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Fade Trade

April 9, 2015 By Jeff White

Contrarians like to fade trade, whereby they look for prices to reverse. Sharper moves in price, whether up or down, tend to be unsustainable, which makes them prime candidates for fade trades. In these cases, the trader wants prices to change direction since the current rally or decline is expected to end or see some short-term interruption.

Option sellers use these price spikes to sell puts into weakness in the underlying asset, and sell calls into strength in the underlying asset, due to the inflated prices of the respective options.

Option buyers prefer to buy calls into weakness in the underlying asset and buy puts on strength in the underlying asset, due to the reduced prices of the respective options.

Return to the main trading glossary page to learn more terms.

Filed Under: Stocks & Options, Uncategorized

Strangle – Option Strategies

April 9, 2015 By Jeff White

A strangle is the simultaneous purchase or sale of a call above the market and a put below the market.

Long Strangle

A long strangle involves the purchase of both an OTM put and an OTM call.  This strategy is generally utilized when the underlying stock or index is expected to make a very large move, but a direction is unknown.  By purchasing both options, the time value of both options begins to erode, so this is an approach often used when an event is expected to spark a sudden move (earnings release, economic data news, conference call, etc.).   A long strangle creates a negative Theta position.

A large move would cause the call or put to go ITM, and a move with great velocity could inflate the volatility component of price as well.  Because only one of the options (either the call or the put) can potentially expire ITM, a strangle buyer needs one option to gain more value than the other side loses in order to turn a profit.

Short Strangle

A short strangle is the sale of both an OTM put and an OTM call.  This strategy is generally utilized when the underlying stock or index is expected to stay within a price range, therefore allowing for the collection of premium on both the call and put sides.  This approach embraces the idea that the time value of both options will begin to erode, therefore creating a positive Theta position.

It’s common to sell strangles around scheduled events (such as earnings announcements) when a big move is expected and implied volatility is high and a contraction in IV is likely.  This causes rich premiums which quickly erode if price stays within the expected range.

Return to the main trading glossary page to learn more terms.

Filed Under: Stocks & Options, Uncategorized

Short Put – Naked Put – Option Strategies

April 9, 2015 By Jeff White

Selling a put short is an uncovered or naked position aiming to collect premium from the sale of the option in expectation of neutral to bullish price action.

If a short position in the underlying stock is already held, then selling a put against that short stock is known as a covered put.

Naked puts involve downside risk in the stock.  For example, if a put is sold in XYZ for $0.60 at the $20 strike, and XYZ is trading at $19 by expiration, the put has moved ITM.  The trader has the choice to either buy back the short option (for a loss since the option would be trading around $1), or get assigned a long stock position in XYZ at $20 (the strike price).  The premium collected from selling the put is kept, which effectively reduces the basis for the long stock position if assigned.  In this case, the trader would be long the stock with a basis of $19.40 ($20 strike price less $0.60 premium collected from put sale).

Short puts have a positive delta, so they are a bullish position unless paired with short stock.

Return to the main trading glossary page to learn more terms.

Filed Under: Investor Education, Uncategorized

Short Call – Naked Call – Option Strategies

April 9, 2015 By Jeff White

Selling a call short is an uncovered or naked position aiming to collect premium from the sale of the option in expectation of neutral to bearish price action.

If the underlying stock is already owned, then selling a call against that long stock is known as a covered call.

Naked calls involve upside risk in the stock.  For example, if a call is sold in XYZ for $0.40 at the $25 strike, and XYZ is trading at $26 by expiration, the call has moved ITM.  The trader has the choice to either buy back the short option (for a loss since the option would be trading around $1), or get assigned a short stock position in XYZ at $25.  The premium collected from selling the call is kept, which effectively improves the basis for the short stock position if assigned.  In this case, the trader would be short the stock with a basis of $25.40 ($25 strike price plus $0.40 premium collected from call sale).

Short calls have a negative delta, so they are a bearish position unless paired with long stock.

Return to the main trading glossary page to learn more terms.

Filed Under: Investor Education, Uncategorized

Theta – Option Greeks

April 9, 2015 By Jeff White

Theta is a measure of time decay for an option.  An option’s theta represents the decline in theoretical value per day with all other factors remaining constant.

Long calls and long puts have a negative theta, as their time value erodes with each passing day.  To the option buyer, this time decay works against their position as the extrinsic time value erodes.

Short calls and short puts have a positive theta.  This benefits the option seller, as the erosion of their time value makes the position become more profitable (being that the trader wants those options to become worthless).  Option sellers, or premium sellers, benefit from a positive theta.  This is because the price of the underlying asset does not need to change in order for a short option position to profit, due to the passage of time and the subsequent erosion of that time value.

It’s important to understand that an option’s theta, or time decay, is not linear.  That is to say that the theta value of an option will change over time in an accelerating fashion as expiration approaches.

For example, with 30 days remaining until expiration, the theta for a short option might be $2.60.  If all other factors remain constant (price, implied volatility, etc.), then with just 7 days remaining until expiration the theta value will have grown exponentially.  That option will not decay exactly $2.60 per day.

Return to the main trading glossary page to learn more terms.

Filed Under: Uncategorized

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