Thomsett's  Instablog

You might believe that the market as a whole, or for a specific stock, is bearish. However, you do not want to risk shorting stock because it is both expensive and risky. There is a solution that has very little risk and costs nothing or close to it.

Hard to believe? It's true. Synthetic short stock is an options position that acts exactly like shorted stock. It consists of a short call and a long put, written at the same strike and expiration. The cost of the long put is offset by the income from the short call and in most instances the net cost is at or close to zero. It may even produce a small net credit.

Risk is lower because with the options at zero cost, the major risk is found in the short call. If the stock's market value falls, the short call becomes worthless and the long put's value grows one dollar for each dollar of decline in intrinsic value (stock price below the strike). However, if the stock's price rises, the put becomes worthless and the short call is in danger of exercise. But you have a few things going for you that you do not have when you short stock. First, the short call's time value declines as expiration nears, so the short position often can be closed at a profit. The position can also be rolled forward to a later exercise date, a move that produces more premium income. Finally, the short call can be covered by the purchase of a long call or 100 shares of stock. None of these strategies are possible with short stock.

Another way to set up synthetic short stock is through a collar. In this strategy, you still have the short call and the long put. However, you also own 100 shares of the underlying stock. The collar gives you many additional benefits. If the short call gets exercised, the stock is called away at a profit (assuming the strike is higher than your original stock basis). Second, you earn dividends as long as you own stock by the ex-dividend date. Third, the offsetting option positions are still at or near zero cost. And finally, if your stock declines in value, the long put provides downside protection point for point below the strike.

The synthetic short stock position, whether involving an uncovered short call or a covered call within the collar, is an intriguing alternative to two other positions: Shorting stock, which is expensive and high-risk, or buying puts for insurance, which requires payment of a premium for protection only until expiration.

Like many options-based strategies, synthetic short stock solves problems of both cost and risk. It and its opposite strategy, synthetic long stock, deserve serious consideration as viable strategies to manage your portfolio and to take up positions with little or no added market risk.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.

You may be familiar with the "Greeks" of option trading, the various indicators that describe option premium and risk levels. Among the Greeks, delta may be the most important and the one giving information that could be the most profitable.

Delta measures how option premium is expected to change with changes in the underlying stock's price. A higher delta tells you that option premium is likely to rise more in relation to rises in the stock price, just as a lower delta tells you the option will be less responsive. Delta may be thought of as a measure of extrinsic value, the third kind of value excluding extrinsic and time value. Extrinsic value is also the degree of implied volatility, and this is what delta is really all about.

Delta may be positive or negative, and overall delta is going to range somewhere between +1 and -1. A call has a positive delta, and a put has a negative delta because put premium increases when stock prices fall, and vice versa.

As you would expect, delta levels rise when a call gets closer to the money and then moves in the money (or for a put, the negative value increases). The delta is also likely to decline if the option moves further out of the money.

The proximity of the strike to current value of the stock is a primary influence of the delta. The second factor is time to expiration. When there is less time remaining, the odds that an option will remain in its "money state" (in or out of the money) also grows. So the closer the option is to expiration, the higher the delta for in-the-money and the lower the delta for out-of-the-money positions.

Recognizing the status of an option in terms of proximity between strike and current value, and also observing how that changes with time to expiration, is the starting point in determining whether an option's current premium level is reasonable. However, the real value to delta is found in noting how rapidly (or slowly) delta tends to change. As a rule, the delta tends to increase as it gets further in or out of the money (this acceleration is yet another Greek called gamma).

The rate of change is affected by proximity and time, and delta normally reflects this change. So an in-the-money call with a delta of 1.0 has a high likelihood of expiring in the money; in comparison, a call with a delta at or close to 0.0 has a very low probability of expiring in the money and is far more likely to close out of the money. Expanding this logic, delta of 0.5 indicates a 50% probability of being in the money at expiration.

The basic rule of delta remains:

- for long calls, delta is positive when the stock price rises.

- for short calls, delta is negative when the stock price falls.

- for long puts, delta is negative when the stock price falls.

- for short puts, delta is positive when the stock price rises.
Calculating delta and other Greeks is not difficult, especially given the numerous free online calculators traders can use. One of the best is provided free of change by the Chicago Board Options Exchange (CBOE), where you can estimate all of the Greeks for any kind of long or short option. Go to CBOE Calculator

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.

Technicians focus for the most part of price patterns and changes, but may easily overlook the value of volume as an important signal for coming trend reversal.

Some charting techniques place great importance on volume spikes, but often do not go beyond this highly visible signal. Candlestick analysis combined with volume spikes is both popular and effective in identifying and confirming reversal, but it may be possible to anticipate changes in momentum and trend strength well ahead of a spike session.

Using on-balance volume (OBV) is one way to observe an emerging trend and a change in price momentum. Developed by well-known market predictor Joe Granville, OBV is a cumulative summary that reveals whether volume is led by buying or selling activity. In a bull market, accumulation by buyers leads volume, and in a bear market, sellers are in command. OBV distinguishes between these two.

Up-day volume is added and down-day volume is subtracted to determine the direction of the OBV trend. Chartists seek a divergence between OBV and price to anticipate changes in price momentum, and this makes OBV not only an early predictive indicator, but also a confirming indicator of what chartists might see in other signals.

When the day's closing price is higher than the previous day, then the currently calculated OBV is added to the prior total; when it is lower, the day's OBV is subtracted. Any divergence in the direction of price and the cumulative direction of OBV is viewed as an early reversal signal. Chartists who see this divergence will want to confirm it with other signals that momentum is shifting.

Today's free charting and automatic calculation of even the most complex indicators makes charting much easier than in the past. OBV can be added to daily charts with the click of a button. However, for those who want to know how OBV is calculated, here is the formula:

upward-moving session

P + V = O

downward-moving session

P - V = O

In this formula, 'P' is the previous day's cumulative OBV, 'V' is the current day's volume, and 'O' is the new OBV.
A flaw in the calculation of OBV is that it assigns absolutely positive or negative value to an entire day even if price tilts only slightly in one direction. So a day that is up only 1/4 point, the entire day's volume is added. It is given the same value as a day whose price jumps six points for the same stock. This limitation is not always going to distort the outcome, however. Because OBV is cumulative, a chartist may easily assume that marginally up-moving days are offset by marginally down-moving days.

OBV is a good early indicator that momentum in the current trend is weakening, serving as a red flag. Chartists may seek confirmation through other means, including trading range tests, triangles in the price trend, or reversal candlestick patterns.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.