Finding Option Opportunities - Part 1

07/31/2013 8:00 am EST


Before we can make money in the options market, we have to locate an opportunity, writes Russ Allen of Online Trading Academy, and here he outlines the process step by step.

There are many ways of identifying opportunities. In this two-part article, we’ll discuss just one of those: look for stocks/ETFs whose options are extremely expensive, and sell those options.

This sounds pretty straightforward, and it is. But several steps are involved, as listed below. We’ll use an example to walk through the steps.

  1. Locate stocks with currently unusually high implied volatility (relative to their own IV history). High IV means expensive options.

  2. Check the stock’s price chart and decide whether it is a bullish, bearish, or neutral picture.

  3. Select an option strategy to match the price outlook—iron condor if neutral, otherwise short options or credit vertical spreads.

  4. Select strike price(s) that the stock is unlikely to reach by the front-month expiration date, and plan the trade.

  5. Calculate the underlying prices for maximum profit, maximum loss, and breakeven. Use option diagramming software to facilitate this.

  6. Identify the stop/unwind price(s), where the trade will be abandoned for a loss if necessary.

  7. Evaluate the likelihood of stock being in the profit zone at the target date.

  8. If all looks good, place the trade.

  9. Once the trade is in place, enter the order(s) to unwind it when/if the underlying hits the stop/unwind price(s).

Now let’s look at an example from July 17:

1. Locate stocks with high implied volatility (relative to their own IV history)
For this step, I used the scanner tool in the TradeStation software platform. That is the trading software that we use in our trading classes, and is also the software that I use for my own trading. One of the scan criteria TradeStation offers is called “IV Percentile (12 month).” Using this criterion and asking for the top 10% of stocks by IV percentile, and further filtering the list to eliminate stocks with a daily average volume of less than one million shares or a price of less than $15, produced a list of about 50 stocks. Each of these was near its highest implied volatility level of the last 12 months. Outside of the TradeStation platform, most other option-trading platforms, such as thinkorswim and OptionsExpress, also offer some kind of screening by implied volatility. Other sources for such scans are also available online, although none is free as far as I know. On this day, one of the stocks my scan turned up was American Tower Corp. (AMT).

2. Check the stock’s price chart and decide whether it is a bullish, bearish, or neutral picture.
Below is AMT’s chart. The stock was near the middle of a channel between roughly $70 and $80, in which it had been trading since May 31. The channel boundaries appeared to be good demand and supply levels. This was a neutral price picture—one where we could bet that the stock would stay within a range, for a limited time.

Figure 1 – AMT Price chart as of 07/17/2103

Click to Enlarge

NEXT PAGE: Match Strategy with Price Outlook


3. Select an option strategy to match the price outlook
In times of high implied volatility, the options are very expensive, so we want an option-selling strategy. We want to sell these expensive options and watch them expire worthless, pocketing the credit we receive for selling them. In this type of strategy, a fairly near-term expiration is lower risk; in this case the August expiration that was 30 days out was chosen.

For a neutral, range-based outlook, the iron condor is a good choice. If the price had been near a demand zone or a supply zone instead of midway between them, we would have chosen a strategy that works well when we do have a price bias. We could use short puts or credit vertical put spreads if we’re bullish; or short calls or credit vertical call spreads if bearish.

4. Select strike price(s) that the stock is unlikely to reach by the selected expiration date, and plan the trade.
In the iron condor strategy, we sell a put at a strike price that we do not expect the stock to reach by the expiration date (say $70 here); and we sell a call at a higher strike price, that we also do not expect the stock to reach. In this case, that was $80. We could have received $1.48 for the August 70 put and $ .58 for the August 80 call, for a total credit of $2.06.

So far, this position would be called a short strangle. That is a viable strategy on its own; but with both a short put and a short call, it has unlimited risk in both directions. To limit the risk, we could add a wider long strangle (buy a putat a lower strike price than $70 and also buy a call at a higher price than $80). We could have bought the August 65 put for $.63, and also the August 85 call for $.15.

5. Calculate underlying prices for maximum profit, maximum loss, and break-even. Use option diagramming software to facilitate this.
Subtracting the costs of the long 65 put ($.63) and the long 85 call ($.15) from our $2.06 credit, we would have a remaining credit (cash in our pocket) of ($2.06 – $.63 – $.13) = $1.28 per share, or $128 per contract.

Our objective would be for the stock to remain between $70 and $80 until the August 17 expiration date, so that the $70 short put and the $80 short call both expire worthless. Our long protective options would also expire worthless, being even farther out of the money. In that case, we would just retain the $128 credit. This would be our maximum profit.

Now that we have the underlying price points for maximum profit ($70 to $80), our break-even prices at expiration are easy to calculate. If we had to give back our $1.28 per share credit in order to get out of the trade, then we would break even. This would occur if at the August expiration AMT were at $80 + $1.28 = $81.28 (we would have to pay $1.28 to buy back the $80 short call); or at $65 – $1.28 = $63.72 (where we would have to pay $1.28 to buy back the $70 short put). With AMT at any price within the 13-1/2 point range between $63.72 to $81.28, we would make some money. We would just have to wait for expiration to earn it all.

NEXT PAGE: Calculating Profit & Loss


Out worst-case loss would occur if AMT dropped below $65 or rose above $85 by expiration day, and we were still in the trade. With AMT at $65 or less, the $80 and $85 calls would both be worthless; both the 65 and 70 puts would be in the money. The $70 put would be worth exactly $5 more than the $65 put. We would have to pay $5.00 per share to unwind the put side. Subtracting the $1.28 credit received earlier, we would have a net lossof $3.72 per share, or $372 total.

A similar result would occur if AMT were above $85. In that case, bothputs would be worthless; both calls would be in the money; and the $80 short call would cost us exactly $5 more to buy back than the amount we could get for selling the $85 long call. Unwinding the call side of the trade would therefore cost $5.00 per share, resulting in the same $372 net loss as an AMT price below $65.

Below is a price chart of AMT with the profit and loss areas highlighted.

Figure 2 – AMT price chart with profit and loss areas highlighted

Click to Enlarge

In the diagram above, the shading indicates profit or loss if AMT were to be in that area at expiration. The right side of the chart ends on the August expiration date.

The green highlighted area between $70 and $80 is the area of maximum profit.

The red highlighted areas above $85 and below $65 show the areas of maximum loss.

The light-green shaded areas from $80 up to $81.28, and from $70 down to $68.72, show areas where we would make some profit, but not the maximum profit.

The light-red shaded areas, which are between the breakeven prices and the max loss prices ($65.00-68.72 and $81.28-85.00), show areas where we would have some loss, but not the maximum loss.

Below is another diagram for this trade. This one is an option payoff diagram, also sometimes called a risk graph.

Figure 3 – AMT Condor Option Payoff Diagram

Click to Enlarge

In the payoff graph above, the green line plots the profit or loss the trade would yield at expiration day at any given price of AMT. Notice that the winged trapezoidal shape of the green plot above is the same as the shape enclosed by the thick green lines on the price chart in Figure 2, but turned sideways. It’s worth spending a few minutes looking at the two graphs and understanding how they relate to each other. Just imagine rotating the green line of the payoff graph in figure 3 counter-clockwise by 90 degrees, and overlaying it on right side of the price chart in Figure 2, and you’ll see what the colored highlights on Figure 2 mean.

Next week, we’ll conclude our discussion on this trade, and see whether it was one we could confidently take.

By Russ Allen, Instructor, Online Trading Academy

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