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Aug
22
Rolling Covered Calls Options Trading Strategy
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Rolling Covered Calls
Writing covered calls has become a popular way for more conservative investors to make use of stock options. As a matter of fact, even retail brokerages like the strategy. This says volumes because most brokerages usually try to keep the average investor away from stock options. This is due to the fact that stock options are more complex than stocks and most brokers don’t have the training in options.
As you already know, a covered call is long stock and short call. You sell the options, collect premiums and if the stock doesn’t move much and the option stays out-of-the- money, you keep the collected premiums from selling the calls at expiration. If the stock stays stagnant, you can repeat this process over and over again. But what happens if the stock moves into-the-money?
If the short call goes into the money, the chance increases that the call option will be exercised. Moreover, it becomes more expensive to buy out of the position (buying back the short call). As a result, you consider “rolling” the position if it appears that the stock isn’t making a second or third standard deviation type move. “Rolling up” involves buying back this month’s option and selling the call for the next strike up in the next month.
Keep in mind that the stock you hold as part of the covered call position has also appreciated in value and this will usually more than offset the costs of closing out the short option position. Of course, when you roll up and sell the new call, you collect the premiums again. If the stock keeps moving up, you can also keep rolling up. So, even though premium collection is mainly for range bound, stagnant stocks, you can also roll up as the stock moves up. OK, but what happens if the stock starts trading down?
When the stock moves down, we don’t roll the position. Why is that? In a covered call strategy, you get out of the call. The covered call strategy no longer applies. If the stock looks like it’s breaking down, you could then buy puts if you intend on keeping the long stock.
As a matter of fact, you can close out the short call by purchasing the corresponding put. (The corresponding put is the put opposite the call-same strike and month). However, if you plan on keeping the stock, just buy two corresponding puts and you will end up with long a put. Of course, you are in a one-to-one ratio with the stock and options. So, if you were long 500 stocks you would have 5 long puts. When you “morph” a position it is also called a continuation strategy.
As Ron Ianieri, stock option guru and founder of the Options University states: “I might roll up strikes as the stock is going in my direction but when the stock stops going in my direction and heads the other way, it’s time to close out unless I have the wits about me to say that the reason I’m closing this position is the stock broke its up trend. It can’t be that it’s just trading down just a bit. It has to be a technical break like when that stock moves below the 50 day moving average and then follow through the next day down further.
I can close out my buy write with the purchase of the first corresponding put, but I can actually get short by buying a second corresponding put and then play the downward movement; that’s called a morph and completely changes the position with just one little trade. I went from being in the wrong covered call position with a stock that’s broken its up trend and has now broken its up trend and is breaking down.
For information, online classes, mentoring and all things stock option, contact the Options University at www.optionsuniversity.com
Aug
21
More on Stock Option Premium Collection Options Trading Strategy
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More on Stock Option Premium Collection
If you insist on owning stocks in your portfolio, a covered call strategy should be an important strategy to pull out of your investor tool box when the stocks you own hit a stagnant period. Being able to capitalize on covered calls can add significantly to the overall return of the stock by adding premium collections during slow times to the gains made in times of the stock appreciation.
As with most stock option positions, each strategy has a sister position. As you may recall, a covered call is constructed of long stock and short calls in a one-to-one ratio. So, what is the sister of the covered call? Well, it is the opposite of the long stock-short call and is short stock and long call, normally referred to as a Synthetic Put. When you sell the call, you collect premiums. With the synthetic put, instead of writing for a premium, you pay for the put options. In other words, a covered call creates a credit to your trading account and a synthetic put creates a debit. Typically, because you are long call, the synthetic put anticipates a slight bias for a slow up trend in the stock. However, the long call is more of insurance and the real philosophy behind the synthetic put strategy is that the stock will make a rapid drop.
So, even though the positions between the covered call and its sister synthetic put are opposite, (long stock-short call; short stock, long call), the philosophy behind the strategies are a bit different. The covered call anticipates little stock movement, whereas the synthetic put anticipates a downward movement in the stock. Moreover, the covered call strategy is a premium collection strategy and the synthetic put is more of a directional play.
An important thing to remember is: the odds are in favor of the seller of an option. You see, stocks are typically range bound more than they make large moves. If this is the case, could a strategy of continuous premium collection-month after month- be an effective strategy? Even though profits are limited on a month by month basis, if they can be repeated with frequency, this can be a very effective long term strategy.
As you can see, a buy-write (aka covered call) strategy can be good strategy particularly when hedged by a long stock position. The worst that can happen is that you lose the potential future profits from the stock if the call buyer is able to exercise the call option you sold them.
This premium collection strategy has become further refined by the creation of certain combinations of stock options, which can replace the need to be long or short stock. These option spreads make it possible to participate in premium collection with much less capital investment. Two of the most popular premium collection spread strategies are the “Bear call credit spread”-usually used in flat to slightly down markets and the sister strategy the “Bull put credit spread” which is usually used in flat to slightly up markets.
For information on just about everything concerning stock options, contact the Options University at www.optionsuniversity.com
Aug
20
More on Writing the Covered Call Options Trading Strategy
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More on Covered Call Writing
As you know, an option can have two types of value: intrinsic and extrinsic value.
Intrinsic value is achieved when the option moves into-the-money. If the strike price was $50 and the stock price moves to $51, the call option will have $1 of intrinsic value. If the option is out-of-the money, it has some value because it has a chance of going into-the- money. This option has no intrinsic value; just extrinsic value for its potential. However it’s important to understand that all extrinsic value decreases as time runs out for the option period.
Extrinsic Value Decay
About 20 days out from the expirations date, chances for moving into-the-money become reduced and there are fewer buyers for that month’s option at that strike price. Option traders will move on to other further out months. As a result, demand for these options fall as does the option premiums. This happens to all out-of-the money options. As a matter of fact, during the last ten days or so of the option period, the drop in premium prices accelerates to zero as the option heads to expiring worthless; after all, there will be no premium left because there will be zero chance of getting into-the- money and producing any intrinsic residual value.
If you plan to sell an option, you are always best to sell at-the-money options because they have the highest amount of extrinsic value. After all, just a bit more and the option gains intrinsic value; needless to say, there is more demand for these options and premiums are priced accordingly.
If you plan to write an option to collect premium, you are best advised to sell a front month option at-the-money. In this way, you can ride the decay as extrinsic value goes to zero and the option stays out-of-the-money. By writing short term contracts with the anticipation of not going into-the-money, you can take advantage of the ability to use this strategy repeatedly so that even small gains can compound over time.
In the “Options Mastery Course” offered by the Options University, the case is established that you are mathematically better off writing front-month contracts than writing out-month contracts.
Profit, loss and breakeven when writing Covered Call options.
The first thing you need to find out is the breakeven; the point that your position makes zero gain or loss. To figure out breakeven, all you need to do is take the stock price and subtract the call price. For example, if you sold a call for a $2 premium, and the at-the-money- strike is at $40, your breakeven would be at $38 for the stock. If the stock goes down to $38, you would lose $2 but you received $2 for selling the options, which would offset the loss.
When you write an option, your maximum profit is the premium collected. If the option goes into-the-money and is exercised, your loss will be the stock you hold, which may not be a loss at all; however, any potential gains from owning the stock is lost due to giving up your stock. Of course, the premium collected helps to offset any losses.
For more information about all things options, go to www.optionsuniversity.com
Aug
19
Advanced Options Trading - Making Money with Stagnant Stocks
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Making Money with Stagnant Stocks
Most stock investors can become comfortable investing in stock options. The fundamentals are easy to understand and usually, once an investor has purchased stocks on margin, it becomes a fairly easy transition to stock options. However, to make the process of transitioning to options easier, it’s a good idea to start using stocks and options in combination.
One of the most simple and conservative ways to incorporate options into a trading strategy is to use what is called “Covered calls” (aka “Buy-write”).
Covered Call/ Buy-Write
This basic options strategy is made up of buying stock and then writing a call; “writing” means selling. This strategy is also called a buy-write because stock is owned or purchased and calls on the stock are sold on a one-to-one ratio. In other words, if you purchase or already own 500 shares of IBM, to set up a covered call position you would sell (write) 5 IBM calls (each contract is 100 shares). In exchange for selling the rights of your shares to the call buyer, you receive payment. This payment is referred to as the premium. If the premium for one share of IBM is $4.00, you would receive $400 for each contract or in the case of our example a total of five contracts is $2,000.
If at the end of the option period the IBM stock hasn’t gone into-the-money, you get to keep all of the premiums you collected. If IBM stock is currently worth $ 120, your 500 shares would be worth $60,000. If your covered call strategy works as you hoped, the $2,000 premium collected yields a 3.3% return based on the value of the stock. Not bad for one month seeing that this strategy can be repeated time and again with the same stock. Of course, if you were successful for 12 straight months, your return would be 39.6 %. So, if your long term hold stocks aren’t performing and you don’t want to sell them, consider writing covered calls while you’re waiting for them to appreciate.
But what happens if the options you sold go into-the-money? Well, first the buyer of the option must exercise their rights by requesting the stock you owe them at the strike price you sold the options for. For example, if you sold 5 options contracts of IBM with a strike price of $125, you would be required to transfer 500 shares of IBM stock at a value of $125 per share. So, if you had purchased the stocks at $110, you would make the $15 profit per share and also keep the $2,000.
However, if IBM continues skyward, that would be your opportunity cost of being forced to hand over your stock. By the same token, if IBM goes down in value, you suffer the loss of the stock, but the premium you collected helps to mitigate the losses. For instance, on the $2,000 premium you collected in the example, the IBM stock would have to go down $4.00 to breakeven. So, in effect a covered call strategy does provide some limited downside protection associated with the holding of the stock. Because of these fairly benign consequences, the covered call strategy (or buy-write) is considered a conservative position and is allowed by most retail brokerages.
When to use the Covered Call strategy
This strategy is called a premium collection strategy and gains are based on the non movement of the stock. Normally, stock investors think of a gain as something coming from the appreciation of the stock (if long) or devaluation of the stock-if short. Rarely does it occur that money can be made by no movement at all!
For information on stock options-from beginner to expert-contact the Options University at www.optionsuniversity.com
Aug
18
Advanced Options Trading - Understanding Synthetics: the Basic Formula
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Understanding Synthetics: the Basic Formula
Let’s talk about put/call parity. Say What? You remember that’s the fact that a corresponding call and put are equal to the parity of the stock at that strike price. In other words, a corresponding call/put will be mathematically related to the current value of the underlying stock. This is key to understanding the option strategy of stock replacement.
In Options University’s Options Mastery course, this relationship is expressed in a formula: Call price-Put price= Stock price-Strike price.
So, when we look at this base formula and we see the call price minus the put price, what we’re doing is canceling out the extrinsic value of that strike and only leaving the intrinsic value of that strike. When we do this, we are left with just intrinsic value of the strike. After all, only one of the corresponding call or put can have intrinsic value.
Likewise, when we subtract the strike price from the stock price, we are left with intrinsic value if the strike is in the money.
The following example taken from the Mastery Course will help to prove the point. For example, let’s take the June 70 calls with the stock at $69.50. From here let’s go back and plug in our numbers and see what we get. We’ll go back for our call price and put price but we know the strike price was $70 and we know that our stock price is $69.50. What type of value do we get, a minus .50 cents, simple math.
Now, let’s look at our call price minus our put price. Our call price is going to be $1.65 and our put price is going to be $2.09, so let’s plug that in, $1.65 for the call and $2.09 for the put. What we come up with is a minus .44 cents. You may say wait, the two of those aren’t equal. That’s because we haven’t adjusted for interest rate and dividend. The bottom line is that if you buy a call and sell the corresponding put, it will create a long synthetic stock position; however, there is no adjustment for interest rate or dividends.
Of course, the same holds true if you want to create a short synthetic stock; buy the put and sell the call. Moreover, we can create the six synthetic stock positions. For example, by either buying stock and buying puts, which will give a long call position, we can create a short call by selling the stock and selling the put. You can create a long put by selling the put and buying a call. Key to making this work is using corresponding options in a one to one ratio.
According to Ron Ianieri, author of the Mastery Course, “These six majors are critical because everything else that we’re going to be doing is going to involve synthetic relationships at some level. This is what separates the men from the boys and the women from the girls. This is what separates people that really understand what they’re doing in options and those who don’t. This is what separates the people who make money in options and the people who lose money in options.”
For information on everything stock options, contact the Options University at:
Aug
17
Advanced Options Trading - More on Synthetic Stock Positions
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More on Synthetic Stock Positions
Anything synthetic is made up of components that when put together in the right way can make up a completely different object. Often times, synthetic products are produced because they accomplish the same thing as the “real thing”, but there are distinct advantages in using the synthetic over the real. In the case of creating a synthetic stock position, stock options have some real advantages for certain situations.
Stock options and stocks are mathematical entities made up of certain measurable entities. For example, one stock has a Delta of 1.0. It is totally correlated to itself. A stock option, on the other hand, has the relational factors of Delta, Gamma, Vega and Theta, which define a specific option (derivative) with its underlying stock. When we want to create an investment in a synthetic stock position, we use stock options that will exactly mimic the movements of the actual stock. From a mathematical standpoint, we want the total Deltas of the options to match the total Deltas of the stock.
For example, if you have 1000 shares of XYZ stock, you would have a total amount of 1000 Deltas. If you want to construct an option position that would exactly mimic the movements of the 1000 XYZ shares, you would need to create an option position which would also have a total of 1000 Deltas.
The Option Pricing Model, which is in constant evolution, mathematically defines the relationship between option derivative and the underlying stock. To construct a synthetic stock position, it is essential to understand how options relate to each other and the underlying stock.
According to Ron Ianieri, one of the founders of Options University, If you can understand synthetic positions, then not only is it going to help you make money but also it’s going to give you a much deeper understanding of options in general. If you can create the exact same position in two different ways, then there is a possibility that one of those ways might be cheaper than the other.
For example, you may often times find that creating a synthetic stock position is cheaper to buy than the underlying stock. If this is the case, than the corresponding ROI will be higher. By being less expensive, a synthetic position will also allow for lower entry and exit points. When talking about the nature of stock options, we talk about flexibility and synthetic positions are just one example.
In the Options University Options Mastery Course, the students learn that there are six basic types of synthetic positions:
· Synthetic long stock and synthetic short stock; by using a combination of a call and its corresponding put you can recreate a long stock position or a short stock position just using a call and a put.
· Synthetic long call and synthetic short call; using a combination of the corresponding put and the stock you can create a long call or a short call simply using the corresponding put and the stock.
· Synthetic long put and synthetic short put; by using a combination of the stock and the call, you can create a long put or a short put, depending on the combination I use.
For everything you want to know about stock options, contact the Options University at:
Aug
16
Rolling-up
What happens if your timing is off and the stock replacement strategy you established looks to expire before the move you anticipated has been completed? Do you have to bail out of the position? The answer is no; you can roll it.
When an option trader wants to maintain a position into a new option period, they can “roll up” the call by selling it and buying the next strike up (if the stock is moving up). Of course, you will be selling a more expensive call and buying a cheaper call. This will create a credit. That credit is actually taking part of the profit you may have made up to that point. This is very different from selling a stock.
When you take some profit from your stock position, you lose some of the position. You must sell the stock. In the case of rolling, you keep a bit of your profit and maintain the same position. Rolling-up allows the option trader to extend the same position and take some profits at the same time.
Morphing
In their Options Mastery Course offered by the Options University, the many ways that an option trader can close out of a trade are explained. For example, if you have established a vertical spread and are considering how best to close out a call spread, you find there are three possible outcomes.
First, the spread can finish out-of-the-money and become valueless. For a call spread, this scenario occurs when the stock closes at or above the strikes of the spread. In order to close out the spread, an option trader would just let it expire. Both options finish out of the money so there is no residual position left over. Say goodbye the premiums you paid to get into the position.
Now, if the spread finishes in-the-money, meaning both options are in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
The last scenario is a bit problematic; what happens if a stock closes between the two strikes of the spread? This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. We know that when both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. But in the case of a closing price between both strikes, it’s different. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
In this situation, there are two actions possible. One is to trade out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid being caught “naked”. If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money.
For more on all things about stock options, go to www.optionsuniversity.com
Aug
15
Advanced Options Trading - Options Vs Stop Loss Orders
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Options Vs Stop Loss Orders
There is a laundry list of advantages of holding stock options over owning the underlying stock. Everybody knows about the lower costs, higher ROI (Return on Investment), and multiple strategies available with using stock options, but few are aware of the risk management strategies that options also offer.
According the Options Mastery Course offered by Options University, options are immune from the flaw that stop loss orders can have. For example, the bad news came out before the opening and the stock drops like a rock as soon as the markets open. The news hasn’t really hit the wires and before any action can be taken, your stop loss has been trampled and the stock is ten dollars lower before your stop order is filled. It happens all the time.
Sometimes, a stop is like that wimpy usher that shyly whispers “you can’t go in there”. You laugh and push yourself by. So, when there is some surprising or catastrophic news which can cause big moves, your peace of mind of having a stop loss in place is blown to pieces. You know, it isn’t the little losses that burn you; it’s the big ones where stop losses can be ineffective.
Options are different in that they are a “full time” stop that will work properly all the time. A strike price, once hit, becomes active from the get go. No worry about getting filled; either it is or it isn’t, period. Indeed, options were developed to become a perfect hedge.
For example, you think XYZ is going to be moving up within the next three months, so you decide to buy an at-the-money call. To protect yourself, you decide that you could accept a 5% loss so you figure out that buying a put that is $5 out-of-the-money will give you that down side protection during the option period. It doesn’t matter what happens, if the price hits the out-of-the-money strike, the put starts making money to help offset the losses suffered by the call. Of course, you must also figure in the cost of the put, which will lower the strike accordingly.
Brokerages recognize the safety of using an option as a stop to help reduce risk and can require much less margin to cover a trade. For example, suppose you set up a bear call credit spread where you sell a $50 call and buy a $52 call. The credit from the short sale usually more than offsets the cost of the long call so the risk is between $50 and $52; less than $200 per contract. Lower capital requirement also raises ROI.
Sometimes, setting up a bear call credit spread might require the precaution of setting up a stop for the short call if there is a significant spread between the short and the long.
For example, if you sell a $50 call and buy a $55 call, you might want to set a stop on the short call around $52 to get you out of the short and leave you long on the OTM call-or you can get totally out of the position. Why not just buy a $52 call? There may not be a strike at this price.
To find out more about all things stock option, contact the Options University for all of their online courses, webinars and mentoring services at www.optionsuniverstiy.com
Aug
14
Advanced Options Trading - More on Synthetic Stock
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More on Synthetic Stock
We know that if we want to simulate an option position that will exactly mimic the movement of the underlying stock, we can but we need to buy an at-the-money call and also buy the corresponding put. We do this because corresponding option contracts produce 100 Deltas and cancel out all the other Greeks. In effect, the position becomes a low cost, time limited simulation of the stock. If the stock moves up $1 the position will move up $1. If the stock moves down $1, the position will move down $1. It is, indeed for the option period a perfect surrogate for the underlying stock.
OK, but why would an option trader want to use a synthetic stock position? As Ron Ianieri of the Options University states: “whenever a trader decides to use the synthetic position instead of the real position, it’s because there’s some type of “volatility skew” creating one way to be cheaper than the other way (owning the stock) yet we know that both ways are the same”. In other words, a synthetic position can provide better pricing and higher profits.
To be more specific, there is something called a “put/call skew”. There is a negative and a positive put/call skew. When a corresponding call is selling for a higher price than its corresponding put, you have positive skew or vice versa when you have a negative skew. Either way, the skew produces more favorable pricing which allows for more profit than the actual purchase of the stock. It’s not a huge amount, but for an active options trader, the advantage can add up over time.
Synthetic Short Stock
Just as we have a synthetic long stock, we also have a synthetic short stock position.
It’s no surprise that the construction of the synthetic short stock position is opposite the construction of the synthetic long stock position. In the synthetic short stock position, we’re going to be long the put and short the call in a one to one ratio.
So, to create a synthetic short, a trader would buy a put which makes you short and then sell the corresponding call which also makes you short. Needless to say, both put and call must be corresponding options and at a one-to-one ratio. Since they are corresponding, they have Deltas that will total negative 100 and Gamma, Vega and Theta that will cancel out. Let’s look at an example.
Suppose you sold a real stock for $67.50 and it went down to $63.50. In this case, you made $4. To construct a synthetic short position, you would pick the closest strike and go short the call and long the put. The closest strike is $65 and you sold the call for $3.32 and now it’s worth $1.09 In this case, you made $2.25 on the call. The put, on the other hand, you purchased for .77 cents and it’s now worth $2.53; a profit of $1.76. The call and the put equal a total profit of $4.01. >That’s the same as selling the stock; however, it was much cheaper to sell the call and buy the put. (Keep in mind that unless you actually own the stock, most brokerages will not let a retail client sell unhedged short positions.)
To find out more about synthetic stock and much more, contact the Options University at www.optionsuniversity.com
Aug
13
Synthetic Stocks
Personally, I prefer the name “shadow stock”; it sounds so much more romantic and mysterious compared to the rather sterile name of “synthetic stock”. I smacks of something you’d buy at Wal-Mart. But, undaunted, we press forward to discuss an important aspect of the many facets of stock options.
Creating a synthetic stock position-either long or short-has some distinct advantages when trading stocks. They’re cheaper, more flexible and have limited risk as opposed to the theoretical “unlimited risk” of actually owning the stock. Yes, an option has a limited life but we are talking a trading strategy and not a buy and hold scenario.
The first synthetic position we’ll talk about is creating the long synthetic stock. The major objective of establishing a synthetic position is to construct a position that will closely mimic the movements of the underlying stock.
Construction of synthetic long stock
In order to create a synthetic long stock position, you want to buy a call and sell the corresponding put in a one-to-one ratio. But how can an option position be just like a stock when you’re buying a call and a put?
What happens is that both option positions are identical because they are corresponding options, which means that both positions have the exact same Greeks, or in other words, the same risk factors and profit potential of the real long stock position; the synthetic long as created by the corresponding options will exactly mimic the real long position in all ways.
In the Options Mastery course offered by the Options University, they give an example of what you are looking for. Suppose you want to set up a synthetic long position for a stock currently trading at $65.50. First thing, you decide that you will hold the position for about three months, a time you estimate sufficient for the stock to do what we think will happen. Let’s say you pick a June option period. You look at the June $65 strike. You see that the call has 56 long Deltas.
However, you now need to sell a put at the same strike and month and you see that this put option will short 44 negative Deltas. If you sell the put, you will be short, which is also a negative and the two negatives of the put and the short sale equals a positive. At this point we are long 56 Deltas from the call and also long the 44 Deltas from the put. This means that the position made up of the corresponding call and put has 100 long Deltas; 100 Deltas means that the position is exactly correlated with the long stock position. This is no coincidence, you see, corresponding options will always sum to an absolute value of 100 Deltas. The relative value depends on whether the position is short or long.
Here’s the kicker, corresponding options also have the same Gamma, Vega and Theta but a real stock position only has 1.0 Delta for each stock. However, the long call and short put Gamma, Vega and Thetas cancel each other out; so, in effect, both the option positions now have only 100 Deltas (100 share contract) as will the 100 shares of underlying stock; therefore, they are both the exactly the same. When this happens, the option positions will match the underlying stock movement penny for penny.
Of course, to assume a synthetic position will cost a fraction of what buying the stocks would cost. This allows you to either “buy more stock” or diversify your capital into other investments. The only difference is time.
For more information on everything to do with stock options, go to: www.optionsuniversity.com
Aug
12
Advanced Options Trading - Timing Stock Options
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Timing Stock Options
It’s an established fact that to get the best correlation for the buck, options traders should look for in-the-money options with Deltas around 80-85. In this way, you can capture at least 80-85% correlation with the movements of the underlying stock. OK, but what expiration month do you choose?
If you think the stock is going to make a similar type of downward movement it made in the past and it made the same downward movement seven months ago, again two years ago, and again four years ago, you think the current pattern is a close match to past patterns and this will be a good indicator of what might happen. In the past, each time it looked like it had taken two to two and a half months to complete the breakdown cycle. So, you decide to buy put options that fit that timing pattern. If you think that it should take about two and a half months to complete the pattern, you would decide to buy an option that expires in three months; in other words, you want to match the days to expiration on the option to the amount of time you think it’s going to take for the stock to make the anticipated movement.
Of course, you can be off a bit on both ends, but picking a month that is most likely to contain at least some of the movement we expect is the key.
In the case of a short stock position, you locate a put option that closely will mimic the short stock position. So, you go out three months and look for an in-the-money put with Deltas around 80-85; this is called “the sweet spot”. Now, you have a good idea of the timing and an option at the best price for what you want to accomplish.
Exception to the Sweet Spot
In the Options Mastery course offered by the Options University, it’s mentioned that there is a time when an option trader doesn’t want to use the sweet spot. That is when a stock is going through a breakout; you should consider buying an at-the-money put. Why is that?
An at-the-money option has a mix of intrinsic and extrinsic value. With extrinsic value, the stock has to perform better than at an in-the-money option to over come the extrinsic value cost; every penny of extrinsic value is one additional penny more that the stock has to move to start making a profit. When an option is deep in-the-money, option and stock prices move in lock-step. But there are times when you would want to capture the volatility of an option; it’s like catching a wave before it breaks.
A break down in a stock is normally a violent, aggressive movement lasting four to maybe eight days. If thisis the case, the problem of time decay is not a major concern because you won’t be in the position for that long. In this case, the at-the-money put becomes a better play. Break downs give you the opportunity to benefit from the volatility and not get hurt as much from the decay because break down stocks usually make their big moves within a short time span.
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Aug
12
Chapter Two Answers
1) ABC stock is trading for $76 near expiration and your $70 call is bidding $5.20. How do you capture the missing intrinsic value?
b) Short the stock and exercise the call
With the stock trading at $76, the $70 call must be worth at the $6 intrinsic value at expiration. However, sometimes the bid-ask spreads can make the bid price slightly less than this intrinsic value. In this question, there are 80 cents missing from the intrinsic value. Rather than just sell your $70 call in the open market and receive $5.20, you can short the stock at $76 and immediately exercise the $75 call, which will leave you with a $6 gain.
2) ABC stock is trading for $37 near expiration and your $40 put is bidding $2.80. How do you capture the missing intrinsic value?
b) Buy the stock and exercise the put
With the stock trading at $37, the $40 put should be worth the $3 intrinsic value at expiration. But just as for call options, sometimes there is some missing intrinsic value near expiration. In this question, you could place an order to buy shares of the stock for $37 and immediately exercise the put and sell the shares for $40 thus capturing a $3 rather than the $2.80 gain you’d get by selling the put in the open market. It does not matter if you don’t have the cash to buy the shares of stock since the exercise of the put guarantees the funds.
3) What is the key factor that gives an option, whether a call or put, its value?
c) Volatility
The volatility of the underlying stock is the key factor in determining an option’s value. Volatility simply measures the fluctuations in a stock’s price. The greater the fluctuations, the greater the uncertainty of prices and options become more valuable.
4) The higher the risk:
c) The lower the price, the higher the reward
If an investment is risky, the market will bid down its price to a level where it becomes desirable. If the price is low, then the potential return, or reward, will be higher.
5) Out-of-the-money option prices move:
c) Only a small fraction with the underlying stock
Out-of-the-money options have a low delta, which means the option’s price will only move a
small percentage when compared to the move in the stock’s price.
6) The maximum value that a call option could ever be is:
a) The price of the underlying stock
The maximum price a call option could ever reach is the price of the stock (Pricing Principle #5). If the price of any call option were to exceed the stock price then arbitrage would be possible.
7) Interest rates are 6% and you will definitely receive $5,000 six months from now. How much should you be willing to accept if the other party wants to settle the debt today?
b) $4,854
If interest rates are 6% per year then they are effectively 3% per six months. The present value of $5,000 would then be $5,000/1.03 = $4,854. This just means you should be indifferent between receiving $4,854 today and $5,000 in six months from now if interest rates are 6%. If you accepted $4,854 today, you could invest that money at the risk-free rate of 6% and it would grow to $5,000 in six months.
You are looking at quotes on IBM March calls. Which is more expensive, the $80 call or the $85 call?d) $80 call is more expensive
With all else being equal (that is, same underlying stock and expiration), lower strike calls must be more valuable than higher strikes (Pricing Principle #1). Although we don’t know what the price of either call will be, we do know that the $80 call would be more valuable since it gives the holder the right to buy shares at a lower price.
9) You are looking at Dell Computer April $30 calls and July $30 calls. Which is more expensive?
d) July will be more expensive
With all else being equal, longer-term options will be more valuable than shorter-term expirations (Pricing Principle #2). The reason is simply that more time allows the underlying stock to make bigger moves, whether higher or lower.
10) You are looking at Intel December puts. Which is more expensive, the $30 put or the $40 put?
c) $40 put is more expensive
With all else being equal, higher-strike puts will be more valuable than lower-strike puts (Pricing Principle #1). The reason is that the higher-strike put allows the holder to sell stock at a higher price, which is more beneficial (valuable) than selling at a lower price.
11) Delta measures:
b) The sensitivity of an option’s price compared to the stock’s price
If a call option has a delta of 0.50, then we know that the option’s price will rise 50 cents for the next dollar move in the stock’s price. If a put has a 0.50 delta, then its price will rise 50 cents for the next dollar fall in the stock’s price. Delta therefore shows how sensitive an option’s price is to movements in the stock’s price.
12) One interpretation of delta is:
b) The probability that the option will expire in-the-money
One mathematical interpretation is that it roughly shows the probability that an option will expire in-the-money at expiration. If an option has a delta of 0.70 then there is roughly a 70% chance that it will expire in-the-money at expiration.
13) XYZ stock is trading for $44.50 near expiration. Your $40 call must be worth at least:
b) $4.50
All options must be worth their intrinsic value at expiration. In this example, the $40 call must be worth $4.50. (If it were worth less than that, you’d simply short the stock and immediately exercise the call as in Question 1.)
14) If the $50 call delta is 0.70, the $50 put delta is:
d) -0.30
Same-strike call and put deltas must sum to one (ignoring the minus sign of the put delta). If the call delta is 0.70, the corresponding put delta must be -0.30.
15) The ABC $50 call is trading for $7. What is the maximum amount the $45 call could be trading for?
a) $12
For any two calls (or puts) the difference in their prices cannot exceed the difference in the strikes (Pricing Principle #6). In this question, there could not be more than a five-dollar difference in their prices since there is a five-dollar difference in strike prices. We also know that lower-strike calls must be more valuable than higher strikes so if the $50 call is $7, the $45 call could not be worth more than $12; otherwise arbitrage is possible.
16) What are the only two prices that are possible for an option to have at expiration?
b) Zero or intrinsic value
An option will be worthless if it is out-of-the-money at expiration. If it is in-the-money, it will be worth exactly the intrinsic value. Remember, prior to expiration, out-of-the-money options will certainly have some value since time remains. But at expiration, they are worthless.
17) You purchased a $40 call for $3. What is the breakeven point on the option?
d) $43
The breakeven point for a call option is found by taking the premium and adding it to the strike price. In this question, the breakeven point is $40 strike + $3 premium = $43 stock price. If the stock is $43 at expiration, the $40 call is worth exactly $3, which is the same as the amount you paid – you have just broken even.
18) You purchased a $70 put for $2. What is the breakeven point on the option?
a) $68
The breakeven point for a put option is found by subtracting the premium from the strike price. In this question, the breakeven point is $70 - $2 = $68 stock price. If the stock is $68 at expiration, the $70 put is worth exactly $2, which is the amount you paid so you have just broken even.
19) Because high-volatility stocks have a better chance for price appreciation, you should:
c) Not choose trades based on this fact because the volatility will be priced into the option.
You will hear many traders tell you to only trade options on high-volatility stocks since there is more room for price appreciation. But this is really a big myth. The reason is that the markets are well aware of that advantage so traders bid the prices of the high-volatility options higher. The net result is that there is no net advantage in trading high-volatility stocks.
20) If a 30-day option has a delta of 80 today:
b) It will change over time
The delta of an option does not stay constant over the life of the option. The delta changes as other factors change. The key factors are time, volatility, and price of the underlying stock. But just because you buy an 80-delta option today does not mean that it will be the same next week. In fact, all in-the-money options approach a delta of 1.0 as expiration gets closer, while all out-of-the-money options approach zero. The delta does not stay constant.
To be continued,,,
Aug
11
Chapter Two Questions
1) ABC stock is trading for $76 near expiration and your $70 call is bidding $5.20. How do you capture the missing intrinsic value?
a) Buy the stock and short the call
b) Short the stock and exercise the call
c) Buy the stock and exercise the call
d) Short the stock and short the call
2) ABC stock is trading for $37 near expiration and your $40 put is bidding $2.80. How do you capture the missing intrinsic value?
a) Short the stock and exercise the put
b) Buy the stock and exercise the put
c) Buy the stock and short the put
d) Short the stock and short the put
3) What is the key factor that gives an option, whether a call or put, its value?
a) The strike price
b) Price of the stock
c) Volatility
d) Open interest
4) The higher the risk:
a) The higher the price, the higher the reward
b) The lower the price, the lower the reward
c) The lower the price, the higher the reward
d) The higher the price, the lower the reward
5) Out-of-the-money option prices move:
a) Dollar-for-dollar with the underlying stock
b) About 50 cents on the dollar with the underlying stock
c) Only a small fraction with the underlying stock
d) About 75 cents on the dollar with the underlying stock
6) The maximum value that a call option could ever be is:
a) The price of the underlying stock
b) There is no limit
c) Only half of the underlying stock’s price
d) The price of the put
7) Interest rates are 6% and you will definitely receive $5,000 six months from now. How much should you be willing to accept if the other party wants to settle the debt today?
a) $4,716
b) $4,854
c) $4,981
d) $4,622
You are looking at quotes on IBM March calls. Which is more expensive, the $80 call or the $85 call? a) Cannot be determined with this information
b) They will be about the same price
c) $85 call is more expensive
d) $80 call is more expensive
9) You are looking at Dell Computer April $30 calls and July $30 calls. Which is more expensive?
a) Cannot be determined with this information
b) They will be about the same price
c) April will be more expensive
d) July will be more expensive
10) You are looking at Intel December puts. Which is more expensive, the $30 put or the $40 put?
a) Cannot be determined with this information
b) They will be about the same price
c) $40 put is more expensive
d) $30 put is more expensive
11) Delta measures:
a) The intrinsic value of the option
b) The sensitivity of an option’s price compared to the stock’s price
c) The time value of the option
d) The sensitivity of an option’s price compared to the overall market
12) One interpretation of delta is:
a) The probability that the option will expire out-of-the-money
b) The probability that the option will expire in-the-money
c) The probability that the option will expire without being exercised
d) The probability that the option will expire
13) XYZ stock is trading for $44.50 near expiration. Your $40 call must be worth at least:
a) $4.00
b) $4.50
c) $44.50
d) There is no way to determine based on this information
14) If the $50 call delta is 0.70, the $50 put delta is:
a) There is no way to determine based on this information
b) -0.50
c) -0.70
d) -0.30
15) The ABC $50 call is trading for $7. What is the maximum amount the $45 call could be trading for?
a) $12
b) $7
c) $8
d) There is no way to determine based on this information
16) What are the only two prices that are possible for an option to have at expiration?
a) Premium or intrinsic value
b) Zero or intrinsic value
c) Zero or time value
d) Time value or intrinsic value
17) You purchased a $40 call for $3. What is the breakeven point on the option?
a) $3
b) $37
c) $40
d) $43
18) You purchased a $70 put for $2. What is the breakeven point on the option?
a) $68
b) $2
c) $72
d) $70
19) Because high volatility stocks have a better chance for price appreciation, you should:
a) Only place trades during highly volatile markets to increase your edge
b) Only trade options on low-volatility stocks for more consistent profits
c) Not choose trades based on this fact because the volatility will be priced into the option
d) Only trade options on high-volatility stocks
20) If a 30-day option has a delta of 80 today:
a) It will remain at 80 over the life of the option
b) It will change over time
c) It cannot fall below 80 but could rise above it
d) It can fall below 80 but not rise above it
Answers coming in next part…
Aug
11
Advanced Options Trading - Puts, the Sweet Spot, and Other things
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Puts, the Sweet Spot, and Other things
Let’s say you decided that you wanted to buy XYZ at a $40 but unfortunately it’s trading now at $50. XYZ is at $50; it’s running up, but if it ever came back down to $40 you’d love to buy it. Ok, here is one way to position yourself; you’re going to sell an out-of-the-money $40 put for XYZ and if the stock ever trades lower than $40 during the option period, then you’re going to own it as more than likely somebody will exercise their rights as the buyer of the put and place the stock with you-the seller. If the stock doesn’t reach $40, no big deal, you’re going to keep the entire premium from the put, a win, win situation, right?
That might be good for some stocks that are volatile but the real world may turn out to be different when you do get the stock when it hits $40. You see, something happened to make the stock move down $10 from $50 and that $40 strike price may just be another tick on the way down to some undefined bottom. In other words, why not just wait until you have an idea of where the bottom might be. So, this strategy of selling a put to buy on the cheap and collect a credit in the process may be more risky than you think.