to place this trade, I would have a strong feeling that the price of GLD was going to decline. The reason this trade is called a vertical credit spread is because the total trade results in a credit to my account of $24 dollars less commissions. The vertical aspect of the trade is based on the arrangement of the positions on the options board, also called an option chain.

    When an option trader places a credit spread, they are relying on time decay, Theta, to provide them with profits. In many cases, option traders will utilize vertical spreads to play a directional bias. In the example above, the bias on GLD would be to the downside. However, the maximum amount I can lose is limited because I purchased the 121 call. The most I can lose is $100 dollars minus the credit of $24 dollars. Thus, the worst case scenario for this call credit spread would be a loss of $76 dollars for every contract I had put on. If I had put on 5 contracts, my loss would have been limited to $380 dollars plus commissions.

    A call debit spread is constructed exactly the opposite direction. If I believed that gold was going to increase in value I could buy 1 August 120 GLD call for $53 dollars and sell 1 August GLD 121 call for $29 dollars. Notice that the sale of the GLD 121 call reduces the cost of the GLD 120 call. By selling the GLD 121 call, I reduce the cost of this spread down to $26 dollars. However, my maximum gain is limited to $74 dollars minus commissions. The point of this illustration is more to focus on the way Theta helps option traders in practical situations.

    When an option trader utilizes a credit spread, Theta operates as the profit engine. When an option trader does the exact opposite by placing a debit spread, Theta acts to reduce the overall cost of the spread reducing the overall risk exposure. As one can see, understanding Theta is crucial when trading options. While vertical spreads are very basic, they can provide nice returns while having the unique ability to control risk with an extremely tight leash.

    In future articles, we will dissect the various option trading strategies which option traders can utilize in different situations, at different points within the option expiration cycle. While this article will conclude the basic overview of Theta, future articles will discuss intimately the key relationship that Theta and implied volatility share. In closing, I will leave you with the famous muse of Benjamin Franklin, “Time is money.”

    Get our Free Weekly Options Education Articles and Options Trading Signals by joining out free newsletter at www.OptionsTradingSignals.com

    Chris Vermeulen – Gold Analyst/Trader
    J.W Jones – Independent Options Trader



    Disclosure: I currently do not own gld options.
    Tags: GLD, metals, gold, options
    Aug 14 10:14 PM | Link | Comment!
  • How to Profit Using Theta When Trading SPX Options

    J.W. Jones & Chris Vermeulen
    As discussed in the first article, “The Hidden Potential of Learning How to Trade SPX and Gold Options” I pointed out that there are several fundamental principles that must be mastered before profits can be attained when trading options. Novice traders typically skip the discussion about “The Greeks” and skim over volatility only to watch their precious trading capital disappear.

    As promised, this article and future articles are going to discuss the Greeks as they relate to options trading in a way that hopefully everyone reading this can understand. While there are more than ten Greek symbols that directly relate to option pricing, an option trader must be able to clearly articulate and understand 4 of the ancient Greek symbols and one English invention. (Vega is not a true Greek symbol-Look it up!)

    The five core Greek symbols which are critical in order to understand are as follows, in no particular order: Delta, Theta, Vega, Gamma, & Rho. Most veteran option traders have a sound understanding of Delta, Theta, Vega, & Gamma. Rho is not nearly as well known, but anyone who has ever studied econometrics, option pricing models, or has studied applied finance know all too well the importance of Rho. For inquiring minds, Rho measures sensitivity to current interest rates.

    Today’s article is going to focus on the Greek symbol Theta. By now many readers may wonder why I continually capitalize the Greek symbols, and the reason is because they are that critical. The technical definition of Theta derived directly from Wikipedia when applied to options is as follows:

    THETA – Θ, measures the sensitivity of the value of the derivative to the passage of time: the “time decay.”

    Time decay (Theta decay) is of critical importance when an option trader is attempting to quantify and/or mitigate risk. There are two parts factored into the price of an option contract: extrinsic value (a major component of extrinsic value is Theta; the other is implied volatility) and intrinsic value which would be the amount of money a trader would gain if they exercised an option right away. A great many authors who opine about options get caught up using terminology like intrinsic and extrinsic value which only serves to confuse most novice option traders even more. I refuse to use those words in my writing as I find them to be cumbersome and option trading can be made much more difficult than it needs to be.

    Theta and time decay are synonyms when discussing options. An easy way to remember their congruence is that the word time starts with a “T” as does Theta. If a trader owns calls or puts outside of any type of spread, they are totally exposed to time decay (Theta) and as an option contract gets closer to expiration, the time value of the contract diminishes. This accompanied with failure to account for implied volatility (to be discussed in the future) are the fundamental reasons why so many people lose money when trading options.

    Just as theta can be an option trader’s worst enemy, it can also be used as a profit engine. If an option trader sells an option contract to open the position, that option trader is using theta as a method to profit or as a way to reduce the cost of a spread. While this article will not spend a ton of time discussing various option spread techniques, in the future we will discuss them in detail. At this point, we are only attempting to understand that Theta represents the time decay priced into an option.

    It is also critical to understand that Theta (time decay) is not linear in the time course of the life of an option and accelerates rapidly the final two weeks before an option expires. The rapid time decay the final two weeks before expiration presents a multitude of ways to drive profitability, but it also can represent unparalleled risk. While this article is just an introduction to Theta, the next article later this week will continue the time decay discussion.

    Since we are discussing Theta, I thought it would make sense to discuss a trade I took last week which utilized Theta as the profit engine. Recently a variety of underlying indices, stocks, and ETF’s have options that expire weekly. Weekly expiration expedites Theta and gives option traders additional vehicles to produce profits.

    While most equity or futures traders might shy away from a chart like this, an option trader has the unique ability to place a high probability trade. I believed that the market would stall around the SPX 1130 area so I looked for a trade which would utilize the SPX weekly options. The SPX weeklies expire based on the Friday SPX open. With the SPX trading around 1124, I put on a call credit spread which used time decay as the primary profit engine.

    The setup I used involved selling an 1150 SPX call and buying an 1175 SPX call, which is also known as a vertical credit spread. I received $100 (1.00) for the 1150 SPX call and purchased the 1175 call for $20 (0.20). The $80 dollar profit represents the maximum gain per contract sold. As an example, if I placed this trade utilizing five contracts per side I would have a maximum gain of $400 dollars. The probability of success at the time when I placed this trade was around 78% based on a log normal distribution of the price of the underlying.

    Immediately after placing the trade I utilized a contingent stop order that would close my trade entirely if the SPX reached the 1135.17 area. Essentially, my maximum loss not including commissions was limited to around $60 dollars per contract with a maximum gain of around $80 per contract assuming we did not get a big gap open.

    Essentially, if the SPX stayed below 1135.17 for two days and opened on Friday below the 1150 level my trade would reach maximum profitability. This is a trade I actually placed on Tuesday afternoon, however I exited the position before the close on Thursday due to the impending jobs report which was set to come out Friday morning. I was able to collect over 60% of the premium sold per contract ($80) which came to about $45-50 per side. At $1,000 dollars risked based on my stop level, the trade would have produced a net gain of around $750 dollars in less than 3 days.

    Hopefully this basic example illustrates the potential profits options can produce if they are traded appropriately with risk clearly defined while having hard stops in place. This trade produced a nice profit, however it was susceptible to a gap open, thus I maintained a relatively small position to mitigate my overall risk profile. As always, a trader must see potential risks from all angles and utilize proper money management principles when determining how much capital to risk. In closing, I will leave you with the insightful muse of famed trader Jesse Livermore, “A loss never troubles me after I take it.”

    If you would like to continue Learning about the Hidden Potential Pptions Trading Can Provide please join my FREE Newsletter: www.OptionsTradingSignals.com



    Disclosure: We currently do not hold a position in SPX
    Tags: SPY, SPY, SSO, SDS, options, etfs, index
    Aug 10 3:26 PM | Link | Comment!
  • Volume by Price Reveals Key Support & Resistance Levels
    I find it amazing how many traders do not use volume as a factor in their trading decisions. I believe it’s always important to track the volume no matter which time frame you are trading simply because it tell you how much interest there is for that investment at that given time and price level. If you use volume and understand how to read it when located at the bottom of the chart which is the standard way of reading it then your well ahead of many traders and just may find this little volume indicator helpful.

    Price and volume are the two most important aspects of trading in my opinion. While news and geopolitical events cause daily blips and in rare occasions change the overall trend of an investment, more times than not its better to just trade the underlying trend. Most news and events cannot be predicted so focusing on the price action and volume helps tell us if investors are bullish or bearish for any given investment.

    Below are a few charts showing the volume by price indicator in use. Reading this indicator is simple, the longer the blue bars the more volume had traded at that point. High volume levels become key support and resistance levels.

    SPY – SP500 Exchange Traded Fund

    As you can see on the chart below and I have pointed out key support and resistance levels using the volume by price indicator. The thin red resistance levels would be areas which I would be tightening my stops and or pulling some money off the table.

    The SP500 is currently trading at the apex of this wedge. The market internals as of Friday were still giving a bullish bias which should bring the index up to resistance once more on Monday or Tuesday. From there we will have to see if we get another wave of heavy selling or a breakout to the upside.

    GLD – Gold Exchange Traded Fund

    Gold has the opposite volume to price action as the SP500. We are seeing a lot more over head resistance and that’s going to make it tough for gold to make a new high any time soon.

    USO – Crude Oil Trading Fund

    Crude oil broke out of is rising wedge last week and has started to drift back down as traders take profits. Many times after a breakout we will see prices dip down and test that breakout level before continuing in the trend of the breakout. I should point out that there is a large gap to be filled from last Monday’s pop in price and we all know most gaps tend to get filled.

    UUP – US Dollar Exchange Traded Fund

    The dollar has been sliding the past 2 months and it’s now trading at the bottom of a major support level. If the dollar starts to bounce it will put some downward pressure on stocks and commodities.

    Weekend ETF Trend Conclusion:

    In short, I feel the market has a little more life left in it. I’m expecting 1-2 more days of bullish/sideways price action, after that we could see the market roll over hard. It’s very likely the US dollar starts a significant rally which will pull stocks and commodities down.

    With the major indices and gold trading at key resistance levels, traders/investors ready to hit the sell button, and the dollar at a key support level I think its only a matter of time before we see a sharp snapback. That being said there is one scenario which is bullish and could still play out. That would be if the US dollar starts to flag and drift sideways for a week or so, and for stocks and commodities to also move sideways before taking another run higher. Watching the intraday price and volume action will help us figure out if buyers are sellers are in control this week. Anyways that’s it for now.

    If you would like to receive my ETF Trading Alerts visit my website at: http://www.thegoldandoilguy.com/specialoffer/signup.html

    Chris Vermeulen



    Disclosure: I am currently in cash
    Tags: UUP, GLD, SPY, USO
    Aug 08 9:28 PM | Link | Comment!
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.