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Nuts & Bolts (and a Case Study on AKAM)

I am an options trader.

When I first started trading options I was hooked by their complexity. Yet that complexity was almost my undoing. In my first blog post, I mentioned that my number one lesson learned over the past ten years was:

"If you don’t understand the [nuts and bolts] of trade or its structure, you will lose money. Period."

While the foundation of options and options pricing are the greeks (delta, gamma, vega, and theta), it is important to understand that there are three elements that drive those greeks. Options are derivatives, therefore they are dependent on price of an underlying stock, implied volatility, and time.

The price of the underlying stock and its movement drives the delta of an option. Not vice versa. If you own calls, your desired price increase of those calls happens if the price of the underlying goes up (if implied volatility and time are constants). The price increase of your calls is directly related to the delta of those calls. Generally an at-the-money (ATM) call will have a 0.50 delta, which means for every $1.00 price increase of the underlying stock, the option price will increase by $0.50. This is really cool if you only paid $0.40 for the option! Gamma measures the acceleration of the delta and is not necessarily needed by the retail trader.

Implied Volatility (IV) can be a boon, but is often a hidden trap for novice traders. There is a great explanation at Khan Academy for those interested in some of the math…. The most relevant for me is that buy/sell transactions give us the visibility of an options price. Essentially those transactions are evidence of the “markets belief” in the value, a.k.a. supply and demand of a particular option. The IV increases when there are more buyers than sellers; the IV decreases when there are more sellers than buyers. Vega represents the amount that an option contract's price changes in reaction to a 1% change in the implied volatility of the underlying asset and like gamma is less useful to the retail trader.

Benjamin Franklin stated “You may delay, but time will not.” Options decrease in value over time until the time component of their price is zero at expiration. There is nothing we can do about this. It is expressed as theta. If the theta of an option is $0.02, the value of that option will decrease in value by $0.02 per day. The tricky part is that Theta accelerates the closer we get to expiration. If we plan to hold an option for longer than one week, we need to understand that if the price of the underlying and and IV do not change, the option will lose some value. Many longer term traders choose options with expiry's greater than 30 days to minimize the effects of the erosion of value based on theta.

With all of the above in mind, an ideal situation is if we can find a low risk high reward trade opportunity where we can predict, based on history, that both the price and the IV will increase faster than the time decay of the option.

Case Study: Akamai (AKAM)

I like to trade AKAM in and around earnings season. The stock historically demonstrates an increase in value from the Friday, 11 days before earnings to the day of Earnings Release (ER), usually on a Tuesday. Over this period of time, IV also has a tendency to double or more.

Friday 1/29/16 to ER: Price declined -13%, IV on ATM) options increased 166%

Friday 4/15/16 to ER: Price increased 3.4%, IV on ATM options increased 105%

Friday 7/15/16 to ER: Price increased 1.4%, IV on ATM options increased 100%

Friday 10/14/16 to ER: Price increased 9.69%, IV on ATM options increased 100%

Friday 1/28/17 to ER: Price increased 4.63%, IV on ATM options increased 115%

Friday 4/21/17 to ER: Price increased 7.2%, IV on ATM options increased 110%

Friday 7/14/17 to ER: Price increased 5.25%, IV on ATM options increased 99%

The next AKAM Earnings Release is After Market Close (AMC) on 10/24/17. It should be noted that IV crushes by more than 50% the next day.

If your technical analysis agrees that the price of AKAM will go up between Friday, 10/13/17 and the next ER, as it has done in the past 6 ER's, one could put together a standard trade plan (as described in my blog on GLD) that if triggered, will profit from the above scenario. Obviously, a trade plan notes both loss and profit targets.

A vous de jouer…