The Broader Markets
Last Week – SPY was lower by about 2.3% last week, in line with the 2.4% move options were pricing. That follows weekly moves of more than 5% the past three weeks and the first time options had the move more or less correctly priced in a while.
This Week – SPY options are pricing about a 2.1% for the upcoming 4 day week.
Implied Volatility / VIX – The VIX closed the week near 27.50, similar to the week before.
Expected Moves for This Week (via Options AI)
- SPY 2.1% (+/- $8)
- QQQ 2.7% (+/- $8)
- IWM 2.5% (+/- $4.50)
- DIA 1.7% (+/- $5.50)
In the News
Tesla (TSLA) reported quarterly deliveries of about 255k over the weekend. That compares to about 201k for the same quarter a year ago. The 255k number was slightly below expectations and the company chalked up some of the miss to supply chain issues and covid restrictions in China. TSLA stock is trading near the same price of a year ago and is down about 45% from its all time highs above $1200. Options, which have underpriced moves in the stock (higher and lower) during its large swings of the past year are now pricing about a 15% move for the rest of July and about a 35% move by year end.
Education
Earnings are light this week so we’ll focus on a bit of education and include more of the same in future posts alongside upcoming earnings. The first subject to focus on is multi-leg spreads.
Why Spreads?
We know that buying a Call (or Put) option means we will see potentially uncapped gains if the underlying stock moves above (or below) our Breakeven at expiration. Our Breakeven being our options Strike Price plus (or minus) the Premium we pay to buy the option. And the Premium being a function of the magnitude of move expected by the options market (the “Expected Move”).
It follows therefore, that in order to realize any gain when buying options, not only do we need to be right on direction, but we also typically need a magnitude of move greater than what the options market was pricing or expecting. In other words, we don’t just need to be right, we also need for the options market to have been wrong. [We are positioning that the crowd has underpriced the move] Therefore, as options buyers, we often accept a relatively lower Probability of Profit (“PoP”) in return for the potential of outsized and uncapped gains.
Turning this on its head, if buying options typically involves Breakevens that need a stock move, and lower Probability of Profit, then selling options and collecting Premium would mean Breakevens requiring a stock to not move to that magnitude, and therefore a higher PoP. While this generally holds true and therefore sounds attractive, it is important to remember that when we are short rather than long options, we are also substituting our potential for uncapped gains with the potential for unlimited losses. Without defining our risk when selling options, when things go wrong, they can go very wrong.
By reminding ourselves of the basic trade-offs in risk, reward and probability when either buying or selling options, we immediately get a sense of why, combining the respective advantages of both buying and selling options, might allow for something altogether smarter.
Spreads, or the simultaneous buying and selling of options to create multi-leg positions, are favored by institutional investors for this very reason. A more advanced strategy, where risk, reward and probability may be optimized for goals of income, leverage or protection.
If buying options is as simple as needing a stock to move beyond your Breakeven and selling options is as simple as needing a stock to stay within your Breakeven, at Options AI we think combining the two as a Spread can be as straightforward as seeing a profit zone on a chart.
Based upon publicly available information derived from option prices at the time of publishing. Intended for informational and educational purposes only and is not any form of recommendation of a particular security, strategy or to open a brokerage account. Options price data and past performance data should not be construed as being indicative of future results and do not guarantee future results or returns. Options involve risk, including exposing investors to potentially significant losses and are therefore not suitable for all investors. Option spreads involve additional risks that should be fully understood prior to investing. Securities trading is offered through Options AI Financial, LLC, member FINRA and SIPC.
