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The Pyramid Optimizer - Instructions

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What might be even more profitable (and risky) than options? Let me give you a hint - instead of adding your profits, you multiply them! If you answered "pyramiding", then you've got this one right. The answer is Stock/Index Option Pyramid.

 

The basic idea is that you buy call options on a stock that you expect to rise. When you achieve a substantial profit on these options, you sell them and use the proceeds to buy call options on the same stock, but at the higher strike price. You can repeat this scheme, as long as the stock does not reach your price objective.

Before we continue with the topic of pyramiding we would like to present you with basic features of this tool, as it can be used in many ways. The basic use of this tool is to calculate strike price of the option that lets you gain the most on particular move in the underlying equity. Calculations take into the account different commission fees from your broker, so it is realistic. You will see the profitability of the best strike price and the profitability of the ATM (at-the-money) options and you can then decide whether the difference is big enough, to justify the higher risk. For example with 400% and 380% it would make sense to buy ATMs, whereas with 400% and 120% it most likely does not. 

The danger in speculation using pyramiding is that you have to be very accurate when it comes to forecasting the range of a particular upswing. Sometimes even if the stock does rise let's say 80% of your predicted range, you can actually lose money. That would be the case if you just bought call options with a high strike price and stocks begins to fall or even consolidating at current level. Your options value will decrease, as each day there is less time to the expiry date. You can decrease the risk by making your price projections really conservative making them more like "stock will rise AT LEAST to this level" instead of "stock COULD reach as high as...".

So, if you've established the amount of capital you want to put into this type of transaction and made conservative price and time projection, there is one more thing that you need to know before putting your money to work - the strikes. Choosing the right strike prices is essential for this transaction to really work. If you choose strikes too close or too far from each other you will not fully take advantage of the enormous profit potential that pyramiding has to offer.

Can we somehow estimate the strikes to maximize the profit? Of course we can! This tool is designed especially for people who want to make the most of their pyramiding strategies.

All you need to do is enter all necessary information and click the "Calculate!" button.

 

Click to expand \ narrow information about the input page.
The "Current data" section is dedicated to values derived directly from the market, whereas the "Forecasts" section includes values that you forecast or for which you want to make the calculations.

Below you'll find details regarding each box in these sections.

  • Choose the option type
    Choose the type of option for which the calculations will be made.
  • Current stock price / index value
    This is the current price of the underlying security.
  • The first strike price
    This is the strike price of the cheapest in-the-money option. If the predicted starting price of this particular trade is lower than this strike price, use the strike price, which is just below (call options) or above (put options) that price.
  • The last strike price
    This is the lowest (for put options) or highest (for call options) available strike price for a particular option chain).
  • The difference between strike prices
    This is the difference between second available strike price and the first one. For example for GOOG and the options that expire in January 2010 that would be 310 - 300 = 10.
  • Current time to expiry (in days)
    Days that remain until the expiration date of that option type. Choose the set of options that corresponds to your time forecasts.
  • Risk free rate
    The theoretical rate of return of an investment with no risk. In practice, the interest rate on a 3-month U.S. T-bill is commonly used. You can check its current value here.
  • Current bid price of the cheapest ITM option
    This is the current bid price of the cheapest of the in-the-money option types. In other words that's the (bid) value of the option, whose strike price is just below current stock price (for call options) or that's the value of the option, whose strike price is just above current stock price (for put options). If the predicted starting price of this particular trade is lower than this strike price, use the bid price of the option, whose strike price you entered in the "First strike price" box.
  • Commission
    Please choose the way of calculating fees that best corresponds to your broker's commission system and enter appropriate value. If you selected commission in cash, then you have to enter the amount of money (in U.S. cents) you are being charged, when buying or selling one option (by one option we mean the option contract for 100 shares).
  • Dominant spread
    This is the most common spread (difference between bid and ask price) among deep out-of-the-money options. For example at the moment of writing, the call option prices for GG that expire in January 2010 have following bids and asks:
    How to calculate spreads
    At the moment of writing $70 was the highest strike price available. The 0.30 spread is both most common and average value for the deep out-of-the-money options and this is precisely what you should enter in the "Dominant spread" box in this case. If these values differ so much that you are unable to determine most common one, you should be fine by entering the spread for the option with highest (call) or lowest (put) strike price available.

  • Starting price of the underlying security
    This is the price of the underlying security at which you want to purchase your first set of options.

  • Initial time to expiry
    Days that remain until the expiration date of the option type that you wish to buy, at the moment of purchase. For example if you predict a move that will materialize in 30 days, you need to purchase options that have more that 30 days until expiration. If available options expire in 20, 40 or more days, you should use options that expire in 40 days or more. The more distant expiry date you choose, the less risky and less profitable the whole transaction will get. Try different scenarios before making your final decision.
  • Final price of the underlying security
    This is the price of the underlying security that you expect to be reached. When the underlying security reaches this price, you plan to take profits.
  • Days needed to reach the price objective
    Days you expect this pyramiding transaction to take place - from the day you purchase your first set of options to the day you expect the underlying security's price to reach the predicted value.

After clicking the "Calculate!" button and waiting several seconds you will see the results.

 

 

Our tool includes the basic Black-Scholes options pricing model. This model was originally designed to price European options, however it is also commonly used to price American options. It can also be used for calculating index options. All assumptions made in this model also apply here. You can find them here.

Please note that one particular assumptions of the Black-Scholes model (the one that says the volatility is constant) may negatively distort calculations, especially in the highly risky and lucrative transactions such as pyramiding. Pyramiding works best when price of particular security rises (or falls) dramatically in a relatively short time frame. Should that be the case, market's perception toward assessing volatility would probably change before you would get to switch strike prices. Both options - the one that you would be selling and the one that you would be buying - would be worth more than our models originally forecasted. This might result in overall change in the profitability of the whole transaction; however in our opinion the changes and general implications of the results should not be very significant.

We also assumed that the stock/index rise is stable percentage-wise - the stock's price increases every day by the same amount percentage-wise (for example 1%) instead of the same amount in nominal terms (for example $1). This makes the price projections more realistic.

 

This tool was designed for educational purposes only and may only be used as such, you use it at your own responsibility.

Please read the disclaimer on the bottom of the website