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Stocks & Commodities V. 25:5 (70-72): Product Review: Options Spreads: Generating Exceptional Returns... by David Penn
PRODUCT REVIEW

Option Spreads: Generating Exceptional


Returns With Tony Ciccone
TRADESECRETS DVD SERIES can make a major difference in a trades
www.traderslibrary.com/tradesecrets results and in a traders profit/loss.
Product: Presentation on DVD One of the things that Ciccone ap-
Price: $99 pears to have learned in the years since
his initial successful foray into option
by David Penn trading was that he preferred non-
directional trading to directional trad-
suppose if I had made more ing. Rather than wondering which way

I than 200% on my first option


trade, Id be pretty keen on
options too. But Tony Ciccone,
who shares a little about his
own trading background and experi-
a stock would go, Ciccone instead
learned to focus on the potential for
movement arguably the most impor-
tant aspect of profitably trading options
also known as volatility. As he says
ences with options during his informa- near the end of his presentation:
tive presentation in video form, Option
Spreads: Generating Exceptional Re- Ive talked to people before and they
say Ive got a list of stocks and I want
turns, believes this kind of option trad-
to put these trades on But the
ing success is more accessible than most reality is suggested by the way I do
would-be and struggling option traders it I look for the beneficial options.
might believe. If you trade within your I dont care what stock its on. If I can understand volatility, the better youll
means, start small and stick to those find a good [option] relationship, then do in the market. And while it is clear
trading opportunities with a high prob- Ill look at the stock. But Im not that he means this in general, it is all the
ability for strong returns and manage- going to waste my time looking at clearer that this understanding is key to
able risk, Ciccone suggests in the con- chart after chart after chart wondering being able to trade volatility in the op-
clusion of his presentation, then success which way a stock is going to go tion market. After pointing out that sta-
at option trading can be yours. tistical volatility answers how likely it
That said, there are a number of ways And maybe, after an hour or so with is for the underlying asset to move
to skin the cat, and no fewer ways for Tony Ciccone, youll learn how to around, Ciccone moves on to discuss
traders and speculators to make money stop wondering and start trading some of the factors that affect theoreti-
trading options. And while a great many volatility too. cal values and make them different from
option traders have started out with stock the actual price of options. Even more
n option trades like covered calls, and VOLATILITY AND PROBABILITY important or, at least, more to the
a significant number of traders have You cant talk about options without point Ciccone discusses the relation-
tried buying naked calls and puts, talking about volatility. And you cant ship between theoretical pricing, vola-
Ciccone lets you know that there are talk about option volatility without talk- tility, and the market price, beginning
other ways of trading options rather ing about statistical and implied volatil- by asking, At what volatility level does
than just marrying them to stocks or ity. This is where Ciccones presenta- the theoretical price of an option equal
treating them like stock substitutes. tion begins, outlining both how he the market price?
His presentation, recorded and made with OptionVue determines statisti- Volatility is not a constant, avers
available to the investing public through cal or historical volatility. Ciccone pre- Ciccone. I like to say that options
the Trade Secrets Video Series, encour- fers an extreme value method, look- breathe: expanding and contracting. Buy
ages traders and speculators to exploit ing back over the previous 20 days and when they are contracting and sell when
some of the more unique aspects of exponentially weighting the more re- they are expanding. When it comes to
options and options analysis. While cent price data. Ciccone adds his statis- evaluating volatility, there are two
many start trading options because of tical volatility (SV) data to an options frames of reference he relies on. The
the leverage these instruments provide, pricing model like Black-Scholes in first is the percentile ranking. Is a given
Ciccone points to another unique char- order to arrive at the fair value or option at the high end or low end of the
acteristic the vulnerability of options theoretical value of a given option. range? Where is the current volatility
to changes in volatility as that which Ciccone notes that the better you level in the context of things?
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 25:5 (70-72): Product Review: Options Spreads: Generating Exceptional Returns... by David Penn

the positive attributes of iron condors,


You cant talk about options without especially as they compare to other ver-
talking about volatility. And you cant talk tical skew trades like straddles and
strangles, and provides examples that
about option volatility without talking show that while iron condors are not
about statistical and implied volatility. perfect trading structures that guarantee
profits every time, they deliver the
The second frame is a longer-term come from speculators as well as those broader range of profit and limited
moving average. Ciccone notes that not looking to hedge or protect positions risk to say nothing of the positive
all options trade at the same implied using options. theta as advertised. The worst thing
volatility level something he says that Ciccone moves on to talk about spe- that can happen to a short condor posi-
not all pricing models take sufficiently cific trading structures that he believes tion is an immediate extreme price move-
into account. His solution, in part, is to are best equipped to allow traders to ment, Ciccone adds.
use the midpoint between the bid and the take advantage of both vertical and hori- What about horizontal skew? Ciccone
ask, something he calls MIV. zontal skew. Traditionally, he notes, makes the point that not all expiration
By way of summary, Ciccone points long straddles and strangles have been months trade at the same volatility level
out that statistical (or historical) volatil- the structures of choice for trading ver- (or, per Ciccone, different MIV levels).
ity refers to the underlying asset and the tical skew insofar as these two struc- Often, a horizontal skew may exist that
magnitude of price swings. Implied tures will gain in value from an in- can be exploited by traders by buying
volatility refers specifically to the op- crease in implied volatility or a signifi- less expensive options that are farther
tions and their volatility, which is im- cant price increase. Remember that out in time and selling more expensive
plied by the market price. Because of vertical skew relates to the degree or options that are closer. Ciccone points to
the phenomenon of reverting to the amount of price movement. Traders four different strategies that traders have
mean, Ciccone posits a rule of thumb wanting to take the other end of this bet used to take advantage of horizontal skew:
that option traders should buy options can sell straddles and strangles, seeking calendar spreads, diagonal credit spreads,
when implied volatility is low near to gain from a decrease in implied vola- double calendar spreads, and double di-
the one percentile and sell options tility or the lack of price movement. agonal credit spreads.
when implied volatility is high near There are risks to both buying and I trade calendar spreads a lot,
the 99 percentile. selling straddles and strangles, and Ciccone announces. Then he adds, This
This discussion of volatility leads Ciccone delineates those risks before is the value of why you are sitting here
Ciccone to another important concept moving on to what seems to be his favor- three trade structures all positive theta
and tool in trading volatility: horizon- ite structure for trading vertical skew: the all paying you to have the trade on.
tal and vertical skew and the volatility iron condor. The iron condor is essen- The benefits of calendar and diago-
skew graph. tially a call credit spread combined with nal credit spreads include the range of
a put credit spread. This limits the risk profit and positive theta from the nearer-
TRADING THE SKEW while only taking away a point or two of term options. Ideally, Ciccone says, he
Skews are essentially differences in profit probability, as Ciccone shows us- likes the legs of his spreads to have five
implied volatility levels, both horizon- ing some of the software tools available months or more between them. By buy-
tally and vertically. Ciccone talks about through OptionVue 5. ing lower implied volatility and selling
both horizontal and vertical skews and An additional benefit of this structure higher implied volatility, The edge can
why they exist as preparation for his is positive theta or positive time decay. be created from the volatility skew, he
later discussion on how traders can take There is only one thing that is guaran- explains.
advantage of both horizontal and verti- teed in option trading, Ciccone says. While a calendar spread will feature
cal skew by using different trade struc- There will always be fewer days until a long and a short leg with different
tures. Horizontal skew, per Ciccone, expiration tomorrow than they are to- expiration months and same strike
comes from the relatively higher de- day. As such, Ciccone says, 95% of prices, a diagonal credit spread features
mand for options with expiration months the trades I put on have positive time long and short legs with different expi-
surrounding events earnings releases, decay, and refers to it as being paid ration months and different strike prices.
legal issues, regulatory issues, and so to hold a position with a high degree of This difference results in a slightly larger
on which may or may not have an profitability. capital outlay because of the credit
impact on price movement. When it comes to condors, Ciccone component with probabilities of profit
Vertical skews, on the other hand, are likes to sell them when volatility is at or that are slightly higher in many in-
derived from the quantity of the ex- near the upper end of its historical range, stances. Multiple calendar and diagonal
pected price movement, as well as from or when implied volatility is signifi- credit spreads can be used to increase
the demand for out-of-the-money op- cantly higher than statistical volatility the profit range, which Ciccone showed
tions. This demand, says Ciccone, can and then turns lower. He underscores vividly in a P/L chart. Ciccone says
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 25:5 (70-72): Product Review: Options Spreads: Generating Exceptional Returns... by David Penn

double calendar and double diagonal be sorted on the basis of their expected sary to help option traders is widely
credit spreads are among the most com- outcomes. available, relatively easy to use, and
mon trade structures he uses. One major point Ciccone introduces often affordable. Its a lot easier, ad-
near the presentation is the importance mits Ciccone, while adding that just
STRESS TEST AND of understanding risk and stress testing. because these trades have extremely
EQUIPMENT CHECK To all of the strategies Ciccone has high probabilities does not mean they
Earlier in his presentation, Ciccone discussed, the biggest danger is extreme are guarantees.
made the point that you cant really price movements or drops in implied Ciccone recommends that traders start
trade options well without instru- volatility. In dealing with these risks, small and always trade within their
ments. As regional director and an Ciccone recommends stress testing means. One advantage with spread trad-
investment advisor with OptionVue, it trades by seeing what worst-case sce- ing of this sort is that since the short
is little surprise that many of those narios with regard to volatility. positions are covered, traders with
instruments he advocates include soft- Stress test all trades across different smaller accounts can trade them with-
ware available through OptionVue changes in implied volatility, Ciccone out the sizable capital often required
though Ciccone acknowledges that other warns, saying that an uncomfortable when writing options naked.
software on the market can do the sort number of up-and-coming traders have That, plus the historically modest
of work to analyze volatility. come up to him with trading problems commissions charged to retail traders in
That said, one of the features Ciccone only to reveal in conversation that they recent years, makes it more possible
is especially appreciative of is never stress tested their positions. I than it has ever been for the average
OptionVues OpScan, which he uses to stress test every trade, says Ciccone. option trader to spread em like a pro.
scan for horizontal volatility skew. As Stress testing has revealed, for ex-
part of his presentation, Ciccone shows ample, that while double calendar David Penn is a Technical Writer for
one of his favorite formulas or screens, spreads do not react well to extreme STOCKS & COMMODITIES.
which looks for instances where im- decreases in implied volatility, double
plied volatility is 15% or more in the diagonal credit spreads seem to be rela-
third month of expiration compared to tively less affected. Another helpful tool
the first. He also looks for high volume is the historical volatility chart. These
(for liquidity) and a generally low charts may give insight as to what
longer-term implied volatility, which changes in implied volatility may be
he determines by way of a 400-day likely, Ciccone says.
exponential moving average. Another The good thing about trading volatil-
tool Ciccone uses is OptionVues Trade ity, says Ciccone by way of conclusion,
Finder, which can identify potential is that anyone can do it. While trading
trade structures that will be effective in volatility does require trading instru-
various situations. The results can also ments, the fact that the software neces- See Traders Glossary for definition S&C

Copyright (c) Technical Analysis Inc.


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