Pages



• Options University Homepage
  Contact Us

• Categories

  • General
  • Market Snapshots
  • Options Q&A's
  • Trading Articles
  • Video Updates

• Archives

  • February 2008
  • January 2008
  • December 2007
  • November 2007
  • October 2007
  • September 2007

• Recent Posts

  • Options Trading Strategies: Basics to Advanced
  • Effects of Stock Price on the Time Spread
  • The Butterfly and Synthetic Positions
  • Why Use Butterflies?
  • The Butterfly
  • Factors that Affect Strangle Prices
  • Strangle Scenarios
  • Option Strangles
  • Market Analysis January 8, 2008
  • RHAT Daily Chart – Short Straddle Example #2

Press Release

• Timely Intensive Options Trading Workshop With Renowned Experts Presented by Options University
  Options University Reports Recent Market Volatility Causes Boom in Options Training
  Recent Market Plunge is the Most Severe Drop Since 9/11 - Investors Can Protect Their Investments and Profit in an Unstable Market
  Options Mastery Series Re-released March 1st Due to High Demand
  New Options Trading Video Library, The Options Mastery Series, Sells Out In One Week - Limited Re-release in March 2007
  Investors Profit Despite Stock Market Volatility With Options Trading
  SEC’s Proposed Drastic Rule Change Will Free Up More Money for Investors
  NASDAQ’s Entry into the Options Market Favors Individual Investors
  Major Recent Nasdaq News Release:
  Trend Alert: Aging Baby Boomers Turn to Options Trading (Risky or Not)

Feeds

RSS Feed













Our Blog Partners



• 
• 
• 

Bookmarking

Add to Onlywire

If this is your first time visiting, subscribe to our RSS feed.

Key Point – The fact that you are creating the covered call strategy (buy-write) by doing the vertical spread is very important to note. For margin purposes, the vertical spread will be margined at a much more favorable rate than the traditional buy-write because you do not own the actual stock and therefore do not have as much to lose. This is especially important to investors/traders who trade on margin.

This scenario includes another significant value added benefit that you receive. When you purchase a spread, the most you can lose is the amount you paid for the spread which in this case is $10.15.

As you already know, the biggest risk in a covered call/buy-write strategy is a large downward move in the stock. If you had done this trade with the actual stock and the stock traded all the way down to $20.00 from $60.00 (although unlikely) we would stand to lose almost $40,000.

However, if you did the trade with the 47.5 calls in place of the stock via the vertical call spread above, the maximum loss is what you spent on the trade. Remember, you purchased the vertical call spread for $10.15. If you traded the spread an equivalent amount of times to equal 1000 shares, you would have bought a total of 10 spreads.

The total dollar amount of your investment would be $10,150.00, as opposed to $58,900 had you bought 1000 shares of Amgen outright. Your loss will be maximized at $10,150 if the stock traded down to $20.00 as opposed to a $38,900.00 loss in the case of outright stock ownership. Even if the stock was to trade down to $0, your maximum possible loss would still be $10,150.

This is because once the stock gets below $47.50, the December 47.5 calls become worthless thus the calls can not lose any more money no matter how much more the stock trades down.

In order to continue or “roll” this position, you will have to roll two options into the next month instead of one. In a traditionally structured covered call strategy (long stock, short call), you are dealing with only one option series.

However, in the stock replacement strategy, you have a second option series (the call you purchased to replace the stock) to roll into the next month. This may incur an additional commission but the trade is obviously well worth it when you look at the previously stated risk/reward scenario and the size of the capital outlay needed to initiate the position.

Conclusion: As we detailed here, the stock replacement version of the covered call/buy-write strategy is an example of the proper use of option leverage. It offers the investor a bigger percentage return, less risk and less capital requirement than the traditional covered call/buy-write strategy.

Anytime you are interested in a high dollar stock, first look to see if there are any deep in-the-money calls that fit this replacement scenario and evaluate if this might be a better option.

Popularity: 27% [?]

The Stock Replacement Covered Call Strategy

Recently, (October and November ‘03), the giant biotech Amgen (AMGN) came under some intense pressure, trading down about $12.00 before it found what appeared to be a decent level of support, and began to consolidate. At this level, anyone interested in going long Amgen at a discounted price would be advised to do so. Implied volatility was high coming off this precipitous drop, which caused premiums in the options to increase considerably.

This scenario can be a very attractive for covered call sellers or buy-writers. On Tuesday, December 2, 2003, Amgen was trading at $58.90, the December 60 call was trading at $1.30, and there were only two weeks left until expiration.

Let’s assume that you wanted to take advantage of this opportunity but you would be unable to participate in it due to capital requirements. The stock was trading at $58.90 and you did not have sufficient funds to support buying the stock at that price. After all, the purchase of just 1000 shares would cost $58,900.00.

This is the time to consider using a strategy called stock replacement. In many instances, an insufficient amount of funds in the investors account can mean the loss of a golden opportunity when dealing with high dollar priced stocks.

So, an alternative to purchasing the stock outright is to find a way to replace the actual stock with something else which is not as expensive. In this case, a deep in-the-money call would do just that.

When a call is deep in-the-money, meaning that the strike price of the call is much lower than the stock price, the delta of the call approaches 100. This means that there is close to a 100% chance that this option will finish in-the-money.

Because of this, the option will trade just like the stock; penny for penny, dollar for dollar (in a theoretical 100 delta scenario.) If you recall, the term delta was mentioned when describing the option in question. Delta is the first derivative of the stock and it has a three pronged definition. The first is percentage change.

The delta is given as a percentage change, meaning how much in percentage terms the option price will change with a movement in the stock. A 50 delta option will move 50% the amount the stock does. If the stock moves $1.00, than the option moves $.50. A 30 delta option moves $.30 on a $1.00 movement in the stock, and so on.

Delta can also be defined as percent chance. This is used to describe the percentage chance that the option will end up in-the-money. A 90 delta option has a 90% chance of finishing in-the-money.

Finally, delta can also be defined as hedge ratio which is the amount of deltas needed to properly hedge a position. These concepts will be discussed in more detail in future Options University courses, but for now it is sufficient to just understand these basic concepts.

It was important to explain the meaning of delta to understand that the deep in-the-money call would perform and act just like the stock. One way to determine if the call you will select is in-the-money enough for your purpose is the delta. A delta in the mid or high 90’s is an ideal candidate.

The selection of the proper in-the-money call to use is a critical element in the success of this strategy. In order to obtain an accurate delta of all options under consideration for stock replacement use, you can go to any number of web sites or consult your broker. If all else fails, there is a little trick of the trade that can be used to aid in selecting a call that is deep enough in-the-money to suit the stock replacement criteria.

To do this, check the quote of the corresponding put (i.e. the December 47.5 put if you are looking at the December 47.5 call for stock replacement). If there is no bid quoted for the put, then the call is deep enough in the money to consider it for a stock surrogate. There are several reasons for this being an effective strategy, which we wont cover here, but for the purposes of this discussion, it is enough to know that this method does work.

So, with the stock at $58.90, the December 47.5 calls met the criteria for stock replacement. This call had a mid to high 90’s delta and its corresponding put had no bid. The December 47.5 call was trading at $11.45 or $.05 over parity. By purchasing this option, you would be equivalently buying the stock at $58.95 (the strike price plus the option price).

Let’s say that you bought the December 47.5 call for $11.45. If a total of 10 calls were purchased (an equivalent of 1000 shares), you would lay out a total of $11,450 to fulfill your stock requirement on this buy-write. If you had purchased the stock outright, you would have spent $58,900. The difference between the capital needed to purchase the stock outright ($58,900) and the capital needed to buy the in-the-money call ($11,450) is the key to this trade.

Now that you have your stock (via the calls you bought above), it is time to sell covered calls against this position, which would be the December 60 calls for $1.30. If the stock stays at its present level, you would then capture the $1.30 premium that you sold the December 60 calls for because they finished out-of-the-money at expiration.

The $1,300 profit in this scenario represents an 11.35% return in only two weeks. This well out-performs the return garnished on a $58,900 investment which would only be a 2.21% return in the two weeks, if you purchased the actual stock.

As we know, the maximum profit of $2.35 will be attained if the stock reaches $60.00 or above. This return comes from the $1.30 you received in the premium for the sale of the now worthless December 60 call plus a $1.05 profit from the December 47.5 call you purchased. With the stock now at $60.00, the December 47.5 call is worth parity, which is $12.50.

You purchased the call for $11.45 thus you received a $1.05 capital gain in the option. This profit of $2350.00 represents a 20.5% return in two weeks verses a 3.98% return in two weeks, if you had purchased the actual stock.

As you can see, you are getting the same overall dollar return on much less money - which creates a much higher percentage rate of return. This is one of the positive leverage effects that the proper usage of options can provide. When you initiate this trade, you are buying and selling two different options simultaneously which is known as a spread. A spread is a trade which involves the buying of one option against the sale of a different option simultaneously and will be covered briefly in the next section.

By buying the December 47.5 calls for $11.45 and then selling the December 60 calls at $1.30, you are buying the December 47.5 December 60 call spread for $10.15. This type of spread is known as a vertical spread.

Popularity: 29% [?]

MER stock trading chart

read more | digg story

Popularity: 24% [?]

NOTES ON Merrill Lynch (MER)
Collar

1) During this viewing period, Merrill trades in an uptrend from late June 2003 at a price of about $45.00 through January 2004 with a high around $60.00.

2) This is a wide trend with some intra-month ranges as much as $5.00 and $6.00 wide, indicating a volatile trend.

3) There were a few gap openings early on in the uptrend during July, but we also want to look at the large intra-day ranges, displayed by the length of the daily candles.

4) The stock also deviates frequently from the mid-line of the trend and although it stays within the trading channel nicely, this still is a volatile trading pattern.

Conclusion: With volatility high, option premiums will probably be expensive. In Merrill’s case, the investors should look to obtain maximum protection, but the protective put would not be the best choice.

Although the stock is very volatile, the uptrend is not a steep one. During the observed period of 6 months, the trends mid-line capital appreciation is only a little more than $6.00, not much compared to many other stocks during this period. With the high volatility, the price of a protective put for any length of time would quickly eat away any profits from the stocks’ rise.

A collar would allow the investor the protection needed, at a reasonable and warranted cost, to justify the potential reward of the capital appreciation.

Popularity: 22% [?]

NOTES ON Yahoo (YHOO)
Collar

1) Yahoo, a historically volatile stock, bottoms out and then trades through resistance of a downtrend in mid-August 2003.

2) Yahoo then trades in an uptrend from a price around $33.00 in late August out through January 2004 with a price high of $46.00. This represents a 40% increase in 4 months.

3) During this uptrend, Yahoo had several gap openings which are considered very volatile events. There are 3 of these gaps in October 2003 and 2 in November 2003.

4) Further, Yahoo has many large intraday range days. This also points to a higher level of volatility for this stock.

5) This uptrend that Yahoo trades in has a wide range. The stock fluctuates widely from the mid-line of the range. Again, indicative of higher volatility.

Conclusion: Yahoo offers the investor a good upside opportunity. However, in a stock as volatile as Yahoo, there is also large potential for loss also.

Here, a maximum protection strategy is advised. Under these higher volatility situations, the collar would be better then the protective put because of overall cost.

When trading a stock with such high volatility, the investor must be aware that option premiums will be expensive if not prohibitive. The collar gives the investor the needed downside protection at a much lower cost (due to premiums received from the sale of the call) while still allowing room for capital appreciation.

Popularity: 25% [?]

NOTES ON EBAY (EBAY)
Collar

1. Ebay traded in a very wide range during July 2003. It started the month around $51.50 and traded up to $57.50 before trading down to $54.40. Within a week it traded to a high of $59.00. The week after that, the end of the month, the stock was down to $52.50.

2. August, was another volatile month. The stock had a high of $57.25 and a low of $50.00.

3. The stock started the month of September trading at $56.50. It traded down to $50.50 then back up to $57.00.

4. Volatility continued in October. The stock had quite a range with a high of $61.50 and a low of $53.50. Moreover, the stock had no less than 5 gap openings. The gap openings were almost evenly divided between “ups” and “downs”.

5. The pattern continued in November 2003. The stock started the month by quickly putting in a high around $58.50. It then traded down, reaching a low around $50.75, before rallying and trading back up to $57.00 before the month’s end.

6. December began with the stock trading around $57.00. It then moved down quietly to $55.00 by the middle of the month. By the end of the month, Ebay was trading at $64.00, up an astounding $9.00 in a little more than two weeks.

Conclusion: A stock this volatile needs a hedging strategy that provides maximum protection. A covered call strategy will provide some protection but not enough for a stock with the month in and month out volatility that Ebay exhibits.

The protective put strategy would work in terms of maximum downside protection, but at what cost? With volatility this high, the puts will be very expensive, maybe too expensive. This situation is perfect for employing the collar.

The sale of a call against the purchase of the put will at least partially offset the expense of the put, making the downside maximum protection affordable, while still leaving room for capital appreciation.

Popularity: 21% [?]

NOTES ON ELI LILLY (LLY)
Collar

1. In a one month span from Nov. 18, 2002 to Dec. 18, 2002 LLY traded from just below $60.00 to just below $70.00 and back down to $62.00.

2. In another one month span from late May 2003 to mid-June 2003, LLY traded from $56.00 up to $72.00.

3. Several gap openings are also apparent with one in mid-January 2003, one in late August and one in very late September. These all point to periods of high or increasing volatility.

4. We also want to notice the individual daily trading ranges. The length of the lines shows the number of large range days. The longer lines indicate larger intraday ranges. In the chart above, LLY shows a very high number of large intraday movement days, again pointing to high volatility.

5. As much as LLY had strong run-ups, it had some large down periods also. In a 2 month period from mid-Jan. to mid-March 2003, LLY traded down from $68.50 to $58.00. Then in another two month period, mid-June to mid August 2003, LLY traded down from $71.00 to $61.00.

Conclusion: LLY appears to be a very volatile stock during the observed period charted above. The stock began this period at around $60.00 and finished the period at $67.00, which is not necessarily a large move. But when we look at the large intra-month ranges, it’s clear that LLY has been very volatile during this period.

With this type of movement, a maximum protection strategy is necessary but, with such high volatility, premiums will likely be expensive. The outright buying of a put may cut too deeply into potential profits making the risk reward scenario unjustified.

The collar strategy, however, will provide the necessary downside protection, while still allowing room for some capital appreciation. The sale of the call will offset the cost of the put purchase to make the trade’s risk/reward scenario more viable. The collar can be leaned to provide either more protection or more capital appreciation, depending on the investors short term outlook.

Popularity: 15% [?]

Key Point – The collar strategy allows for a limited but continued capital appreciation of a long stock position while providing for a limited, fixed downside exposure. The position is very inexpensive to initiate due to the offsetting premiums of the long (purchased) put and short (sold) call.

The collar is an excellent protective strategy for an investor who has a bullish opinion on a stock.

In looking at the bullish lean example, one of the flaws is the fact that if you move that upside call to the higher strikes you may overly decrease the amount of premium you receive for the sale of that call which, as you know, is supposed to compensate for the amount spent on your protective put.

One way to adjust for this is to look further out across the months in the strike you are interested in. Selling a call out two or three months may generate enough premiums to fully offset the price of the put.

Remember, premiums increase over time for all options. You do not have to be confined by the idea that your long put and short call have to be in the same expiration month.

This adjustment provides more acceptable premium balance allowing extra room for a strong upward stock move while still giving you maximum downside protection.

Popularity: 18% [?]

Like other strategies, the collar can be leaned toward the investor’s perception of the stock’s direction and strength.

Let’s look at the potential leans that can be taken. Say that you have a very strong feeling the XYZ is going to go up. Instead of buying a put and selling a call with strikes that are roughly equidistant from the stock price, you would sell a call that is further out-of-the-money.

This would allow more room for a larger increase in stock price because the stock would not be called away as early. You retain ownership for a longer period of time during the increasing price period.

Of course, by increasing the distance of the option’s strike away from the stock, the amount of the call’s premium will decrease. The overall effect is that you’ll have to pay more to own the position. (You will pay out more money for the put than you will receive from the call.)

Again, we’ll start with the same prices as in our original case, (stock $28.00, Dec. 27.5 put $1.00 and Dec. 30 call $1.00) only now we will change the Dec. 30 call at $1.00 to the Dec. 32.5 call at $ .35.

In our other examples, we incurred no debit or credit from our option position. This time, with the bullish lean, a debit is incurred. The purchase of the Dec. 27.5 put for $1.00 combined with the receipt of $ .35 from the sale of the Dec. 32.5 call produces a $ .65 debit.

Remember, this debit must be subtracted from the bottom line profit or added to the bottom line loss of the stock’s capital result. This means that before you make any money from the position, the stock must trade up $ .65.

If the stock stays stagnant you will lose $ .65, and any capital loss you incur will be $ .65 worse. Now back to the position in our previous example. With the selling of the Dec. 30 call, we had an upside potential of $1.50. In this example things change.

As was stated, our maximum upside potential is calculated by setting the stock price at the strike price of the short call which is 32.5 in this case. With the stock at $32.50 at expiration, you would have a $4.00 stock gain since the stock was purchased for $28.50.

Remembering your $ .65 debit to enter the position, we subtract that from the $4.00 and we have a total maximum profit of $3.35. This is significantly more potential reward than our original example using the Dec. 30 call.

As in all trading situations that offer a higher potential reward, there comes a higher potential risk. If the stock stays at $28.50, (the stagnant scenario) you have a loss of $.65 in option costs. In the down “scenario,” calculating the maximum risk is done by setting the stock price at $27.50 on expiration.

The stock, purchased at $28.50 has lost $1.00. The options, not neutral, resulted in a $.65 loss. The total loss is $1.65. In both the “stagnant” and “down” scenarios, the loss increased over that in our original example. As you can see, the higher potential gain is accompanied by an increased potential risk.

Popularity: 18% [?]

Let’s take a look at how the strategy works with this position. For the sake of our illustration and to make our calculations easy let’s establish the collar using the December 27.5 put and the December 30 call, with both trading at $1.00.

Remember our stock price was $28.50. The cost of the collar will be $0 because you paid $1.00 for the put but you collected $1.00 from the sale of the call. How does the collar work in our usual three scenarios: the “up” scenario, the “down” scenario and the “stagnant” scenario?

In the “up” scenario, we find that when the stock rises, the investor gains penny for penny until the stock reaches the call strike. Once the stock reaches that level, the position no longer gains because the stock is at the point where it will be called away.

Capital gains of the position are maximized when the stock reaches the call’s strike price. Let’s take a closer look at what happens as the stock price goes up. With the stock at $29.00, both the Dec. 30 calls and the Dec. 27.5 puts are out of the money and thus worthless. Since there was no debit or credit incurred in the options, the option profit (loss) is $0. Only the stock position remains. The stock purchased at $28.50 is now trading at $29.00 for a $.50 profit.

Let’s raise the stock price to $30.00. The puts and calls are again worthless so your profit (loss) is solely determined by the stock. The stock, which was purchased for $28.50 is now worth $30.00 and represents a gain of $1.50. This $1.50 gain is the maximum gain the position allows.

Once the stock goes over $30.00, the Dec. 30 call, which we are short, would become in-the-money and therefore the stock position would be called away at that price. When the stock price rises to $31.00, the puts would be out-of-the-money thus worthless but the calls would be worth $1.00.

You received no money for the establishment of the collar so you would have a $1.00 loss in the options. Meanwhile, the stock that you purchased at$ 28.50 is now worth $31.00 at expiration, which is a $2.50 gain.

Combine the $2.50 gain in the stock with the $1.00 options loss; you have a $1.50 profit again. You may do this calculation with higher and higher stock prices but the outcome will always be the same. This example shows how your upside potential is limited.

Obviously, if the option portion of the collar incurred a debit or credit, that inflow or outflow of money must be added to or subtracted from the stock gain to get the overall return of the position.

Normally, there will be a debit or credit incurred in the collar. It is usually difficult to find a put and a call that you want to use in the collar trading at an equal value. Let’s use our last example with some minor price changes.

If the put had been trading at $1.25 instead of $1.00, then there would be a $.25 capital outflow that would have to be subtracted from the $1.50 gain to reduce it to only a $1.25 gain.

On the other hand, if the call was trading at $1.25 then you would have collected an extra $ .25 which added to the $1.50 gain would produce a $1.75 gain. The cost of the collar always impacts the bottom line profit or loss of the position.

Looking at the collar in the “stagnant” scenario, the stock price would be unchanged thus neutral in terms of return. Therefore, the potential profit or loss would come strictly from the debit or credit of the two options.

If the stock does not move, as in our example, both the put and call would finish out-of-the-money and be worthless.

Our profit or loss would simply be calculated from whether you paid for the collar or collected from the collar and how much that amount was.

Using the same prices as the previous example (the stock purchase price of $28.00, the Dec. 27.5 put $1.00 and the Dec 30 call $1.00) we will now take a look at the “down” scenario. Let’s set the stock price at $28.00 on expiration. At this price both the Dec. 27.5 put and the Dec. 30 call are out-of-the money and worthless. Since there is no credit or debit incurred in the option position ($1.00 inflow from the calls, $1.00 outflow from puts) the total return of the position is simply the gain or loss from the stock.

With the stock purchase price of $28.50 and a stock price of $28.00 on expiration, there will be a $ .50 loss in the position. Setting the stock price at $27.50, we see that the Dec. 27.50 puts and the Dec. 30 calls are again worthless and with no debit or credit incurred, the positions profit or loss will come down to the gain or loss on the stock.

With the purchase price of the stock being $28.50 and the stock price at expiration $27.50, there will be a $1.00 loss. In this case, we have reached the maximum loss. No matter how low the stock goes, you can only incur a maximum loss of $1.00.

Now, let’s set the stock price at $26.00 and see if this holds true. With the stock at $26.00 on expiration, the Dec. 30 calls are out-of-the-money and worthless. The Dec. 27.5 puts, however, are in-the-money and now worth $1.50.

The stock you purchased for $28.50 is now worth $26.00 on expiration which is a $2.50 loss. Combining the $2.50 stock loss with the $1.50 gain in the puts and you have a $1.00 loss in the overall position.

This demonstrates that $1.00 is the maximum loss of the position. Keep in mind that if the stock position creates a debit or a credit, it must be added to, or subtracted from the stock loss.

Most of the time, there will be a small debit or credit incurred in the option position. It is relatively infrequent that the put and call used in the collar are trading at the exact same price.

Popularity: 18% [?]

Next Page →

Subscribe to Blog

• Enter Your Primary Email Address To Receive The Latest Market Commentary & Blog Updates Automatically:

• Search Blog

  
  




Inner Circle Membership

• 
  Click Here to Register For Your 30-Day Trial
  
  

Upcoming Technical Analysis Class



• 
  Technical Analysis Classes
  
  

Options Intensive Workshop



• 
  Option Intensive Workshop DVD's
  
  

Our Best Seller Software



• 
  
  

Options Trading 101




• Blogroll

  • Options University Strategist