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NOTES ON SPRINT (FON)
Covered Call

1. After a large drop at the end of Jan 2003, Sprint consolidates around $12.00 and trades in a relatively tight range, around $12.00, for approximately 5 months or until mid-May 2003. This period is the first opportunity for premium collection.

2. At the end of May 2003, Sprint trades up to the top of its trading range in a slow, methodical way, indicating a period of decreasing volatility

3. Sprint breaks out of old trading range by trading through resistance set by the 2 highs in February, around $13.25. It develops a new trading range at the $15.00 level by trading up in a slow, step like pattern which also indicates a period of decreasing volatility.

4. Sprint trades around the $15.50 range and really tightens up around October 2003 thru January 2004. This again, is a long period of decreasing volatility.

Conclusion: Sprint shows two favorable patterns here that are friendly to covered call writing. The first is that Sprint shows the tendency to trade in a tight range for extended periods of time, as seen in Feb. – May 2003 and Jul. – Dec. 2003. This is advantageous for premium collection.

The second is that when Sprint does move, it mostly trades up in a slow, directional type of move, as opposed to gapping (with the exception of Jan. 2003). These slow upward directional moves work well for covered call writers in two ways; capital appreciation and premium capturing.

NOTES ON DELL COMPUTER (DELL)
Covered Call

1. After dropping out of a higher trading range, Dell trades down throughout the months of December 2002, January 2003 and into mid-February 2003 before bottoming out. During this period of time, the drop was a low volatility, gradual one in which the stock loss could have been well offset by premium collection.

2. After rebounding off a low around $22.50 in mid February, Dell rebounded quickly to the $26.00 -$27.00 level where it consolidated until mid-March. The stock traded in a tight band until starting to trade up.

3. After the consolidating period, Dell began a slow, deliberate rise over the course of the next 9 months or so, with most months showing an overall trading range of $2.00 or less. The long, slow, step like growth pattern can be seen both in the daily trading ranges, as well as in the monthly trading ranges. This is very favorable to writing covered calls.

Conclusion: Dell spent the better portion of nine months trading up in a manner that is suggestive of decreasing volatility. Because the stock was in an up trend, and a gradual one at that, a buy-writer would have been able to profit from capital appreciation as well as a having a good chance at seeing a positive return in terms of the collection of premiums.

Furthermore, during Dell’s down cycle, the stock traded down slowly enough to be able to receive several months of premium. This should have, at least partially, offset enough of the loss to allow the trader time to profit from the subsequent recovery.

Today’stickers: BIDU, VIX, JWN, SII, F, GM, WMT, NRG, GSF, GOOG

BIDU – When Confucius said that a journey of a thousand miles starts with a single step, he didn’t know he was likely referring to the share price performance of Chinese Internet search-engine Baidu.com. Just one year ago the shares could be bought for less than $100 each and until today the march upwards has met with only a tiny degree of resistance. Shares traded at a record high this morning above $350. the company has been likened to Google, with the added boost that the company operates in China, where replication of just half of the success that Google has had, will lead to a phenomenal performance for Baidu. However, today’s revenue forecast reduction from a JP Morgan analyst sent shares into a tailspin quickly losing 10% of its value. The latest 65% EPS growth and all of the opportunity that the company promises in Asia has left the company sitting on a PE ratio of 156 times. JP Morgan only reduced its revenue forecast by 3.2% to $65.7 million but perhaps the episode serves to remind investors that Baidu revenues don’t compare to those of Google and that no matter how attractive Asian markets might appear, investors need to understand the size and profitability of the companies they are investing in. Today’s move weighed heavily across the market and turned a positive day into a key reversal with many markets reaching record heights before closing lower on this side of the Atlantic. This might upset the cozy applecart in the fourth quarter where investors were beginning to overlook the low bar set for minimal earnings growth.

The downgrade sparked heavy options trading on Baidu. There was heavy selling in the October call at the 350 strike, which was the most heavily traded series today. More than 700 calls traded to the bid at a premium of around 17.0. Earlier in the session, the same calls were traded at premiums in excess of 20.0 and during the fallout lost as much as 75% of their value trading at 4.5. In the November contract put buyers emerged on decent volume as low as the 280 strike indicating a fear that Baidu shares may fall further in coming sessions. Options implied volatility jumped 21% to stand at 91% late in the session as options traders were caught on the hop with the oversized reaction to the news. The historical movement on the share price is around half of today’s closing options volatility.

VIX futures surged late in the session as the stock market turned southwards reversing a triple-digit Dow industrials gain and turning into a 69 point loss. As such investors reached for portfolio insurance and bought VIX futures driving the index up from a loss on the day to a 13% gain to close at 18.94. Heavy volume was apparent in the November strikes at the 22.5 and 25 contracts where premiums rose by around one half this afternoon.

JWN – Bearer of bad retail tidings, department store chain Nordstrom cropped its Q3 profit forecast due to weak sales growth and stagnant inventories. Shares are currently trading 6.5% lower at $45.41, 12% below its average share price for the year to date. A look at today’s option action shows traders bearing little confidence that Nordstrom can pull off a substantial recovery even after the holiday shopping season. Some of the volume in the January contract looks like it may be deployed in call spreads, involving the purchase of the 45 calls, funded by the sale of the same month’s calls at the 50 strike. A look at the delta on the 45 calls shows option traders pricing in better than 50/50 chance of that strike being profitable by expiry. By comparison, the 50 strike has only about a one-in-three chance of landing safely in the money. To put Nordstrom’s current woes in perspective, last winter’s sales took Nordstrom shares within range of $60 – its standing 52-week high of $59.70 was set back on February 22.

GSF – Offshire oil driller GlobalSantaFe, which operates a fleet of 61 marine drilling rigs, is trading 2% higher today at $79.30, and the options market is rife with bullish speculation in the company. Options are trading at 28 times the average volume, with the 76,000 active contracts matching about a fifth of prior open option positions in Global Santa Fe. Today’s volume is split between the October 80 and November 85 calls, which have traded to buyers on sharply higher premiums, as traders wager on a move past the standing 52-week high of $80.34 by mid-November.

SII – Fellow oil services ticker Smith International, the producer of small hardware for the oil and gas exploratory and production sectors, is also revelling in a 1.5% gain in shares to $74.76. Options are moving at 10 times the normal level, with trading in calls and puts picking up sharply today, on no apparent news catalyst. The brisk buying in the October 80 and November 85 calls, implying continued upside tear in the next two months, is given particular gravitas when you consider that Smith’s prices have more than doubled in value this year. Today’s share price represents a fresh 52-week high. Implied volatility has remained mostly steady since late August.

F – Yesterday’s 6-hour walkout by Chrysler auto workers under the banner of the UAW was mercifully brief thanks to an accord that will create a union-run medical fund for Chrysler workers, but without the rub of future job guarantees like those wangled from talks frontunner GM. The agreement raised prospects that a strikeless settlement can be reached with tertiary target Ford, generally regarded as the weak link of the three auto makers – the one with the shallowest pockets for concessions and with the greatest potential damage effect from a strike. Ford shares responded buoyantly to the news, gaining 5.6% to $8.69. Volume appears clustered in the November and December contract, where traders wrote November 9.0 calls in fresh positioning, against the purchase of November 8.0 puts. The strategy was reversed in the December contract, where December 9.0 calls were bought against the sale of puts at the 7.0 strike level.

GM – Meanwhile, shares in Ford peer General Motors bounded to a two-year high today, up 5% to stand just above $40 after UAW members ratified the terms of its recent collective bargain agreement. Option traders put more than 308,000 contracts in play, plowing into the October 40 calls, which were heavily bought. The same strike in the November contract attracted buyers and sellers, as the price of the November 40 call doubled in price today. While overall open interest shows investors still defensively positioned in GM options, with puts outweighing calls by a factor of 1.8, today’s volume is an indication of some traders betting on a return of GM shares to 2004 levels.

WMT – This morning’s rise in September same-store sales and upscaling of Q3 earnings guidance were a welcome revelation to investors weary of sifting through the jumble-sale prospects of leading retailers. Just a couple of months ago the big-box chain was sounding the alarm over the pinched state of the American discount consumer. The news sent shares 3% higher to $47.00 today, with more than 102,000 option contracts in play. A look at options action shows traders less inclined to jump on the directional bandwagon and likelier to take profits. Twice as many calls are moving as puts today, with heavy selling in the November 47.50 calls, where premiums increased 100% overnight. The urge to close out call positions extended into the December contract at the 50 strike, where premiums are up 62% today.

NRG – Shares are currently 1.6% higher at $44.39, having been up as much as 4% early in the session, sending options traders on a quest for bull plays. With options trading at more than 5 and a half times the average volume, call buyers are plying into the 45 and 50 calls in the October, November and December contracts on sharply higher premiums. Implied volatility, at 40% and rising, also shows a keen elevation from the 25% historical reading. NSF reports earnings on October 29.

GOOG – The enchanted search engine continues to cast a spell over market bulls, but early gains have turned flat this afternoon, as the ticker trades at $624.04 this afternoon. Option players activated more than 211,000 contracts this afternoon, with a volume bias to calls. The upward trek was accompanied by implied volatility – which took a 12% leap this morning, 1 week ahead of earnings. Today’s activity is a call flurry in the front month contract at strikes of 620 to 650, with builds at the 750 strike seen in October and November after a fresh wave of punditry betting on Google “trigger-numbers” inthe $735-750 range.

Andrew Wilkinson Senior Market Analyst

Rebecca Engmann Darst Equity Options Analyst

NOTES OF J.P.MORGAN (JPM)
Covered Call

1. By June of 2003, JPM had traded up from a lower trading range in the $25.00 area to a new range around $35.00.

2. Since entering the new trading range in June, the stock has consolidated into a relatively flat, horizontal trading channel. For the most part, this channel is only around $3.00 to $4.00 wide.

3. This trading channel is not only tight, but it seems to be equally dispersed around the $35.00 mark. The stock does not seem to venture very far on either side of $35.00.

4. From the time that the stock enters the trading channel, the range of the channel has been decreasing or tightening, which indicates decreasing volatility.

Conclusion: JPM sets up a classic text book buy-write opportunity above. After finding a new trading range, the stock consolidates into a tight, trading channel that is almost horizontal. Further, this channel tightens and does not deviate from $35.00 to the point where it even comes close to a channel line violation.

Here, an investor would most likely be interested in writing the 35 strike price calls to collect premium as the stock trades sideways. Obviously, there is no way to predict how long a stock will consolidate like this, but the risks are low, and in this case – the covered call strategy would have returned some very nice, low risk returns over this period.

NOTES ON McDONALD’S (MCD)
Covered Call

1. Around June 2, 2003, MCD breaks out through a resistance level established back in late Nov. early Dec. 2002 after failing to break that resistance level in mid May 2003.

2. MCD climbs up from $20.00 to the $25.00 range in a slow gradual uptrend step like pattern. This type of pattern is an opportunity for buy-writers because this type of gradual rise normally brings about a decreasing implied volatility period which is great for premium selling.

3. Notice the size of the daily vertical lines during the period from mid-August 2003 to December 2003. The size of the lines represents the daily trading range of the stock. As you can see, the lines are very short which indicates that the stock does not move much intra-day. Again, this is an indication of decreasing volatility which is a positive sign for buy-writers.

Conclusion: The two most prominent and noticeable patterns both bode well for buy-writers. The covered call strategy does not need a lack of movement, as much as slow, consistent non-volatile movement.

So, in the case of McDonalds above, the slow trending movement of the stock brings about a decreasing volatility. Added to this is the contraction of intra-day movement, as shown by the decreasing range of daily trading.

These two factors each contribute to decreasing volatility and provide an opportune time to write a covered call. This is the type of pattern that offers both capital appreciation as well as premium returns.

Rolling is defined in options as moving a position from one strike to another either vertically in the same month, horizontally to another month or some combination thereof.

Other times, you may have to buy your short call back so that you will not lose your stock. Sometimes, you may even want to allow the stock to be called away if you have decided that the stock has reached a level were you want to take your profits and begin to look for another opportunity.

The term “roll” means to move your position either out to the next strike or to move your position up or down a strike in the same month. The term “roll” means “to move.”

Rolling is normally done via time spread and/or vertical spreads. Without getting into the trading of spreads, which is a unique strategy in itself and a topic for future Options University courses, we will talk a little about the “roll.”

As stated before, the covered call strategy is most effective when executed month in and month out over an extended period of time.

In order to do this, an investor must re-initiate the position every month at the option’s expiration. The re-initiation of the position every month is where the term rolling comes from. However, there may be times when you may want to give yourself a little more upside room for capital appreciation. In those rare cases, you will not want to “roll” the position, because it might be called away if the call you sold is exercised when it becomes ‘in the money.’

When an option’s expiration approaches, your short option can either be in-the-money or out-of-the-money. As we discuss the two potential outcomes, let’s first assume that we want to hold onto our stock.

If the option is going to finish out of the money, you would let it expire worthless and then sell the next month’s call. If the option is going to expire in-the-money and you want to keep the stock you will need to buy the short option back and sell the next month’s call.

This trade will consist of two option trades. You will be buying one option and selling another, which is commonly known as a spread and is referred to as a single trade.

So, when you roll out your covered call or buy-write, you do it by doing a spread. The front month option, the one that you happen to be short, will be bought back thus ensuring you keep your stock.

The second month option will be sold short thus re-initiating your covered call strategy. The position that remains is long stock and short calls. As far as the selection process of the spread used for the rolling of the position, there will be some choices.

Of course, there is no choice as to the front month option, you must buy back the option you are short. However, you do have a choice as to the next month option you are going to sell, whether it be near term or farther out in expiration.

This goes back to our earlier conversation about lean. If you are no longer bullish then you would not have bought back your short call and instead allowed it to be exercised and have the stock called away from you. If you choose to roll the position then you must be somewhat bullish on the stock. Your lean will dictate to you which new option to sell.

Well, there is an old axiom that says something like “a sane man who dwells in a society of the insane, will then appear insane himself”.  This paraphrasing is, I am sure, words that ring very true to market bears that find themselves scratching their heads after yet another decisive rally on Wall Street on Friday, based apparently on nothing but a tepidly favorable September employment report (does a few thousand extra service and government jobs signal an economy that is not ripe for a recession?).  However, relating once again to my previous quote, it is the crowd that moves markets, and sometimes being intrinsically “right” in a market that is “wrong” can make your portfolio become anemic with sound logic as the perpetrator.  There are many people with tremendous market savvy who have become broke based on their inability to abandon their own correct and sometimes precocious logic.

Having said that,  I personally cannot see much of a case for the health of a market where the basic prescribed key to rescue the economy is to cheapen the dollar, print more money and encourage Americans to purchase and consume things that they cannot afford that were bought from other countries that employ slave laborers.  I guess it’s easy to see that I am a little bearish on equities here.  I also would like someone to explain to me how it is now being proposed that these “strong employment numbers” that indicate  “healthy economy”  will now make the 50 basis point cuts that were basically priced in for the next two FOMC meetings now unnecessary.  Will that be bullish as well?  Not to mention the enormous draw downs by several large financial institutions, which was brought on by the still to be determined damage by the credit crisis and reckless loaning/borrowing.  In addition, we also must deal with the constant specter of outlandishly priced energy and commodities.

Earnings season is upon us, and with the expected aggregate numbers to be much lower than previously expected (according to the analysts), one would expect some warnings to be forthcoming.  The DOW did sell off quite significantly in the last hour of trading on Friday, which could be somewhat comforting for the bears.  However, after the close, previous month’s employment numbers were revised to show stronger data.  I guess someone saw what a few extra jobs in Sep. could do to the market and then decided that better numbers from the last two months could give us even more upside.

Technically, it is obvious that the markets are having a difficult time with these levels, and while I predicted last week that we would find the all time high imminently, I also said that I believe consolidation will occur for quite a while at these levels.  With the VIX down 1.53 for the week to close at 16.91, I feel fairly comfortable that will be the case.  That would mean a concentration on selling premium such as buy-writes, short iron condors/butterflies, long condors/butterflies, long time spreads, and vertical spreads with short at the money options.  I personally use a 3% false violation parameter when considering a move to be a violation of resistance, especially in the indices, and we are quite a way from there.  But still the question remains. Is bad news good or bad news bad?  Fighting the tape is a lonely place regardless.

Gregory Wolfe

The Options University

Professional traders use the term “lean” to refer to one’s perception about the directional strength of the stock. When you own a stock and intend to hold it for a period of time, you are aware that you will probably be holding it while it goes up and while it goes down.

This means that at any given moment in time, you might have a different opinion of the potential movement of that stock. Knowing this, there is a way to address your present level of confidence or “lean.” You do this by your choice of which option you sell.

While it is true that the at-the-money option has the most amount of extrinsic value, it might not always be the ideal option to sell in every situation.

For instance, if you feel that the stock itself has a very high chance of producing capital appreciation above the potential amount of premium you could receive from selling an at-the-money call, then sell an out-of-the-money-call so you can allow yourself a little more room to the upside on the stock.

For example, let’s say the stock is trading at $27.00. Normally, you would sell the 27.5 calls at say $1.00. If the stock were to rise quickly and eclipse the $28.50 mark, then with the buy-write strategy, your position would have maxed out at $28.50, and you would have a $1.50 one month gain. Not bad, but if the stock went to $29.50 then you would have missed out on another $1.00 profit. However, if we had sold the 30 calls for $.30 then we would have another outcome. You bought the stock at $27.00 and sold the 30 calls for $.30 and the stock goes to $29.50.

You would have made $2.50 in capital appreciation and $.30 in option premium for a total of a $2.80 return.

So, if you feel the stock has a real good shot at taking a run up, you can lean your position long by selling an out-of-the-money call.

If you have a more neutral view on your stock you would sell an at-the-money-call in order to receive a bigger premium which allows for greater downside protection if the stock trades down and higher potential profit if the stock becomes stagnant.

This strategy also works on the downside. If, by chance, you feel that the stock may trade down a bit during the life of the option, then you can sell an in-the-money-call. The effect of this would be to provide you with a little extra premium to cover more downside risk.

Remember when you sell an option you seek to capture extrinsic value. An in-the-money option not only has extrinsic value but also some intrinsic value.

When you feel that you want to lean your covered call strategy (buy-write) a little short, choose to sell an in-the-money call so you can also have some intrinsic value to cover your downside.

As an example, say your stock is trading at $29.00 and you feel that your stock may trade down a little but still remain in an uptrend cycle. You don’t want to get rid of the stock but you also don’t want to lose any money so you sell the 27.5 call at $2.00.

The stock starts to trade down and finishes at $26.00. If you had owned the stock naked, then you would have lost three dollars since you owned the stock at $29.00 and it closed at $26.00 on expiration.

However, because you sold the 27.5 calls at $2.00, you would only realize a $1.00 loss in the stock. The premium received will offset the loss due to the fact that you identified and adjusted for a likely move.

As you can see, the buy-write strategy can be altered to fit any directional view you have on your selected stock.

Finally, if you intend to use the buy-write strategy successfully, you generally need to sell the calls against your stock on a consistent, recurring interval, over a period of time.

This means that you will have to be prepared to “roll” your calls out to the next month come expiration. Sometimes, all you’ll need to do is to sell the next month out call.

The “stagnant” scenario

When we apply the covered call strategy to the stagnant stock scenario, we take a negative return scenario and turn it into a positive scenario. Remember, when we sell an option, we receive a premium for doing so.

When the stock does not move during the option’s life, the extrinsic value of the option goes to zero. The amount of money paid for the option goes to the seller. We’ll take a look at how this sets up.

Let’s go back to our previous example with the stock trading at exactly $9.50. We sell the front month, at-the-money call, which would be the 10 strike call. We sell the front month 10 strike calls at $.50. As time goes by, there is less chance for the option to become “in-the-money”. As this happens, the extrinsic value lessens and finally, after Friday expiration, the option is worthless.

The stock finishes at $10.00 and you have received no capital appreciation but you have received the full $.50 of extrinsic value from the option sale. If the studies are correct and selling the premium works 80% of the time, then you will collect approximately $4.00 per contract sold over the course of the year.

As the examples demonstrate, writing covered calls against a stagnant stock can provide you with an acceptable return instead of frustration, wasted time and capital.

The “down” scenario

In the final scenario, where your stock purchase is headed down into negative territory, the covered call strategy can help minimize your losses. Although picking losers and incurring losses is inescapable, it can be minimized and controlled. Let’s take a look at how the buy-write can help us do that.

For example, let’s say you bought a stock for $9.50 and at the end of the month the stock had traded down to $8.50, you would have a $1.00 loss on our investment.

However, if you had sold the 10 strike calls for $.50, you would only have a $.50 loss. You would have a $1.00 capital loss in the stock, but a $.50 option gain from selling the option, which would expire worthless.

If you were going to buy the stock anyway and incur a possible loss, it is better to take a $.50 loss than a $1.00 loss. In this down scenario, the option premium received helped to offset the capital loss.

If the stock is down more than the amount you received for selling the call, then the option premium serves as an offset to the loss of the stock.

However, you can still make money in the “down scenario” using the covered strategy if the stock is only down a small amount. There is a scenario in the buy-write strategy where you can profit from owning a stock that is lower than where you bought it.

Going back to the previous example, you bought a stock for $9.50 and you sold the front month 10 strike calls for $.50. At expiration, the stock finishes down $.20 at $9.30 You would have incurred a $.20 loss on your stock.

However, with the stock at $9.30, the 10 strike call that you sold for $.50 is now worthless. So, you have a $.20 loss on the stock and a $.50 gain from the option premium sold. This leaves you with a gain of $.30 on a stock that is down $.20 since the time you purchased it.

To recap: in our third scenario, the “down scenario,” your loss will be offset by the option premium you received so your loss will not be as severe. You still may incur a loss, but it will be minimized, and minimizing losses is a key to successful investing.

For a complete breakdown of these three scenarios, please refer to the table below.

In the “up” scenario, the maximum gain that can be attained is the stock finishing at $10.00 or higher.

At $10.00, you would profit from the full value of the extrinsic value of the option which is $.50 and you would also have $.50 of capital appreciation from the stock for a total of $1.00. This represents a 10.52% one-month return or an annualized return of 126.32%.

It is not realistic to expect this type of return every month but remember, recent studies show that premium selling works approximately 80% of the time, which is still very good.

We stated earlier that the maximum return of this buy-write will be actualized when the stock reaches $10.00 or above and the maximum return will be $1.00, and no more than $1.00. As the stock goes higher, the option will earn less in direct proportion with the increase in capital appreciation.

For example, if the stock closes at $10.30 you would receive only $.20 from the option. The option would now be worth $.30 because with the stock at $10.30, the 10 strike call would have $.30 of intrinsic value.

Since you sold the option at $.50, you would see a $.20 profit ($.50 – $.30 = $.20). Since you bought the stock at $9.50 and it is now $10.30 you have $.80 of capital appreciation. Combine the two and you have a $1.00 profit.

Let’s look at what happens when the stock trades up to $12.00 and see if you again have a $1.00 return on the position. At $12.00, the option will have $2.00 of intrinsic value (stock price – strike price) because it is in the money.

You sold the option at $.50 so you have a $1.50 loss. However, you bought the stock for $9.50 therefore you have a $2.50 capital gain. Combined, you have a $1.00 profit.

In a third example, if the stock trades up as little at $.10 you still have a $.60 gain. You will receive $.50 from the sale of the call which would expire out of the money thus worthless plus $.10 of capital appreciation. $.60 represents a 6.3% one month return.

Please refer to the chart below for examples of total dollar profits per number of contracts, remembering that each contract controls 100 shares of stock.

Observe that if the stock closes over $10.00, then your stock will be called away because your short calls will be exercised. This is correct but we will talk about position management later. For now, let’s get back to our three scenarios.

In the “up” scenario, you would profit with the buy-write when the stock is up as little as a penny, but you are also limited on our maximum profit.

You are limited on your maximum profit as defined by the formula below:

Maximum Profit = Strike Price + Option Price – Stock Price.

This method of calculation will work every time. As you see, the buy-write has a positive but limited upside potential.

 

 

Time decay, also known as theta, is defined as the rate by which an option’s value erodes into expiration. The value of the option over parity to the stock is called extrinsic value.

Since an option is a depreciating asset, meaning it has a limited life, the extrinsic value in the option will wither away daily until expiration. This “decay” is not a linear function meaning it is not equally distributed between all of the days to expiration.

As the option gets closer to expiration, the daily rate of decay increases and continues to increase daily until expiration of the option. At expiration, all options in the expiration month, calls and puts, in-the-money and out-of-the-money must be completely devoid of extrinsic value as noted in the time value decay charts below.

As more time goes by, the options extrinsic value decreases. Again, it is important to note that the rate of this decrease is not linear, meaning not smooth and even throughout the life of the option contract. An option contract starts feeling the decay curve increasing when the option has about 45 days to expiration. It increases rapidly again at about 30 days out and really starts losing its value in the last two weeks before expiration.

This is like a boulder rolling down a hill. The further it goes down the hill, the more steam it picks up until the hill ends.

By selling the option and owning the stock, the covered call seller captures the extrinsic value in the option by holding the short call until expiration.

As mentioned earlier, an option’s loss of extrinsic value over its life is called time decay. In the covered call strategy the option’s time decay works to the seller’s advantage in that the more that time goes by, the more the extrinsic value decreases.

Key Point – The covered call strategy provides the investor with another opportunity to gain income from a long stock position. The strategy not only produces gains when the stock trades up, but also provides above average gains in a stagnant period, while offsetting losses when the stock declines in price.

We have now seen how a covered call strategy is constructed and how it is supposed to work. Keep in mind that the trade can be entered into in two ways. You can either sell calls against stock you already own (Covered Call) or you can buy stock and sell calls against them at the same time (Buy Write).

Example 1

You own 1000 shares of Oracle at $9.50.

The stock has been stuck around this level for a long time now and you have grown impatient. You finally give in and sell the front month (November for example) at-the-money calls. The at-the-money calls would have a strike price of $10 if the stock was trading at $9.50.

You sell the calls at a $.50 premium per contract which creates a $10.50 breakeven point. Remember, in a buy-write, the breakeven point is the strike price plus the option premium. Let’s look at what our returns will be in each of the three scenarios.

 

 

For better or worse, most investors purchase stocks with the intent of holding their shares for an extended period of time.

We do this mainly because the media and industry professionals have drilled into our heads, year after year, time after time, that it’s best to buy and hold. The recent bull market phenomenon also fueled this mindset because the ‘buy and hold’ strategy worked extremely well – for a while.

Whether or the not the ‘buy and hold’ strategy is still the most efficient way of investing remains a topic for discussion. However, it is still the strategy that most investors are comfortable with and tend to follow.

The first strategy we will discuss is a hybrid of the buy and hold strategy, one that provides for better and more consistent returns a large majority of the time when compared to naked stock ownership alone.

When we buy a stock, there are three possible outcomes. As we discussed previously, two of these scenarios are generally negative and only one outcome is generally positive. If the stock goes up, that is good. If the stock goes down, that is bad. And if the stock stays still, that is also a bad outcome.

To briefly recap, not only do you have a loss in opportunity cost (the money invested in your stagnant stock could be making you money if somewhere else) but also, you have incurred commission costs on both the way in and way out. So, in this case, only one of the three scenarios provides a positive return.

For the sake of description, we will identify the three potential scenarios as the “up” scenario, the “down” scenario and the “stagnant” scenario. By employing the covered call or “buy-write” strategy, you can change the outcome of the scenario profile so you have two positive potential results instead of only one.

Employing the covered call or “buy-write,” we still have the “up” scenario as a positive result, but now the “stagnant” scenario will also produce a positive result since we collect a premium and the third scenario, the “down” scenario will not be as negative.

Thanks to the covered call strategy, now two of three scenarios end in a positive result and the third has a result that is less negative.

Let’s take a closer look at the covered call strategy and its construction. There are two components of the covered call strategy, the stock component and the option component.

The stock component consists of a long stock position (you own stock). The option component consists of selling one call per every one-hundred shares of stock owned.

Remember, one option contract is worth one hundred shares of stock. So for example, 1000 shares of stock equals 10 call contracts or 200 shares equals 2 call contracts.

The chart below shows more examples of the proper construction of buy-writes.

Please take special note that the ratio of stock to calls must be exactly 100 shares to 1 option contract.

Number of Shares Owned	Call Contracts to Sell
100	1
300	3
1700	17
9200	92
14500	145
267000	2670

The philosophy behind the covered call strategy is not complicated. It entails using a long stock position along with a short call option to create a positive stream of additional income, much in the same way a person would purchase a house and then lease it out to collect rent in order to pay for the mortgage.

Another analogy is that of the insurance company. An insurance company receives premiums month in and month out. Over a period of time, this constant stream of income easily builds to a point where it outweighs any pay out the insurance company may face, even for catastrophic events.

The constant and reoccurring collection of option premiums works better if done over longer periods of time (for example, one year.) That time frame allows the odds to play into your favor.

Now let’s talk about the odds. There have been several studies done on the topic of premium buying versus premium selling. The goal of the studies was to determine whether it is better to buy options or sell options.

Recent studies have found that selling the premium was the correct trade 78% to 83% of the time. That is a very high percentage and is worth taking advantage of when a good opportunity presents itself.

The covered call strategy takes advantage of the fact that an option is a depreciating asset because its extrinsic value goes to zero at expiration. The process by which an option’s extrinsic value dissipates is called time decay.

 

 

An at-the-money option has both advantages and disadvantages over stock and in-the-money options. First, the at-the-money option will be cheaper then both the stock and the in-the-money option. So there is less capital requirement and less total risk.

Remember, when buying an option, you can only lose what you spend. The problem is the amount of extrinsic in the at-the-money option.

In order for you to profit from buying an at-the-money option, you need the stock to make a move very quickly. Because you have so much extrinsic value, you will be battling against the option’s daily rate of decay.

So, the movement of the stock must happen quickly enough and large enough to offset the amount of money you will be losing daily as expiration draws near.

With this said, the best chance you have to make money when buying a naked at-the-money option is to use it as a short term trade. The longer you hold onto this option, the harder it is for you to be profitable due to the options decaying extrinsic value.

At The Money Call vs. In The Money Call

For chart below, stock price = $35.00

Strike Price	Option Price	Delta	Breakeven	Extrinsic Value
$30	5.20	85	35.20	$.20
$35	1.00	52	36.00	$1.00
$40	.30	20	40.30	$.30

An out-of-the-money option presents many of the same advantage & disadvantage parameters to the investor. The out-of-the-money option is even cheaper then the at-the-money option which means more leverage and less risk.

However, with a smaller delta, the stock must move much more than either the in or at-the-money options in order for the options to become profitable. Again, we need the option’s delta to outpace the option’s rate of decay.

Now, with the out-of-the-money option, there is less extrinsic value than the at-the-money option so the amount of total possible decay (cost of the option) and the rate of this decay is less than the at-the-money option.

By being further out-of-the-money, this option needs more movement from the stock. As a naked option, this out-or-the-money example is extremely speculative and should only be used naked when the investor feels there is a very good chance of a stock having a large percentage move.

An investor must understand that the odds of them profiting from the purchase of a naked out-of-the-money option is very slim. When purchasing a naked out-of-the-money option, be prepared to lose your entire investment.

Out of The Money Call vs. At The Money Call

For chart below, stock price = $35.00

Strike Price	Option Price	Delta	Breakeven	Extrinsic Value
$30	5.20	85	35.20	$.20
$35	1.00	52	36.00	$1.00
$40	.30	20	40.30	$.30

Although options can be traded by themselves for directional plays, and can perform well under the right conditions, they are much better used in coordination with stock or other options in formatted strategies which will be discussed in the next section.

While buying naked calls and puts can provide some of the biggest leverage and highest returns, they can also involve the most risk. This strategy should only be used by experienced options traders or traders using risk capital.

 

 

Today’s tickers: SLM, WAG, GRMN, RIO, FCX, NEM, AA, MFE, PDLI, CREE & CBH

SLM – News today that an investment consortium led by J.C. Flowers and including Bank of America and JP Morgan Chase would offer $50 per share for Sallie Mae (SLM) in combination with warrants for outstanding shares, sent the company’s fortunes up .34% this afternoon to $50.07. A post-deal analysis in the Wall Street Journal noted that these warrants – pending Sallie Mae’s business performance going forward – could be worth up to $10 per share, creating the impression that J.C. Flowers’ original $60-per-share offer (a price from which the buyers balked last week) is still nominally intact. Option traders put more than 132,000 Sallie Mae options in play, with calls and puts trading at near parity – but virtually no one staking bets on that elusive $60 mark. The October 50 strike appeared to be the watermark for today’s activity. The 30,000 lot-volume in the October 50 calls looks to have been generated by sellers, unloading for $2.40 positions that were bought at prices of $1.20-1.85 last week. Puts at the same strike in the October contract traded to buyers and sellers. We also noted heavy liquidity in the November 50 calls, which traded 13,600 times – open interest having tripled at this strike over the past week. Implied volatility has continued its decline, since topping out at 67% last Thursday, and now rests at 33%.

HSY – Shares in Hershey, the country’s biggest candy maker, were unsettled by this morning’s news of the departure at year’s end of CEO Richard Lenny, due to reported wrangling with the majority shareholding Hershey Trust over the company’s strategic direction. Implied volatility ticked up to 26% as a trader took the opportunity to enter a 9,000 position in the January 40/50 strangle. The position, which costs $1.20 to enter, supposes a break outside the range of the strike prices above $51.20 or below $38.80 in the wake of Lenny’s departure. Hershey’s share price has shown a mostly steady decline for the past 6 months since peaking at $56.75 in early April – the reigning 52-week high. The current share price is hovering just about $2 above the 52-week low set in August. Hershey’s shares were trading as high as the $60 mark in October 2005, but hasn’t touched those levels since.

GRMN – GPS-technology maker (GRMN) continues to captivate option traders’ attention in the wake of Nokia’s contentious bid for Navteq yesterday. Shares are extending the downtrend from yesterday, down 7% to $99.80, with 116,770 options – the rough equivalent of 42% of its open interest – in play. It appears that the October 100 calls are the pivot point for extensive volatility positioning in the October contract, some of this possibly tied up in the 100 straddle, a position which costs more than 10% of today’s share price to buy – or with strangles involving the 95 puts. Activity in the November contracts seems to show traders favoring a sale of calls at strikes 105 and 100.

WAG – Shares in Walgreen’s (WAG) tacked on another .40% loss today to stand at $40.00 – slightly off a new 52-week low set earlier today – while options remain a favorite target for option traders. The 87,760 options in play this afternoon reflect traders waging bets on the at-the-money front-month straddle, which has traded on comparable volume to buyers and sellers today.

There was a strong overnight performance for Asian equities with more stories surfacing that the $200 billion Chinese investment fund would buy Chinese stocks listed in Hong Kong. Local stocks rose by more than 3%. Elsewhere around the globe new record highs are being set by the day as investors buy the story that growth outside of the U.S. continues to steal the limelight from the overused terms of “subprime and credit concerns.” In Monday the price of gold (the anti-dollar) rose close to a 28-year high as the value of the dollar slumped to a secular low. The dollar boost was exacerbated following comments from European central bank members who noted the potential damage to the fragile domestic economy from a swift rise in the value of the euro.

But Tuesday is a different day. Investors in the local market are watching to see what reaction Monday’s convincing penetration of index highs will bring. So far some light profit taking is the order of the day. Meanwhile the dollar has bounced hard against the euro currency and its trade weighted value as measured by the NYBOT’s dollar index contract has risen by 0.5%. Broadly speaking that move is bad for commodities – we note that gold has shed 2.5% today to $728.50 per ounce in the October contract. Meanwhile, shares at several mining companies are facing selling pressures.

RIO – Cia Vale do Rio Doce saw its share price slide 2% to $35.35. It’s on days like this that options traders put a brave foot forward and take the opportunity to place bullish trades. The call/put ratio at 1.6 indicates one third more call activity than across the put complex. The bulk of Tuesday’s activity stood at the October 35 line where nearly 14,000 contracts changed hands reserving the right to buy shares at that price ahead of expiration in two weeks time. At a premium of 1.95 shares would need to break above $36.95 for option buyers to be profitable. The likelihood of these calls landing in the money according to the delta on the calls is three-in-four.

FCX – Freeport McMoRan shares fell in line with the rally in the dollar losing 2% to stand at $109.15. Again call buyers were out in force on the price decline and buyers of the November calls at the 105 strike took advantage of lower premium prices as they bought 2,900 lots. The October straddle at the 110 strike gives a good reading of implied volatility on the options. Today that straddle – the combined cost of a call and a put is 9.25 generating a share price range of between $101.25 and $119.25 over the coming couple of weeks. Actual implied volatility stands at 48%, which is in line with the historic reading of volatility on the underlying shares.

NEM – Newmont Mining Corp. saw its share price lose 2% to stand at $45.14 today, but unlike above, put buyers seemed to arrive on the scene. Implied volatility on the options at 33% shows that options players aren’t overly concerned by today’s push lower. In Monday’s session it appears that fresh positioning of 3,000 puts at the March 45 strike took place. Today it was the turn of the January series where 11,000 puts at the same 45 strike traded at 2.95. Such puts would protect a long investor in Newmont against share price declines below $42.05. Still the bulls wouldn’t be deterred and added call spreads in the October contract as they bought the 47 strike for 0.40 and sold the 50 calls for 0.10. At a net premium of 0.30 it’s a cheap play on a big rebound on the gold price, which investors would hope filters through dramatically to boost the fortunes at Newmont.

AA – Alcoa Inc. We noted some bull call positioning in Alcoa shares today even though its share price declined .77% to $38.85. In the January 47.5 contract some 2,200 calls were bought at 0.85 indicating that investors see a bounce ahead for the stock. In the April 40 puts a seller sold around 6,700 lots at around 4.4. That would indicate that they see shares moving higher. Don’t forget that Alcoa was left jilted at the altar when Rio Tinto stole the Canadian bride-to-be away from Alcan. Additional positioning in April calls at the same strike confirm the bullish profile. The logic seems to be that if commodity prices and demand both remain firm, there is no reason that the fortunes for Alcoa are as bad as was suggested by the share price decline following the failure to acquire its Canadian rival. Shares fell from close to $50 to almost $30 in the aftermath and the past few days performance suggests a revival is imminent.

MFE – The revival and swift propagation of M&A rumors suggesting a possible tie-up with Dell (DELL), coming one day after a major product announcement, has led to a rabid level of interest in options in tech security giant McAfee (MFE – $36.84). Implied volatility rose more than 18% on the session to stand at 43.11%, as options traded at 28 times the average rate. Of note was heavy buying in the October 40 calls, which were snatched up at $0.40 apiece. We also observed heavy liquidity in the November 40 calls. Traffic in each of these strikes appeared to be fresh positioning – i.e., not the closing out of previously open positions. McAfee shares have shown a gradual but consistent incline over the past year, up 48.5% during the past year, handily outperforming the S&P Midcap Index, of which the company is a component. Yesterday McAfee formally announced that it was first-to-market in unveiling an industry standard “triple play” security offering on the IT market, providing protection for consumer PC, web and mobile phones.

PDLI – Following yesterday’s executive announcement that PDL Pharmaceuticals (PDLI) – maker of drugs for hypertension, acute myocardial infection and leukemia – will seek to sell the entire company, option traders rejoindered in the affirmative… and in trend with a near-9% gain for shares to $23.28. Traders today put more than 56,000 contracts in action – matching about 20% of its total open interest, and 5 times the normal level. Today’s volume was skewed to the calls, where three-figure percentage increases in call premiums were indicative of much of the action. Volume appeared heaviest at strikes 22.50 in the October and November contracts, while volume of 1,000 lots has gone through in the October 25 calls and the November calls. Traders here appear to be positioning for a test of the previous 52-week high of $27.98. Meanwhile, implied volatility in PDL shares surged about 18% to 49% – still below the 69% volatility that its shares have shown historically.

CREE – Options activity in North Carolina-based semiconductor maker Cree Corp (CREE) piqued our volume scanners today, with nearly 26,000 contracts in play against a 2% gain for shares to $32.72. The stock has been the subject of previous takeover scuttle, but as yet all the talk has failed to give form to the fog. Earlier today we observed heavy liquidity on either side of the October 30 and 35 strikes, with premiums favoring the call side. The calls, it seems, sold to the bid, while the puts traded to the middle of the market. Note here that the price of the October 35 straddle is $4.25 – 12% of the share price, and indicative of a traditionally volatile stock. While option traders are factoring in 60% volatility, Cree is a stock that has shown more than a 57% degree of fluctuation historically. And as for the October 35 call strike – delta on this call shows option traders pricing in about a 40% chance that this strike will land in the money, placing Cree on the perch of a new 52-week high, by October expiry.

CBH – Following this morning’s news of a buyout by Canada’s TD Bank Financial Group – options in Jersey-based Commerce Bancorp (CBH) picked up to twice the average clip, as shares traded flat-to-lower at $39.47. The 20,000 contracts in play matched more than 10% of Commerce Bank’s prior open interest. Today’s volume appeared hemmed in the front month, where traders may have sought to avail themselves of a 50% overnight drop in implied volatility by selling the October 37.50/40 strangle. This same sharp retreat in implied volatility made short order of yesterday’s build in open interest in the October 42.50 calls. Possibly acting on a rumor on the eve of TD’s bid, traders sent open interest on the October 42.50 from a meager 735 contracts to nearly 4,370 at closing bell, with contracts commanding $0.55 apiece. After TD’s $42-per-share bid, those $42.50 calls plummeted in value to only about a dime apiece, and traders may have closed those positions out this morning. This is also a hint that the market believes Commerce Bank’s shares are fairly valued by TD, owing to the anticipated dilution in earnings following the deal.

Andrew Wilkinson Senior Market Analyst

Rebecca Engmann Darst Equity Options Analyst

A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right but not the obligation to sell a specified stock or other underlying instrument at a specified price by a specified date.

The seller of a put option assumes the obligation of taking delivery of the stock or other underlying instrument from the buyer should the buyer wish to exercise his option. The put is known as a short instrument which means that the buyer profits from the stock going down.

For the seller to profit, the stock must not move below the strike price plus the amount of money received for the sale of the option. This point is known as the breakeven point and is calculated by adding the call’s strike price to the option’s premium. Obviously, the buyer hopes that the stock price exceeds the breakeven point.

For example, you buy the MSFT January 65 put for $2.00 because you think Microsoft is going to go down. This option gives you the right, but not the obligation to sell the stock at $65.00. In order to obtain this right, you had to spend $2.00. In order for you to make money, the stock would have to trade down below $63.00 by expiration.

This is because the stock has to trade down below the strike plus the cost of the option. If the stock traded down to $60.00, you would make $5.00 because you have the right to sell it at $65.00. However, because you paid $2.00 for the put, you must subtract that from your $5.00 profit for a total profit of $3.00. You have just made $3.00 on a $2.00 investment. Not a bad return.

The buyer of the put has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the put. His unlimited potential gain comes from the stocks unlimited downside potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the put. The unlimited risk comes from the stock price’s ability to decline during the life of the contract.

For example, if a seller sold the MSFT January 65 put for $2.00, he is giving the buyer the right to sell 100 shares (per contract) of MSFT to him at $65.00 per share at any time until the option expires.

If MSFT declines and trades down to $55.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00), for a net loss of $8.00. Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00), for a net gain of $8.00 per contract.

If MSFT were to trade up to $75.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). The seller is obligated to take delivery of the stock from the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale.

Again, the following graphs are called parity graphs. They are intended to show you your option’s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a put purchase and the second shows a put sale. The graphs show the amount of
your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven.

Using the fictitious stock XYZ below, make note of where the stock needs to be at expiration in order for you to be profitable, and how the premium paid (in the case of a purchase) or the premium received (in the case of a sale) affects your profitability.

Also notice the difference in the profit potential between a purchase of the option as opposed to a sale of the option. Lastly, it is important to note the unlimited potential risk inherent in the sale of an option, compared to the fixed risk of an option purchase.

An option is a derivative trading product that is best used by investors as a hedging tool providing profit protection and profit enhancement. Although it is a powerful risk management tool, it can also be used effectively as a stand-alone trading vehicle.

Under the proper conditions, options do not have to be paired with stock or another option to be an effective trading tool. To successfully trade naked options, an investor must realize that certain options will fit certain scenarios and certain options will not.

One of the major misconceptions that investors have about options stems from the fact that most do not know how to trade them properly. When they lose money trading them, they feel that there is something wrong with the option. They do not understand that options are on a higher, more sophisticated level when compared to stocks.

Stock trading has fewer variables involved and is therefore easier. No one is saying that the individual investor isn’t smart enough to trade options. The problem is not intelligence; it’s just education and experience. Most investors have not been properly educated in the proper use of options, and even fewer have had any real experience trading them.

One of the biggest problems investors have is this: Even if you buy a call and the stock goes up, you can still lose money. Most investors tend to buy out of the money options at a cheap price. The stock trades up a little, which is the right direction, but the option still loses money and the investor wonders why.

What the investor fails to realize is that in order for the option to be profitable the options delta must out-pace its rate of decay. Implied volatility also plays a key role if the stock does trade up while implied volatility decreases, the options delta must then outperform the decrease in volatility. Remember, when volatility increases, the price of all options goes up. When volatility decreases, the price of all options goes down.

We have categorized options in several ways. One way is by the option’s strike price, and its distance from the stock price. We identified these options as either in-the-money, at-the-money, or out-of-the-money.

In our discussion about trading naked calls and puts, we will identify trading opportunities or situations that fit each of these types of options, for both calls and puts. But it is important to first review the definition of Delta before continuing.

Remember, delta tells you how much the option will move with a similar move in the stock and is given as a percentage. For example, a 33 delta option means that the option will move 33% of the movement of the stock and 70 delta option will move 70%. In-the-money options act like stock. The deeper in the money the calls are, the more they act like the stock. As the call moves deeper and deeper in the money, the calls delta approaches 100 which means it’s price movement will reflect 100% of the stock’s movement. (This is discussed in more detail later in “The Stock Replacement Covered Call Strategy”).

In fact, deep-in-the-money options are sometimes even used to replace stock positions. If you look at the charts below, you can see how closely the in-the-money call mimics the upward movement of the stock (2nd quadrant).

In the money options are best used for smaller stock movements. The reason is that in-the-money options contain less extrinsic value. The extrinsic value can work against you when purchasing an option because extrinsic value is affected by time decay.

As you wait for your stock movement, the in-the-money option will decay less than either the at-the-money or out-of-the-money options because it has less extrinsic value. The amount of money you lose in time decay must then be made back by additional stock movement.

Obviously, the less you lose in decay, the less the stock has to move for you to be profitable because it has less decay loss to make up for.

This is because an in-the-money call has a high delta and a much higher percentage chance of finishing in-the-money by expiration so they follow the stock more closely.

With less extrinsic value loss to make up for, a smaller movement in the stock will produce a greater profit. For a call example, as you can see in the chart below, the in-the-money produces a profit with the least amount of stock movement. With less extrinsic value, the ITM option has a lower break-even point.

For chart below, stock price = $35.00

Strike Price	Option Price	Delta	Breakeven	Extrinsic Value
$30	5.20	85	35.20	$.20
$35	1.00	52	36.00	$1.00
$40	.30	20	40.30	$.30

 

Today’s tickers: HLF, CVS, AKS, GRMN, WAG, C, RIO, NVT & EWH

WAG – Walgreens share price took a smack on the chin despite a bullish start to the week. The near-15% slump in its shares created a fertile battleground for options traders thanks to the presence of liquidity and volatility. The company announced a 4% decline in quarterly profits thanks to a nasty combination of rising wage costs, store expenses and lower reimbursements for generic drugs. That potent potion is precisely why the stock is being punished today. None of the inputs are necessarily one off problems for the quarter and looking forward investors will need to see precisely what strategic shifts management makes to address the concerns.

Around 135,600 options contracts were in circulation Monday or put in an alternative context that’s about 67% of the overall open interest in the options series. Implied volatility surged by around one-third as uncertainty returned to the direction for the stock. Volatility jumped to 27.5%. Shares in Walgreens, which haven’t traded below $43 this year, fell to $40.31 – a 52-week low. October call options prices slumped with calls at the 40 strike losing 83% of its value to 1.25. On the other side of the coin put values surged. The October 42.5 calls for example, having settled at just a nickel on Friday, were actively traded at prices as high as $2.80 today.

It does appear that some investors are betting on steeper declines looking forward or simply betting that this might need a stronger prescription from management. There seems to have been a heavy amount of call option selling in the January 40 calls, where several blocks of 500 contracts were sold to the bid. Premiums slipped from 3.5 to 2.5 during the morning on volume of 11,650 lots.

CVS – Arch-rival CVS/Caremark came out shortly after the Walgreens release to reiterate its profit guidance for the year, but that didn’t stop a 6% pummeling-by-proxy for its shares on the market. With 95,000-plus option contracts trading this afternoon, we observed what may have been call holders looking to unload positions at the November 40 strike as premiums eroded, with volume at the 37.50 strike trading to buyers and sellers. Given the comparably heavy volume, and distribution of buyers and sellers, on the other side of that strike on the puts, it seems conceivable that today’s play is the at-the-money November straddle. A buyer of this strike pays the $2.75 premium in the belief that – whether CVS/Caremark’s profit guidance stocks – its shares are set for tumult in the coming weeks. A seller would take comfort in last week’s bank upgrade, and the fact that shares are still within 5% of a 52-week high, and play against short-term sniffles for the stock, pocketing the premium for good measure.

HLF –Options activity in nutritional supplement maker Herbalife ticked our volume scanners today as shares settled on a new 52-week high of $45.74. But despite short term bull momentum for the stock, it appears that skittish option traders holding Herbalife stock may have sought to hedge their bets on the mid-term outlook by playing the November collar. This would have involved buying the 40 puts at today’s premium of $1.05 against the sale of calls at the November 50 strike at $0.90 apiece in hopes of protecting against a sudden drop in share price below the $39.85 mark by November’s expiry. Overall open interest in Herbalife shows a surprising balance of outstanding puts and calls, with puts narrowly outnumbering calls by a factor of 1.1. Significantly, much of this build in puts accumulated during the month of September.

C – Citigroup Inc. shares reacted positively to its forewarning of a 60% dip in quarterly profits earlier today and losses incurred to its exposure to subprime debt. Investors seem to have taken the confession with a huge sigh of relief and bought stock, perhaps in the hope that this is the bloodletting that people have demanded to see. Shares have recently held at the $45 support line. Implied volatility came off while put premiums at the 45 line sank by around one half. Shares in the bank gained 2.2% to stand at $47.70. The December calls at the 50 strike reflected optimism by investors as premium rose by one-third to 1.0. Shares slipped below $50 in late July and haven’t recovered since. The 50 line was the most active call line in today’s trade. In the March contract it looks as though a couple of thousand puts at the 42.5 line may have been sold against call purchases at the 50 and 55 lines.

RIO – Cia Vale do Rio Doce – Commodity companies shares remained an investor favorite given the solid case afforded to them by the combination of a weakening dollar and strong commodity demand. Shares in Brazilian copper miner Vale rallied 6.5% Monday to stand at $36.15. Premiums at the October 35 and 37.5 calls jumped by around one half on heavy volume. Strongest volume occurred at the January 32.5 strike in the put side where some 13,500 contracts traded. As the stock rallied premiums came off, but this looks more like put selling rather than buying indicating continued conviction in a rally in shares.

AKS – AK Steel Holdings piqued our volume scanners today with nearly 127,000 active contracts against open interest of just about 335,000. Interested by the modest, half-percent gain in shares to $44.88, it appears that a trader closed out a position involving 24,000 lots in the October 35 puts in favor of new positioning in the November 40 puts, which traded on inflated premiums of around $1.90. AK Steel is due to report Q3 earnings on October 23.

NVT – Navteq Corp. Options activity at nearly 60,000 comprised exceeded the previous overall options open interest. Despite news that handset maker Nokia would buy the navigation software maker, shares took a 2% shave in early trading and sustained the loss this afternoon. The deal agreement sent implied volatility sharper lower and undermined any bullish positioning in the call options. For example, October calls at the 80 strike trading at 0.40 lost 85% of their value today.

GRMN – While news of Nokia’s acquisition was – somewhat counter-intuitively – bad news for Navtech’s share price, it was even worse for Navtech crosstown rival Garmin Ltd., whose shares swan-dived 10% to $107.25. Implied volatility shot up to 60%, having remained stable at 50% for much of September – a phenomenon that has borne out in put-side premiums today. Today’s 116,000 active option contracts show volume actively dispersed throughout the October contract, particularly concentrated between strikes 110 and 115 in both calls and puts. This is a strong hint of traders looking to position for continued volatility in Garmin share prices in the coming weeks. An interesting note about those October 100 calls, which traded 10,000 times today at prices around $9.80 – the going price for this contract last Thursday was $21.80. Ouch!

EWH – iShares MSCI Hong Kong – Shares jumped 1.8% today to rise to $21.42. Options activity was a robust 44,600 contracts – equivalent to around one-half of current open interest on the shares. The December 18 and 20 calls have traded on volume of 20,000 contracts each on prices of 0.30 and 0.75. It could be that as shares have ratcheted higher, an investor has rolled up the strike to remain closer to the current share price. Shares have been on a tear over the last six weeks adding around one third as the Pacific rim continues toshow economic strength.

Andrew Wilkinson Senior Market Analyst

Rebecca Engmann Darst Equity Options Analyst

Parity – When we discuss parity in terms of options, we say that parity is the amount by which an option is in the money. Parity refers to the option trading in unison with the stock. This also means that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the
option’s premium consists of only its intrinsic value.

For example, if Microsoft was trading at $53.00 and the January 50 calls were trading at $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00

Now if these calls were trading for more than parity, the amount (in dollars) over parity is called ‘premium over parity.’ Thus, the term ‘premium over parity’ is synonymous with extrinsic value, which was discussed above.

If the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 represents the premium over parity that is also the amount of extrinsic value. The $3.00 is the amount of intrinsic value or parity.

The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract.

This concept can be illustrated by the charts below.

Volatility is defined as the degree to which the price of a stock or other underlying instrument tends to move or fluctuate over a period of time.

Implied Volatility is a value derived from the option’s price.  It indicated what the market’s perception of the volatility of the stock or underlying will be during the future life of the contract.

A stock that has a wide trading range (moved around a lot) is said to have a high volatility. A stock that has a narrow trading range (does not move around much) is said to have a low volatility.

The importance of volatility is that it has the single biggest effect of the amount of extrinsic value in an option’s price. When volatility goes up (increases), the extrinsic value of both the calls and the puts increase. This makes all the option prices more expensive. When volatility goes down (decreases), the extrinsic value of both the calls and the puts decrease. This makes all of the option prices less expensive.

As stated earlier, a call option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right, but not the obligation, to purchase a specified stock or other underlying instrument, at a predetermined price on or prior to a specified date.

The seller of a call option assumes the obligation of delivering the stock or other underlying instrument to the buyer should the buyer wish to exercise his option.

The call is known as a long instrument, which means the buyer profits from the stock going up, and the seller hopes the stock goes down or remains the same. For the buyer to profit, the stock must move above the strike price plus the amount of money spent to purchase the option.

This point is known as the breakeven point and is calculated by adding the strike price of the call to its premium. While the buyer hopes the stock price exceeds this point, the seller hopes that the stock stays below the breakeven point.

The buyer of the call has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the call. His unlimited potential gain comes from the stock’s upside growth potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the call. His unlimited risk comes from the stock price’s ability to rise during the life of the contract.

The seller is responsible for delivering the stock to the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale.  It is compensation for taking on this risk.

For example, if a seller sold the MSFT January 65 call for $2.00, he is giving the buyer the right to buy 100 shares (per contract) of MSFT from him for $65.00 per share at any time until the option expires.

If MSFT rallies and trades up to $75.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00). Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00).

If MSFT were to trade down to $55.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00).

Parity graphs are intended to show you your option’s profit and loss at expiration (when they are trading at parity: i.e. when they are trading without intrinsic value). The first graph shows a call purchase and the second shows a call sale. The graphs show the amount of your expenditure (in the case of a purchase) or the amount you have received (in the case of a sale) and the dollar price of the stock where you would breakeven.

In this example, we use the fictitious stock XYZ. Please make note of where the stock needs to be at expiration in order for you to be profitable, and how the premium paid (in the case of a purchase) or the premium received (in the case of a sale) affects your profitability.

Also notice the difference in the profit potential between a purchase of the option as opposed to a sale of the option. Lastly, it is important to note the unlimited potential risk inherent in the sale of an option, compared to the fixed risk of an option purchase.

The third fiscal quarter ended on Friday on a bearish note, although US equities are once again flirting with lofty all time highs.  The lagging volume and consolidating technical pattern of all the major markets, coupled with a slight move to the downside on the last day of a bullish quarter could lead some to believe that the approaching apex of 14,024 in the DJIA could be a very convenient wall of resistance and an impetus of a substantial retracement.  The fascinating thing to me is that the ambivalent perception of the impact of forthcoming economic data, continuing debate over the severity of global credit issues, a totally devalued dollar, astronomical energy and commodity prices, and totally undefined corporate earnings are meeting at a plexus right at our ALL TIME highs.

One could easily hold a position that the major averages are not really trading at these levels at all, simply smoke and mirrors resulting from band-aid policies of liquidity infusion and interest rate cuts.  With October a historically foreboding and bear friendly month, this may not be the time to speculate with any long directional positions that are not completely hedged, with locked in loss parameters (i.e. appropriate options strategies/spreads).  From a technical aspect, the DJIA recent bull activity seems a bit overheated, and the Fast Stochastic %K has crossed over the %D moving down from overbought areas.  Meanwhile the SPY, or spiders, the tradable index of the spx, has formed a fairly symmetrical tightening triangle on constricting volume and could be another case made for some downside.  Unfortunately, if you look hard enough, an indicator can always be found that will make you a bull or a bear in any market.Final settlement prices for the week on Friday were as follows: DJIA, 13,895, + 75.44; COMP 2701.50, +30.28; SPX, 1526.75, +1.00.  Two other interesting pieces of information are that the advancers vs. decliners on the NYSE almost fell to parity last week, and Russell 2000 small cap was off 3.4 %for the quarter after advancing the last four quarters. Additionally Crude closed at $81.66, -.04 for the week and gold traded up over $11 per ounce to close at $742.80. The CBOE volatility index was of f 1.04 to close at 18.00 for the week, and the put/call ratio heated up to a bullish 153/100 as opposed to last week’s 130/100, although that is a suspect indication of institutional bias.

The week ahead sees the ISM index for September to be released at 10 a.m. on Monday, August factory orders will be stated at 10 am on Thursday, and Friday will see employment data and consumer credit numbers at 8:30.  Of course this week, as stated before, will be quite interesting as this fundamental data could have to be digested by the markets at historic technical levels.

Gregory Wolfe, The Options University
September 30, 2007

Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of the premium of the option.

The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value.

Please view charts below for option price (premium) examples.

Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.

For example, with MSFT trading at $65.00, the MSFT January 60 calls will have $5.00 of intrinsic value. If the MSFT January 60 calls were trading at $5.70, then $5.00 of that premium would be intrinsic value.

At the same time, the MSFT January 70 put will also have $5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of that premium would be intrinsic value.

Please view charts below for intrinsic value examples.

Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option’s entire price consists only of extrinsic value. Extrinsic value is made up of several components, with the largest being volatility.

In the examples above, if the MSFT January 60 calls were trading at $5.70 and $5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at $5.70 and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic value.

Please view charts below for extrinsic value examples.