Here Comes 2017

Here Comes 2017

The Trump rally continues….but for how much longer? A rallying stock market, rising bond yields and the return of inflationary pressures are creating new challenges for the Federal Reserve.

Investors are going to be looking past an expected increase in the benchmark rate and focusing on any signals about a more aggressive policy in the months and years ahead.

No surprise the FOMC came out and raised the Fed Funds rate by 25 basis points. Rates continue to move up too much and too fast. The market is hyperbolic in its bullishness, which has no basis in anything tangible other than optimism that Trump’s presidency will bring GDP growth and reignite corporate profit growth. It’s natural to want to be optimistic, but this rally is too powerful. At some point, early in Trump’s term, speculators will recognize the obvious: Trump isn’t a miracle worker.

Perhaps there is too much Christmas cheer and we need to take a look of Christmas past. Last January we saw the same scenario play out. Rate hike in December and the Markets went for a tumble.

Continue reading “Here Comes 2017”

Trading Options, The Common Mistakes

Common Mistakes When Trading Options

Hi, my name is Michael McNelis and I am an Options Strategist with Key2Options. I want to share some of the common mistakes I see options traders make so that you can accelerate your learning curve and become a profitable trader.

As with most endeavors, we learn things by making mistakes. Options trading is no different. Let’s take a look at some of the most common mistakes I see in options trading and how you can avoid them.

  1. Not having a plan
  2. Buying options with too short of a duration.
  3. No understanding of implied volatility
  4. Failing to Diversify Strategies

Not having a plan – One of the Mantras at Key2Options is plan the trade and trade the plan. Prior to entering a trade, we review 10 years of historical trades to find optimal trading parameters for the strategy you have chosen. Prior to entering into a trade, we know how we will manage the trade if the market moves higher, moves lower or stays the same level. With Key2Options, we help you make rational trades not emotional trades.

Continue reading “Trading Options, The Common Mistakes”

Commission Free Trading

Commission Free Trading with Key2Options and Tradier Brokerage

Huge leaps in computing power are transforming modern finance in ways that few have ever imagined.  Key2Options is an institutional grade software program designed to allow both retail and professional traders the ability to backtest trading strategies using historical stock and options data without having any knowledge of computer programming.

Large hedge funds and financial institutions have been quant trading for years. They had the money and the computing power to crunch the numbers and discover pattern recognition. Algorithmic trading can be expensive depending on the frequency of the system. Profitable quantitative models can be turn to losses when commission cost are applied. If, for example, you only have $1,000 to invest in a trade and you’re using a discount broker that charges $20 per trade, 2% of the value of your trade is eaten away by the commission fee when you first enter your position. When you eventually decide to close out of your trade, you will likely pay another $20 commission fee, which means that the round-trip cost of the trade is $40, or 4% of your initial cash amount. That means that you will need to earn at least a 4% return on your trade before you break even and can begin to make a profit.

We wanted to create a tool for traders who didn’t have access to computer programmers to be able to have their trading signals vetted. We have a simple trader friendly platform that lets trader’s backtest and create trading strategies without programming and remove emotion from trade execution.   Key2Options answers the question, “What if I had applied investment strategy X during period Y.”   Humans do not have the ability to compute large sets of data. We supply you the data and the platform necessary to make rational, vetted trades. This puts retail traders on par analyzing data like institutional traders.

As a member with Key2Options, we give you commission free trading!  With Key2Options, you can create, backtest, optimize and design your trade plans based on individual risk-reward expectations and trade commission free right from our options platform.

Once desired trade plans are locked in for live market scans, Key2Options platform will identify the right stocks, options with strikes and expirations that match the trade plans and send alerts. These trades can be directly sent to Tradier for commission free trading.

With Key2Options you have the ability to analyze the past and trade the future commission free. The power of Key2Option combined with the speed of Tradier, a winning combination.

Volatility and Directional Trading Strategies

What type of Options Trader are you?

In options trading there are two types of traders: Directional traders and Volatility traders.

What does it mean? In short, if you are a directional options trader, you are basing your buys/sell decisions on the price direction of the underlying stock or index. A person who buys and sell stocks are also considered directional traders. Directional trading is the most common trading in the markets. You have two basic possibilities. You can speculate on an increase in an asset’s price – in this case you say you are bullish. Or you can speculate on a fall in an asset’s price and you say you are bearish. If you are a volatility trader, you are selling options to directional traders. Volatility traders want to sell options when they are overvalued. We will discuss how we know whether an option is overpriced later!

Stock pricing is cut and dry. The price of XYZ is $50 a share. Option pricing is a little more complicated. The primary drivers of the price of an option: current stock price, intrinsic value, extrinsic value (time to expiration or time value, and volatility). The current stock price is fairly obvious. The movement of the price of the stock up or down has a direct – although not equal – effect on the price of the option. As the price of a stock rises, the more likely the price of a call option will rise and the price of a put option will fall. If the stock price goes down, then the reverse will most likely happen to the price of the calls and puts.

As we noted, options prices are comprised of intrinsic value and extrinsic value. Intrinsic value is how much the option is worth regardless of other factors (extrinsic value). If you have a $25 call option and the price of the stock is $30, then you have $5 of intrinsic value. Extrinsic value is comprised of time and volatility. Option contracts have a specified time period. The shorter the duration of the option, the less that will be charged. The second component of extrinsic value is volatility. Every quarter, companies come out with earnings. This creates uncertainty because it is unknown what the company will announce. Because of this, option sellers raise the price of options due to the possible news associated with their earnings announcement.

Think of options as insurance. If I sell you car insurance for one day, it will be cheaper than for a whole year. Why, because you have a shorter period of time in which an accident can occur. As for the volatility aspect, the car insurance company charges more for a sports car than a minivan. The sports car goes faster and therefore is considered more likely to get in an accident and therefore more volatile.

Three economist created a mathematical formula called the Black-Sholes model for determining a theoretical value for option. Option prices can be priced higher or lower than theoretical value. In times of unrest, option sellers will raise the cost of options so high, that it is nearly impossible to make money buying options.

trader-type-ss

With our Key2Options Platform, we can scan for stocks that have high implied volatility (expensive) or that have low volatility (inexpensive). When Options are expensive, we want to be sellers of options (Volatility trader). When options are inexpensive during times of low volatility, we want to be buyers of options (directional trader).

Sometimes it’s better to be a directional trader, sometimes a volatility trader. It just depends whether the option is under or overpriced. Learn how to trade both ways with the Key2Options platform.

Always remember to Plan your Trade and Trade your Plan with Key2Options.

Hedging Portfolio with VIX Options Backtesting

Hedging Your Portfolio

With the markets at frothy nosebleed levels, we have been asked about how to hedge your portfolio in the event of a market correction. Long term investors may have tax consequences to consider so they look to hedge their positions with options. Investors who believe there could be a correction or Black Swan event in the coming future may design a hedge with options to reduce the effect of an event.

Options are a great tool for protecting your portfolio. With any insurance, there are questions to be answered before deciding on the proper amount of insurance. Do I want to protect the entire portfolio or just a portion of it? What is the composition of my portfolio? How long do I want protection?

Why Hedge?

1987, 2001, 2008. If you lived through the markets during those years, you already know what can happen.

What goes up, must come down…at some point. Like death and taxes, market corrections are part of life. Using options to protect your portfolio is costly, but allows one sleep like a baby at night. Let’s take a look at how we can hedge a portfolio with options.

Hedging 101

When purchasing put options, you will want to pick an index that has a similar beta to your portfolio. The S&P has a 1.0 beta. A beta of less than 1 means that the security is theoretically less volatile than the market. A beta of greater than 1 indicates that the security’s price is theoretically more volatile than the market.

The SPY is best for a diversified portfolio of larger cap stocks. Those who own mostly small cap stocks might consider using the IWM, while the QQQQ would match up well with a portfolio made up mostly of tech stocks. All three of these ETFs are heavily traded and have very liquid options markets.

Let’s assume your portfolio is correlated to the S&P index. We will use the SPY options for our hedge.

To determine how many contracts we need to hedge, we will use the formula below.

Portfolio Hedging Formula

Portfolio Value: $100,000

Underlying Value of 1 SPY Option Contract:

$218 x 100 = $21,800

Contracts Needed to Fully Hedge Portfolio:

$100,000 / $21,800 = 4.58 Contracts

We will round up the options to 5 to be safe. The current price for the At the Money SPY 218 put strike with December expiration is $8.00. The cost of your hedge would be $8*5*100 which equals $4,000 or 4% of your portfolio.

If your $100,000 shares were in SPY, you would own approximately 460 shares. We will look at some different scenarios.

Chart - Hedging Your Portfolio

Summary

This is a general hedging strategy for those who may be concern about upcoming volatility. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. A hedge is essentially an insurance policy for your portfolio and whether or not you decide to hedge your own portfolio will depend on your specific market outlook and risk tolerance.

Using Quant Modeling to Trade for a Black Swan Event

Black Swan Event

Dear Traders,

Fact or Fiction?

The S&P continues its grind higher. It is within a few points of our most aggressive target. Fact

The VIX is historically low. It is in State 8 and has reached our aggressive target. Fact 

The markets has to go down because it’s overvalued. Fiction- Markets can go up and down without “proper reasoning.” 

As you know at Key2Options, we deal with mathematics and do not listen to headlines as we believe that the prices are reflected in the underlying price. While we our reaching our targets in most of our major averages, the market can defy the “normal” ranges it typically trades in. So if you tell me the market goes past our aggressive targets, I would not be shocked. We deal in averages, and the averages are saying it’s time to look to get defensive if not short.

When we trade, we look at what we know and try to use statistics to take measured guesses on where the underlying will move. There are movement though go outside the normal standard deviations we look at typically.  What if we had a 5 sigma move, or even a 17 sigma move?

First, what is sigma? In statistics and probability, the lower case Greek letter sigma is used to denote the standard deviation of a distribution, which as the name implies, is the accepted unit to measure how much an outcome can vary from its mean or average. A Wikipedia article lists the following table for the likelihood of sigma deviations for the standard normal distribution

image28

Is there a Black Swan event coming soon? A black swan event is an occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict; the term was popularized by Nassim Nicholas Taleb, a finance professor.

On Monday, October 19th, 1987 we suffered a 22.6% drop in the Dow Jones. This was a 17 standard deviation move. The chances of these events happening are slim but they do occur.

Let me pose 3 possible Black swan events that could cause a greater move to the downside than what we have seen in the past.

  1. We are in a Presidential race in the United States. It’s no secret that both domestically and abroad there is animosity towards the United States government, as well as, for both Hillary Clinton and Donald Trump. What if one or both candidates were assassinated? It has been 53 years since JFK was shot and killed. A 4 sigma move would suggest this happens every 43 years.
  2. The opening day for American football Season is on September 11th, 2016. We all know what happened on that day in history. A targeted attack on multiple stadiums with drone bombs is possible.
  3. The outstanding global derivatives market is over $700 trillion — 10 times global GDP.  One bank, Deutsche Bank, owns about $75 trillion of those derivatives. That’s roughly 13% of all outstanding global derivatives.   Consider that Lehman Bros. was leveraged 31-to-1 before its 2008 collapse. Deutsche Bank is now leveraged over 40-to-1.

This is not in any way to suggest any of these events will happen. It is highly improbable. The market, however, is historically overvalued based on a Price Earnings ratio.

Options gives us a great way to hedge our portfolios. This might be a good time to take a look at your portfolio in the event of a Black Swan event!

Buy and Sell Put Options and Call Options

The Fireworks are just getting started in the Stock Markets

I hope everyone had a safe and happy 4th of July!

The US Stock market sure has had a lot of fireworks over the last 7 years. Stocks have had a great run since 2009, but like all good things, at some point it has to come to an end.

In a seven year span, the S&P index is up roughly 200%. Despite the recent correction after the Brexit vote, we’re still in one of the biggest stock rallies in history. Generally speaking though, stocks have never been worth more than they’re worth right now. Price earnings ratios and Price to sales ratios are at an extreme highs making stocks very expensive.

What can you do if this bull market is ending?

Just to be clear, I’ve made it no secret that I’ve been expecting 2016 to be a bad year for the markets. I have said that we could see possibly a 40% correction, taking the S&P to the 1250 area. Today, I’ll show you how you can use a plain, simple options strategy to protect your portfolio against the next crash.

How? By Buying Put Options.

Most investors who are new to the options world are most familiar with call options. Calls are popular because buying them is a lot like buying a stock, only with a ramped up reward-to-risk ratio. When the stock goes up, call options go up a lot. Put options offer the same reward profile but makes money when the stock or index goes down in value. As many of you know, it takes a while for stocks to go up, but they can come down rapidly.

As a refresher, buying a put option gives you the right (but not the obligation) to sell a specific stock at a specific strike price and by a predetermined expiration date. What does that accomplish exactly?

Basically, buying a put lets you bet against a stock or an index like the S&P 500.

Let’s say that our imaginary example XYZ Corporation has shares of its stock currently trading for $5. But this time, you think that the stock is overpriced and it’s headed lower in the next couple of months — so you buy an XYZ Corp. $5 June put option. Your put option gives you the right to “sell shares” of XYZ for $5 anytime between now and June’s options expiration date (the date isn’t important in this example).

So, if you’re right, and XYZ falls down to $2, your puts give you the ability to make $3. Sell it for $5 and buy it back for $2.

In every other way, buying puts works just like buying calls: your risk is limited to the cost of the options (because if XYZ’s price rises above $5, you wouldn’t bother with it), and the cost of the options is determined by intrinsic value and time value.

With puts, intrinsic value is found by subtracting the option’s strike price from the stock’s current price.

In a big way, put options are a lot like insurance.

When you buy a $200,000 homeowner’s insurance policy for your house, you’re saying that you want to be able to get $200,000 for your home if a catastrophe takes place. With our XYZ put example, you’re saying that you want to be able to get $5 for shares of XYZ — even if some catastrophe destroys shares’ value.

For instance, you can buy a put option on a market S&P 500 and get paid out when the stock market drops!

Insuring Against a Crash

To insure against a crash, you need to buy a put option with two characteristics: it’s got to be cheap, and it’s got to have plenty of time to play out.

The best way to do that in one step is by buying a long-term put that’s way “out of the money.” Out of the money options have zero intrinsic value. Think of these options as betting on a long shot in a horse race.

Remember, you want to minimize the cost of your portfolio’s “insurance policy”. That cost has two factors: time value and intrinsic value. We need plenty of time on our “insurance policy” — so unfortunately, our time value is going to cost more. To make up for that higher time value, we’ll use a put option that has zero intrinsic value. That way, our insurance policy only pays out on a really big move down, but it’s cheap to buy.

So, let me show you how that would work if the Stock Market does crash!

As of this writing (early July 2016), the S&P trades for around $2085 per share. Let’s say we want our “insurance policy” to kick in if the index crashes, we could buy the SPX $1350 December 2016 put. That put gives us the right to sell the SPX for $1350 per share anytime between now and December 2016.

That option currently costs $4.75, which means a total investment of $475 for a contract ($4.75 per share time’s 100 shares in a contract).

If the market crashes, and SPX falls through $1350, your insurance policy starts paying out.

During the recent Brexit market fall, this option doubled in value. If the SPX does go down to $1250, your $4.75 option will be worth a minimum of $100!

Just like a regular insurance policy, if you don’t use it you’re only out what you paid for your premiums or $4.75.

The Stock market tends to go in cycles. Remember the internet bubble of 2000? How about the crash in 2008? Hmm every 8 years…. That would make 2016 a year to go down. The question you have to ask yourself is… is it worth a chance to invest $4.75 to make $100? I’ll take my chances!

Remember to Plan your Trade and Trade your Plan

State Modeling™ Helps Predict When to Sell Stocks

Sell in May and go away?

There is an axiom in the market that suggest you should sell stocks in May and not get back into the market until November.

Many markets, especially commodity based markets have seasonality trends. For example, in the summertime we see an increase in oil prices due to the summer driving season. Often, we will see the stock price of oil companies’ rise during this period.

History suggest that this is more than a folksy axiom. Surprisingly, from 1950 through 2015, the average monthly returns for the S&P 500 from the November through April periods are dramatically higher than the May through October periods. Returns from November through April are 1.42% compared to 0.52%.

This year may have even more reasons to sell in May. One, we have a presidential election. Wall Street does not like uncertainty. The polls are tightening and quite frankly America doesn’t seem to be enthused by either candidate. This uncertainty leads to selling. The last three presidential races resulted in a loss in the stock market from May through October. In 2008 the loss was 27.3% in the Dow Jones Industrial Average.

This year could be worse. The one fundamental indicator I look at is the Price/Earnings Ratio. The price-to-earnings ratio (P/E) is a valuation method used to compare a company’s current share price to its per-share earnings. It can also be used on Indexes.  Dividing the common stock market share price (numerator) by earnings per share (denominator) produces the ratio. For example, let us do a sample calculation with company XYZ that currently trades at $100.00 and has an earnings per share (EPS) of $5.00. Using the previously mentioned formula, you can calculate that XYZ’s price-to-earnings ratio is 100 / 5 = 20.

Historically, The S&P 500 has averaged a P/E ratio of 16.67. Currently it is 25.68. With current earnings of $87.53 for the S&P 500, if you used its average P/E of 16.67, the Value of the S&P should be 1459. Currently The S&P 500 is trading at 2055. This would be a 29% movement to the downside if it reverts back to its historical average. Prior to the collapse in 2008, the P/E ratio was at 28.

Finally as of this writing, Our Major Indexes have just entered into a mildly bearish State 2 in the Key2Options Program for the first time in about 60 days. Our State Modeling predicts when stocks will go up (bullish) or when they will go down (bearish).

Characteristics of State Modeling

STATE TREND EXPECTATION BEHAVIOR
State 1 Bullish Extremely Bullish Price rise upwards
State 2 Bearish Pullback from uptrend Pullback from uptrend
State 3 Bullish Bullish Bulls and Bears are fighting aggressively but still mildly bullish
State 4 Bearish Moderate Bearish Lead indicator for upcoming sharp downtrend
State 5 Bullish Moderate Bullish Bulls and Bears are fighting aggressively but still mildly bullish
State 6 Bearish Bearish Expect new lows and sharp falls
State 7 Bullish Pullback from downtrend Pullback from downtrend
State 8 Bearish Extremely Bearish Price fall downward and expect new lows

States 1, 3, 5 and 7 are bullish States. States 2, 4, 6 and 8 are bearish States. State 1 and 8 are at the extremes of bullishness and bearishness.

This could be the sign of a small pullback or a prelude to a dramatic sell off in the coming months. Check with the Key2Options blog post at http://key2options.com/blog/ to stay up to date with the latest trends in the financial markets.