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Oct
31
Key Point in – The Stock Replacement Covered Call Strategy
Filed Under Intermediate Options Trading | Leave a Comment
Key Point – The fact that you are creating the covered call strategy (buy-write) by doing the vertical spread is very important to note. For margin purposes, the vertical spread will be margined at a much more favorable rate than the traditional buy-write because you do not own the actual stock and therefore do not have as much to lose. This is especially important to investors/traders who trade on margin.
This scenario includes another significant value added benefit that you receive. When you purchase a spread, the most you can lose is the amount you paid for the spread which in this case is $10.15.
As you already know, the biggest risk in a covered call/buy-write strategy is a large downward move in the stock. If you had done this trade with the actual stock and the stock traded all the way down to $20.00 from $60.00 (although unlikely) we would stand to lose almost $40,000.
However, if you did the trade with the 47.5 calls in place of the stock via the vertical call spread above, the maximum loss is what you spent on the trade. Remember, you purchased the vertical call spread for $10.15. If you traded the spread an equivalent amount of times to equal 1000 shares, you would have bought a total of 10 spreads.
The total dollar amount of your investment would be $10,150.00, as opposed to $58,900 had you bought 1000 shares of Amgen outright. Your loss will be maximized at $10,150 if the stock traded down to $20.00 as opposed to a $38,900.00 loss in the case of outright stock ownership. Even if the stock was to trade down to $0, your maximum possible loss would still be $10,150.
This is because once the stock gets below $47.50, the December 47.5 calls become worthless thus the calls can not lose any more money no matter how much more the stock trades down.
In order to continue or “roll” this position, you will have to roll two options into the next month instead of one. In a traditionally structured covered call strategy (long stock, short call), you are dealing with only one option series.
However, in the stock replacement strategy, you have a second option series (the call you purchased to replace the stock) to roll into the next month. This may incur an additional commission but the trade is obviously well worth it when you look at the previously stated risk/reward scenario and the size of the capital outlay needed to initiate the position.
Conclusion: As we detailed here, the stock replacement version of the covered call/buy-write strategy is an example of the proper use of option leverage. It offers the investor a bigger percentage return, less risk and less capital requirement than the traditional covered call/buy-write strategy.
Anytime you are interested in a high dollar stock, first look to see if there are any deep in-the-money calls that fit this replacement scenario and evaluate if this might be a better option.
Oct
30
Advanced Strategies
Filed Under Intermediate Options Trading | Leave a Comment
The Stock Replacement Covered Call Strategy
Recently, (October and November ‘03), the giant biotech Amgen (AMGN) came under some intense pressure, trading down about $12.00 before it found what appeared to be a decent level of support, and began to consolidate. At this level, anyone interested in going long Amgen at a discounted price would be advised to do so. Implied volatility was high coming off this precipitous drop, which caused premiums in the options to increase considerably.
This scenario can be a very attractive for covered call sellers or buy-writers. On Tuesday, December 2, 2003, Amgen was trading at $58.90, the December 60 call was trading at $1.30, and there were only two weeks left until expiration.
Let’s assume that you wanted to take advantage of this opportunity but you would be unable to participate in it due to capital requirements. The stock was trading at $58.90 and you did not have sufficient funds to support buying the stock at that price. After all, the purchase of just 1000 shares would cost $58,900.00.
This is the time to consider using a strategy called stock replacement. In many instances, an insufficient amount of funds in the investors account can mean the loss of a golden opportunity when dealing with high dollar priced stocks.
So, an alternative to purchasing the stock outright is to find a way to replace the actual stock with something else which is not as expensive. In this case, a deep in-the-money call would do just that.
When a call is deep in-the-money, meaning that the strike price of the call is much lower than the stock price, the delta of the call approaches 100. This means that there is close to a 100% chance that this option will finish in-the-money.
Because of this, the option will trade just like the stock; penny for penny, dollar for dollar (in a theoretical 100 delta scenario.) If you recall, the term delta was mentioned when describing the option in question. Delta is the first derivative of the stock and it has a three pronged definition. The first is percentage change.
The delta is given as a percentage change, meaning how much in percentage terms the option price will change with a movement in the stock. A 50 delta option will move 50% the amount the stock does. If the stock moves $1.00, than the option moves $.50. A 30 delta option moves $.30 on a $1.00 movement in the stock, and so on.
Delta can also be defined as percent chance. This is used to describe the percentage chance that the option will end up in-the-money. A 90 delta option has a 90% chance of finishing in-the-money.
Finally, delta can also be defined as hedge ratio which is the amount of deltas needed to properly hedge a position. These concepts will be discussed in more detail in future Options University courses, but for now it is sufficient to just understand these basic concepts.
It was important to explain the meaning of delta to understand that the deep in-the-money call would perform and act just like the stock. One way to determine if the call you will select is in-the-money enough for your purpose is the delta. A delta in the mid or high 90’s is an ideal candidate.
The selection of the proper in-the-money call to use is a critical element in the success of this strategy. In order to obtain an accurate delta of all options under consideration for stock replacement use, you can go to any number of web sites or consult your broker. If all else fails, there is a little trick of the trade that can be used to aid in selecting a call that is deep enough in-the-money to suit the stock replacement criteria.
To do this, check the quote of the corresponding put (i.e. the December 47.5 put if you are looking at the December 47.5 call for stock replacement). If there is no bid quoted for the put, then the call is deep enough in the money to consider it for a stock surrogate. There are several reasons for this being an effective strategy, which we wont cover here, but for the purposes of this discussion, it is enough to know that this method does work.
So, with the stock at $58.90, the December 47.5 calls met the criteria for stock replacement. This call had a mid to high 90’s delta and its corresponding put had no bid. The December 47.5 call was trading at $11.45 or $.05 over parity. By purchasing this option, you would be equivalently buying the stock at $58.95 (the strike price plus the option price).
Let’s say that you bought the December 47.5 call for $11.45. If a total of 10 calls were purchased (an equivalent of 1000 shares), you would lay out a total of $11,450 to fulfill your stock requirement on this buy-write. If you had purchased the stock outright, you would have spent $58,900. The difference between the capital needed to purchase the stock outright ($58,900) and the capital needed to buy the in-the-money call ($11,450) is the key to this trade.
Now that you have your stock (via the calls you bought above), it is time to sell covered calls against this position, which would be the December 60 calls for $1.30. If the stock stays at its present level, you would then capture the $1.30 premium that you sold the December 60 calls for because they finished out-of-the-money at expiration.
The $1,300 profit in this scenario represents an 11.35% return in only two weeks. This well out-performs the return garnished on a $58,900 investment which would only be a 2.21% return in the two weeks, if you purchased the actual stock.
As we know, the maximum profit of $2.35 will be attained if the stock reaches $60.00 or above. This return comes from the $1.30 you received in the premium for the sale of the now worthless December 60 call plus a $1.05 profit from the December 47.5 call you purchased. With the stock now at $60.00, the December 47.5 call is worth parity, which is $12.50.
You purchased the call for $11.45 thus you received a $1.05 capital gain in the option. This profit of $2350.00 represents a 20.5% return in two weeks verses a 3.98% return in two weeks, if you had purchased the actual stock.
As you can see, you are getting the same overall dollar return on much less money – which creates a much higher percentage rate of return. This is one of the positive leverage effects that the proper usage of options can provide. When you initiate this trade, you are buying and selling two different options simultaneously which is known as a spread. A spread is a trade which involves the buying of one option against the sale of a different option simultaneously and will be covered briefly in the next section.
By buying the December 47.5 calls for $11.45 and then selling the December 60 calls at $1.30, you are buying the December 47.5 December 60 call spread for $10.15. This type of spread is known as a vertical spread.
Oct
29
MER stock trading chart
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Oct
29
NOTES ON Merrill Lynch (MER)
Collar
2) This is a wide trend with some intra-month ranges as much as $5.00 and $6.00 wide, indicating a volatile trend.
3) There were a few gap openings early on in the uptrend during July, but we also want to look at the large intra-day ranges, displayed by the length of the daily candles.
4) The stock also deviates frequently from the mid-line of the trend and although it stays within the trading channel nicely, this still is a volatile trading pattern.
Conclusion: With volatility high, option premiums will probably be expensive. In Merrill’s case, the investors should look to obtain maximum protection, but the protective put would not be the best choice.
Although the stock is very volatile, the uptrend is not a steep one. During the observed period of 6 months, the trends mid-line capital appreciation is only a little more than $6.00, not much compared to many other stocks during this period. With the high volatility, the price of a protective put for any length of time would quickly eat away any profits from the stocks’ rise.
A collar would allow the investor the protection needed, at a reasonable and warranted cost, to justify the potential reward of the capital appreciation.
Oct
28
NOTES ON Yahoo (YHOO)
Collar
2) Yahoo then trades in an uptrend from a price around $33.00 in late August out through January 2004 with a price high of $46.00. This represents a 40% increase in 4 months.
3) During this uptrend, Yahoo had several gap openings which are considered very volatile events. There are 3 of these gaps in October 2003 and 2 in November 2003.
4) Further, Yahoo has many large intraday range days. This also points to a higher level of volatility for this stock.
5) This uptrend that Yahoo trades in has a wide range. The stock fluctuates widely from the mid-line of the range. Again, indicative of higher volatility.
Conclusion: Yahoo offers the investor a good upside opportunity. However, in a stock as volatile as Yahoo, there is also large potential for loss also.
Here, a maximum protection strategy is advised. Under these higher volatility situations, the collar would be better then the protective put because of overall cost.
When trading a stock with such high volatility, the investor must be aware that option premiums will be expensive if not prohibitive. The collar gives the investor the needed downside protection at a much lower cost (due to premiums received from the sale of the call) while still allowing room for capital appreciation.
Oct
27
NOTES ON EBAY (EBAY)
Collar
2. August, was another volatile month. The stock had a high of $57.25 and a low of $50.00.
3. The stock started the month of September trading at $56.50. It traded down to $50.50 then back up to $57.00.
4. Volatility continued in October. The stock had quite a range with a high of $61.50 and a low of $53.50. Moreover, the stock had no less than 5 gap openings. The gap openings were almost evenly divided between “ups” and “downs”.
5. The pattern continued in November 2003. The stock started the month by quickly putting in a high around $58.50. It then traded down, reaching a low around $50.75, before rallying and trading back up to $57.00 before the month’s end.
6. December began with the stock trading around $57.00. It then moved down quietly to $55.00 by the middle of the month. By the end of the month, Ebay was trading at $64.00, up an astounding $9.00 in a little more than two weeks.
Conclusion: A stock this volatile needs a hedging strategy that provides maximum protection. A covered call strategy will provide some protection but not enough for a stock with the month in and month out volatility that Ebay exhibits.
The protective put strategy would work in terms of maximum downside protection, but at what cost? With volatility this high, the puts will be very expensive, maybe too expensive. This situation is perfect for employing the collar.
The sale of a call against the purchase of the put will at least partially offset the expense of the put, making the downside maximum protection affordable, while still leaving room for capital appreciation.
Oct
26
NOTES ON ELI LILLY (LLY)
Collar
2. In another one month span from late May 2003 to mid-June 2003, LLY traded from $56.00 up to $72.00.
3. Several gap openings are also apparent with one in mid-January 2003, one in late August and one in very late September. These all point to periods of high or increasing volatility.
4. We also want to notice the individual daily trading ranges. The length of the lines shows the number of large range days. The longer lines indicate larger intraday ranges. In the chart above, LLY shows a very high number of large intraday movement days, again pointing to high volatility.
5. As much as LLY had strong run-ups, it had some large down periods also. In a 2 month period from mid-Jan. to mid-March 2003, LLY traded down from $68.50 to $58.00. Then in another two month period, mid-June to mid August 2003, LLY traded down from $71.00 to $61.00.
Conclusion: LLY appears to be a very volatile stock during the observed period charted above. The stock began this period at around $60.00 and finished the period at $67.00, which is not necessarily a large move. But when we look at the large intra-month ranges, it’s clear that LLY has been very volatile during this period.
With this type of movement, a maximum protection strategy is necessary but, with such high volatility, premiums will likely be expensive. The outright buying of a put may cut too deeply into potential profits making the risk reward scenario unjustified.
The collar strategy, however, will provide the necessary downside protection, while still allowing room for some capital appreciation. The sale of the call will offset the cost of the put purchase to make the trade’s risk/reward scenario more viable. The collar can be leaned to provide either more protection or more capital appreciation, depending on the investors short term outlook.
Oct
25
Key Point – The collar strategy allows for a limited but continued capital appreciation of a long stock position while providing for a limited, fixed downside exposure. The position is very inexpensive to initiate due to the offsetting premiums of the long (purchased) put and short (sold) call.
The collar is an excellent protective strategy for an investor who has a bullish opinion on a stock.
In looking at the bullish lean example, one of the flaws is the fact that if you move that upside call to the higher strikes you may overly decrease the amount of premium you receive for the sale of that call which, as you know, is supposed to compensate for the amount spent on your protective put.
One way to adjust for this is to look further out across the months in the strike you are interested in. Selling a call out two or three months may generate enough premiums to fully offset the price of the put.
Remember, premiums increase over time for all options. You do not have to be confined by the idea that your long put and short call have to be in the same expiration month.
This adjustment provides more acceptable premium balance allowing extra room for a strong upward stock move while still giving you maximum downside protection.
Oct
24
Like other strategies, the collar can be leaned toward the investor’s perception of the stock’s direction and strength.
Let’s look at the potential leans that can be taken. Say that you have a very strong feeling the XYZ is going to go up. Instead of buying a put and selling a call with strikes that are roughly equidistant from the stock price, you would sell a call that is further out-of-the-money.
This would allow more room for a larger increase in stock price because the stock would not be called away as early. You retain ownership for a longer period of time during the increasing price period.
Of course, by increasing the distance of the option’s strike away from the stock, the amount of the call’s premium will decrease. The overall effect is that you’ll have to pay more to own the position. (You will pay out more money for the put than you will receive from the call.)
Again, we’ll start with the same prices as in our original case, (stock $28.00, Dec. 27.5 put $1.00 and Dec. 30 call $1.00) only now we will change the Dec. 30 call at $1.00 to the Dec. 32.5 call at $ .35.
In our other examples, we incurred no debit or credit from our option position. This time, with the bullish lean, a debit is incurred. The purchase of the Dec. 27.5 put for $1.00 combined with the receipt of $ .35 from the sale of the Dec. 32.5 call produces a $ .65 debit.
Remember, this debit must be subtracted from the bottom line profit or added to the bottom line loss of the stock’s capital result. This means that before you make any money from the position, the stock must trade up $ .65.
If the stock stays stagnant you will lose $ .65, and any capital loss you incur will be $ .65 worse. Now back to the position in our previous example. With the selling of the Dec. 30 call, we had an upside potential of $1.50. In this example things change.
As was stated, our maximum upside potential is calculated by setting the stock price at the strike price of the short call which is 32.5 in this case. With the stock at $32.50 at expiration, you would have a $4.00 stock gain since the stock was purchased for $28.50.
Remembering your $ .65 debit to enter the position, we subtract that from the $4.00 and we have a total maximum profit of $3.35. This is significantly more potential reward than our original example using the Dec. 30 call.
As in all trading situations that offer a higher potential reward, there comes a higher potential risk. If the stock stays at $28.50, (the stagnant scenario) you have a loss of $.65 in option costs. In the down “scenario,” calculating the maximum risk is done by setting the stock price at $27.50 on expiration.
The stock, purchased at $28.50 has lost $1.00. The options, not neutral, resulted in a $.65 loss. The total loss is $1.65. In both the “stagnant” and “down” scenarios, the loss increased over that in our original example. As you can see, the higher potential gain is accompanied by an increased potential risk.
Oct
23
How The Collar Strategy works in different scenarios?
Filed Under Intermediate Options Trading | Leave a Comment
Let’s take a look at how the strategy works with this position. For the sake of our illustration and to make our calculations easy let’s establish the collar using the December 27.5 put and the December 30 call, with both trading at $1.00.
Remember our stock price was $28.50. The cost of the collar will be $0 because you paid $1.00 for the put but you collected $1.00 from the sale of the call. How does the collar work in our usual three scenarios: the “up” scenario, the “down” scenario and the “stagnant” scenario?
In the “up” scenario, we find that when the stock rises, the investor gains penny for penny until the stock reaches the call strike. Once the stock reaches that level, the position no longer gains because the stock is at the point where it will be called away.
Capital gains of the position are maximized when the stock reaches the call’s strike price. Let’s take a closer look at what happens as the stock price goes up. With the stock at $29.00, both the Dec. 30 calls and the Dec. 27.5 puts are out of the money and thus worthless. Since there was no debit or credit incurred in the options, the option profit (loss) is $0. Only the stock position remains. The stock purchased at $28.50 is now trading at $29.00 for a $.50 profit.
Let’s raise the stock price to $30.00. The puts and calls are again worthless so your profit (loss) is solely determined by the stock. The stock, which was purchased for $28.50 is now worth $30.00 and represents a gain of $1.50. This $1.50 gain is the maximum gain the position allows.
Once the stock goes over $30.00, the Dec. 30 call, which we are short, would become in-the-money and therefore the stock position would be called away at that price. When the stock price rises to $31.00, the puts would be out-of-the-money thus worthless but the calls would be worth $1.00.
You received no money for the establishment of the collar so you would have a $1.00 loss in the options. Meanwhile, the stock that you purchased at$ 28.50 is now worth $31.00 at expiration, which is a $2.50 gain.
Combine the $2.50 gain in the stock with the $1.00 options loss; you have a $1.50 profit again. You may do this calculation with higher and higher stock prices but the outcome will always be the same. This example shows how your upside potential is limited.
Obviously, if the option portion of the collar incurred a debit or credit, that inflow or outflow of money must be added to or subtracted from the stock gain to get the overall return of the position.
Normally, there will be a debit or credit incurred in the collar. It is usually difficult to find a put and a call that you want to use in the collar trading at an equal value. Let’s use our last example with some minor price changes.
If the put had been trading at $1.25 instead of $1.00, then there would be a $.25 capital outflow that would have to be subtracted from the $1.50 gain to reduce it to only a $1.25 gain.
On the other hand, if the call was trading at $1.25 then you would have collected an extra $ .25 which added to the $1.50 gain would produce a $1.75 gain. The cost of the collar always impacts the bottom line profit or loss of the position.
Looking at the collar in the “stagnant” scenario, the stock price would be unchanged thus neutral in terms of return. Therefore, the potential profit or loss would come strictly from the debit or credit of the two options.
If the stock does not move, as in our example, both the put and call would finish out-of-the-money and be worthless.
Our profit or loss would simply be calculated from whether you paid for the collar or collected from the collar and how much that amount was.
Using the same prices as the previous example (the stock purchase price of $28.00, the Dec. 27.5 put $1.00 and the Dec 30 call $1.00) we will now take a look at the “down” scenario. Let’s set the stock price at $28.00 on expiration. At this price both the Dec. 27.5 put and the Dec. 30 call are out-of-the money and worthless. Since there is no credit or debit incurred in the option position ($1.00 inflow from the calls, $1.00 outflow from puts) the total return of the position is simply the gain or loss from the stock.
With the stock purchase price of $28.50 and a stock price of $28.00 on expiration, there will be a $ .50 loss in the position. Setting the stock price at $27.50, we see that the Dec. 27.50 puts and the Dec. 30 calls are again worthless and with no debit or credit incurred, the positions profit or loss will come down to the gain or loss on the stock.
With the purchase price of the stock being $28.50 and the stock price at expiration $27.50, there will be a $1.00 loss. In this case, we have reached the maximum loss. No matter how low the stock goes, you can only incur a maximum loss of $1.00.
Now, let’s set the stock price at $26.00 and see if this holds true. With the stock at $26.00 on expiration, the Dec. 30 calls are out-of-the-money and worthless. The Dec. 27.5 puts, however, are in-the-money and now worth $1.50.
The stock you purchased for $28.50 is now worth $26.00 on expiration which is a $2.50 loss. Combining the $2.50 stock loss with the $1.50 gain in the puts and you have a $1.00 loss in the overall position.
This demonstrates that $1.00 is the maximum loss of the position. Keep in mind that if the stock position creates a debit or a credit, it must be added to, or subtracted from the stock loss.
Most of the time, there will be a small debit or credit incurred in the option position. It is relatively infrequent that the put and call used in the collar are trading at the exact same price.
Oct
22
The Collar Strategy
Filed Under Intermediate Options Trading | Leave a Comment
THE COLLAR STRATEGY
Another protective strategy that allows for some upside capital gain while providing maximum down side protection is the collar.
The collar is a combination of the covered call and protective put strategies. The collar uses a long put position in coordination with a short call position along with a long stock position. The ratio is one short call, one long put (not of the same strike) and 100 shares of stock.
As you remember, one contract is equal to 100 shares. The options that we will use to construct this strategy will be out-of-the-money puts and calls.
The object here is to construct a protective put strategy without having to pay for the purchase of the put. We talked about premium in the covered call strategy and how we are better off collecting premiums over a period of time, not paying them out. By selling the call, we collect premium which can be used to offset the capital outlay we incurred for the put purchase.
We said that two of three scenarios in the covered call strategy were positive while the protective put scenario had only one scenario that produced a positive outcome.
However, the protective put was the strategy that provided the most downside protection. The challenge was to construct a protective put strategy without paying out money. The solution is the collar strategy.
The collar takes on the characteristics of both the protective put and covered call strategies. Like the covered call, there is an upside cap on profits and like the protective put there is unlimited downside protection.
Ideally, the collar is set up to be an “even” trade meaning you neither receive nor pay out any money. Realistically, depending on the options used, you may have to pay out a small premium or even receive a small premium but the goal of the collar in terms of premium is to be neutral.
As mentioned previously, to construct a collar, just buy one out-of-the-money put and sell one out-of-the-money call per every 100 shares of stock owned.
Obviously, the put and the call must be of differing strikes (it is impossible for a put and a call of identical strike price to both to be out-of-the-money or both to be in-the-money).
For example, with a stock priced at $28.50 a collar may be constructed by the purchase of the December 27.5 puts and the sale of the December 30 calls. Hopefully, the price of the call and put are close enough so that the funds generated by the sale of the call are enough to offset the cost of the put purchase.
Oct
21
NOTES ON GM General Motors
Protective Put
1. After trading in a tight range for a considerable period of time with low volatility, GM’s volatility spiked in early December 2003 and the stock gapped open considerably higher, followed by another breakout gap opening several days later.
2. This second gap opening forced the stock up through a previous resistance level, as the stock broke out and began a new, higher trading range.
3. The stock then advanced five of the next seven trading days with bigger intraday ranges than average during the previous 12 months, indicating increasing volatility.
4. The initial GM breakout, when it traded through $44.00 and quickly proceeded to trade up to the $54.00 range in less than one month, represented a 25% return in a very short period of time.
Conclusion: GM is a perfect example of an opportunity to use the protective put strategy to provide protection against a false break-out when buying a stock on a technical breakout.
In this case, GM had been trading in a lower volatility pattern for several months, which would have kept option premiums down. This would have allowed the investor to purchase the put at an advantageous price.
With the protective put in place, and at a relatively inexpensive price, the investor could ride the break-out with patience and confidence, with limited loss and controlled risk.
Even though this stock was in a rapid uptrend after breaking out of its previous trading range, and the protective puts purchased would have expired worthless, it still would have been a good idea to put on this protection in case the stock pulled in.
Gap openings tend to get filled at some point before proceeding higher, and in the case of a rapid sustained rally, there is usually some type of pullback when the stock is overbought.
In this case, the puts would not have been profitable, but would have provided the necessary protection in case the rally failed, or temporarily retraced.
We wanted to show this example where the puts would not have been profitable, because you never know where the stock is going to go. But even though the puts would have expired worthless, the rise in stock price would have clearly offset the cost of these puts.
So again, the protective put strategy here would have provided a cost effective insurance policy against the stock’s pulling back or a failed rally.
Oct
20
NOTES ON WAL-MART (WMT)
Protective Put
1. In mid-November 2003, Walmart opens down $1.50 to $56.25 and proceeds to trade down from there breaking the lower end of an uptrend channel.
2. Wal-mart then has a quick consolidation in mid-November around the $54.50- $55.00 level followed by a small technical rebound back to around $56.25. This may have been due to some investors thinking that the consolidation was a bottoming and thus a buying opportunity.
As it turned out, it was a false bottom and the stock traded back down rapidly to lower lows. A purchase at that level probably led to losses.
3. In early December, Walmart starts another consolidation around the $52.50 level. It seems to be another buying opportunity for bottom fishers. There has already been one false bottom that has cost someone a lot of money. If that investor employed a protective put, the loss would have been limited and they may have been able to purchase again at this level if they wished.
4. The $52.50 level turns out to be another false bottom and the stock trades down another $2.00 to $50.50. Here again, the same opportunity exists. Is this the bottom? If it is, a nice profit can be made quickly. If not, losses can mount quickly as another false bottom occurs and the stock trades down rapidly. This level, so far, turns out to be a good buying opportunity as the stock rebounds back up to $52.50 quickly.
Conclusion: Bottom fishing can be a very risky endeavor; however, an investor can not ignore the potential reward that comes with the risk. If the risk can be minimized without affecting the potential reward to a significantdegree, the risk/reward scenario will be an advantageous one for a potential investment.
The protective put will accomplish this perfectly. In a case like this, the protective put strategy should be employed at any level where the investor deems it worthy of a capital commitment.
Oct
19
NOTES ON AMGEN (AMGN)
Protective Put
1. With the use of Technical Analysis, Amgen is identified to be poised to break down through a technical support as determined by a line drawn through three bottoms points, occurring in January 2002.
2. Then, in May 2002, the stock breaks down below the support line indicating an upcoming drop to a new, lower trading range.
3. The stock begins to consolidate at around $46.00, and attempts to rebound. A protective put can be used here with the purchase of the stock in case the stock has a false bottom.
4. Indeed, this level is a false bottom as the rally fails, and the stock heads lower before the next consolidation level at point around $41.00. Again, stock may be purchased here with a protective put.
5. The rally fails again and the stock falls to around $32.00, before putting a final bottom & reversing. Again, a protective put can be purchased here to guard against further downside. At this level, the stock begins its real rally and rises quickly from this point to provide an outstanding return from $32.00 to a high of $72.00 in one year.
4. In September 2002 at a stock price around $41.00, you could also buy a protective put as the stock pauses in its uptrend before continuing higher. At this level, the stock could be gathering up strength for the next leg of the rally (which it does) or it can become tired and begin to trade down again.
CONCLUSION: The protective put allows the investor the room to be wrong by limiting the total loss. Because the loss is limited, the protective put investor has a staying power not afforded to naked stock buyers who would feel the full brunt of the loss.
This ability to play again increases the protective put buyer’s chance of being right and therefore more profitable than the naked stock buyer would be. The Amgen chart is a textbook example of a stock in position for the use of the protective put strategy.
Obviously, this was a risky trade, but one that could, and in this case did, provide an outstanding return. This is the perfect time to use the protective put. The protective put provides maximum protection in risky situations while allowing you to have almost the maximum available upside.
So, if you did buy the wrong bottom, the put would have bailed you out by limiting your downside and saving you enough money to try again. As you see from the chart, within 12 months of the July 2002 low of around $32.00, the stock traded to a high of over $72.00. This profit is more than enough to have covered the purchase of a few puts.
As stated earlier, this is a textbook case and one that should be studied for its value of properly showing why and when to use the protective put.
Oct
18
NOTES ON RJ REYNOLDS (RJR)
Protective Put
1. Up until early March 2003, RJR was in a trading range with a high of $47.50 and a low around $38.00.
2. In early March, RJR broke that low around $38.00 and traded down to around $28.00 before trading back up to the $38.00 level. It failed to break that resistant level a couple times. Then, in mid-September 2003, RJR gaps up and breaks the resistance level.
3. Normally, when a stock breaks a resistance level, it normally trades up to find a new range most specifically a top of the range. Often, there is an opportunity to make a large gain in a very short amount of time when a stock beaks a support or a resistance.
4. After breaking out of the previous trading range, in mid-September 2003 at a price of about $40.00, RJR trades up to $60.00 by mid-December 2003. This represents a 50% gain in approximately 3 months.
Conclusion: RJR offers investors two opportunities to use the protective put strategy and in two different ways.
First, the protective put strategy can be used to provide protection when an investor tries to pick the bottom in a stock. The wrong bottom can cost the investor dearly if they buy the stock naked. The put will limit and control the loss, allowing the investor to be wrong, but still allow the opportunity to hold out or play again.
Second, RJR later shows what a stock can do when breaking out of a technical resistance. It can provide investors with large potential gains. However, the fact is that stocks that do break out can, and sometimes do, fail and trade down to the bottom of the stock’s previous range. This can leave you with a large loss.
The protective put strategy provides maximum protection in case of a false break out, while allowing for full capital appreciation less the cost of the put if the break out is real.
Oct
17
Key Point - The protective put strategy, when used correctly, will allow investors to take advantage of some opportunities that could provide large potential gains without being exposed to the severe risks that normally accompany such risky opportunities. With the proper protection in place, the investor can profit from aggressive upside moves in the stock while having a fixed, limited loss.
As stated before, this strategy is not going to work all the time. However, there are some especially favorable opportunities for implementing the protective put strategy.
One is the case of a stock in the process of a steep decline. Quite often, stocks experience bad news or break down through a technical support level and trade down to seek a new, lower trading range.
Everyone wants to find the bottom to buy and go long, catching the technical rebound, or to start accumulating the stock at lower levels for the longer term.
Although this scenario sounds good, these types of trades are risky. The risk is in identifying the true bottom. A stock that is in a freefall or rapid decline might give a false indication of a bottom which could lead to substantial losses. The protective put will provide protection against this kind of substantial loss.
A stock that goes through a freefall finally “exhausts” or works through the sellers. The stock proceeds down to lower levels where sellers are no longer interested in selling the stock.
At this level, the stock consolidates and buyers move in. Because the sellers are now done (exhausted) the pressure is lifted from the stock and it proceeds up as buyers out-number sellers.
There are models that are used to calculate where this bottom may lie, commonly referred to as “exhaustion models.” The problem is that the stock, on the way down, may stop and give the appearance of exhaustion but then continue further down. If you had bought at the false appearance of exhaustion, you could be looking at a big loss.
There is a potential for a very big reward if you pick the “right” bottom. However, with the big potential gain comes the big potential loss that is common in these types of risk/reward scenarios. Here is a perfect opportunity to employ the protective put strategy!
Remember, the protective put allows for a large potential upside with a limited, fixed downside risk. If you feel that the stock has bottomed out and is starting to consolidate, you purchase the stock and purchase the put.
If you are right, and the stock runs back up, the stock profit will well exceed the price paid for the put. Once the stock trades back up, consolidates, and develops its new trading range, the need for the protective put is over. At this time, if you still like the stock and want to hold on to the long position, you could always start selling calls against it.
Use the formula for maximum loss discussed earlier. Calculate the loss in the stock and the amount you paid for the put and add them together for your maximum loss in this position. The protective put has limited your loss.
This protection will save you enough money when you pick a false (wrong) bottom that you may, if you like, try to pick the bottom again at a lower point. The exhaustion scenario, as described here, is a perfect opportunity to apply the protective put strategy.
As seen with the exhaustion example, the protective put strategy is best used in situations where the stock has a potential for an aggressive upside move and the chance of a big downside move.
Another potential opportunity for using the protective put is in combination with Technical Analysis. Technical Analysis is the study of charts, indicators oscillators, etc. Charting has proven to be more than reasonably accurate in forecasting future stock movements.
Stocks travel in cycles that can and do form repetitious patterns. These patterns are predictable and detectable by the use of any number of charts, indicators and oscillators.
Although there are many, many forms and styles of technical analysis, they all have several similarities. The one we want to focus on is the technical “break-out.” A break-out is described as a movement of the stock where its price trades quickly through and beyond an obvious “technical resistance” or resistance point.
For a bullish breakout, this level is at the very top of its present trading range. Once through that level, the stock is considered to have “broken out” of its trading range and will now often trade higher, and establish a new higher trading range.
The “break-out” is normally a rapid, large upward movement that usually offers an outstanding potential return if identified properly and acted upon in a timely fashion. However, if the break-out fails, the stock could trade back down to the bottom of the previous trading range.
If this were to happen, you would have incurred a large loss because you would have bought at the upper end of the previous trading range. As you can see the “break-out” scenario is an opportunity that has large potential rewards but can on occasion, have a large downside risk.
Therefore, this is an excellent scenario for application of the protective put strategy.
For example, XYZ is presently at the top of a trading range with the upper end of the range being $66.00 and the bottom end of the range being $58.00. When the chart, indicator, or oscillator you are using identifies the break-out of the stock (when it trades through $66.00), you would buy the stock immediately.
The risk of the stock not following through with its breakout is not large but it does happen. The stock could trade back down to $58.00 which is the bottom of the trading range. If you had bought the stock naked above $66.00, you would realize a minimum $8.00 loss.
However, if you were to apply a protective put strategy with the stock purchase, you can drastically limit your downside exposure. For instance, say you were to buy the 65 strike put for $2.00. If the stock trades up to $75.00, you would make $9.00 if done naked but only make $7.00 if done with the protective put.
This difference is the cost of the put. This $2.00 investment is more than worth it should the stock go down. If the break-out turns out to be a “false” break-out and the stock reverses and trades down, your 65 put will allow you to sell your stock out at $65.00 minus the $2.00 you paid for the put. This limits your loss to $3.00 instead of a potential $8.00 loss. This is a much better risk/reward scenario.
Oct
16
How can Protective Put Strategy adjusted?
Filed Under Intermediate Options Trading | Leave a Comment
The Protective Put Strategy can be adjusted to address the particular lean that the stock owner has at a particular time. (The term lean describes the stock owner’s perception of the directional strength of the stock.)
At any given time, an investor could feel that a stock may go up or down, a little or a lot, or just stay where it is. The protective put is not a position you would put on if you feel that the stock you own was going to consolidate for a while. You would have a loss in the stagnant lean scenario since the stock made no gain but you were out $1.00 for the purchase of the put.
However, the situation is different in a bullish lean scenario.
A stock that has the potential to rise quickly also has the potential to fall just as quickly. A stock that has substantial potential gain has an equal potential loss.
An investor choosing to buy a stock like this should have more protection to the downside then a covered call can provide and at the same time more allowance for a larger upside potential than the covered call allows.
This is a perfect time to use the protective put strategy. The purchase of an out-of-the-money put will be a relatively inexpensive investment but will provide the kind of results that will best fit a bullish lean.
You will have maximum downside protection with all the room you need for your stock’s potential run up. Of course, this comes at a price. You must pay for the protection and freedom this position can provide.
The protective put can also be used when you have a little bearish lean on your stock. Let’s say that you own a stock that has taken a very nice run up. The stock has gotten to a point where you think about possibly selling and taking your profits but are afraid to because you feel it may still run up more and you will not forgive yourself for getting out too early.
Instead of selling the stock and missing out on the continued run, look into buying a put for protection. It will allow you to continue your capital appreciation as the stock trades up while limiting your loss to a fixed, known amount.
In cases such as this one, the purchase of an at-the-money or slightly in-the-money put will ensure you get a good sale price if the stock heads down and allows you ongoing profit if the stock continues up.
Of course, if the stock stays still, you would lose the amount of premium you spent on the put. If the stock goes up, it would have to trade higher than the amount you spent on the put before your long stock’s upward movement starts to make you money again.
Oct
15
Protective Put Strategy in different scenarios
Filed Under Intermediate Options Trading | Leave a Comment
As previously stated, when we buy a stock, three potential outcomes exist. The stock can go up, go down, or remain stagnant. Let’s hypothesize results across these three scenarios. Say you buy the stock for $31.00 and buy the front month 30 put for $1.00.
In the “up” scenario, let’s assume the stock price is $31.50 at expiration. The results are that you have a $.50 gain from capital appreciation and a $1.00 loss from the purchase of the put which combined gives us a $.50 overall loss.
It is important to realize that the up scenario will only produce a positive return if the stock gain is greater than the amount paid for the put. That being the case, you calculate the breakeven point for the protective put strategy by adding the purchase price of the stock to the price of the put.
In the “up” scenario, add the stock price $31.00 plus the option price $1.00 and you get a breakeven of $32.00. So, until the stock reaches $32.00, the position will not produce a positive return. Above $32.00 the position will gain the amount equal to the stock price minus the premium paid for the option..
In the “stagnant” scenario, the position will produce a loss. Since the stock hasn’t moved, there will be no capital gain or loss and with the stock at $31.00 at expiration, the puts are worthless. The position lost $1.00, the amount you paid for the puts.
In the “down” scenario, the position will again produce a loss. If the stock price were to trade down $1.00 to $30.00, then you would have a $1.00 capital loss.
With the stock at $30.00, the 30 puts will be worthless, thus you incur a $1.00 loss because that is what you paid for them. Your total loss will be $2.00.
However, in the “down” scenario, the protective put will set a cap on your losses. Let’s see how that works. We’ll set the stock price down to $28.00. Since you purchased the stock at $31.00, there will be a capital loss of $3.00.
The puts, however, are now in the money with the stock below $30.00. With the stock at $28.00, the 30 puts are worth $2.00. You paid $1.00 for them so you have a $1.00 profit in the puts.
Combine the put profit ($1.00) with the capital loss (-$3.00) and you have an overall loss of $2.00. The $2.00 loss is the maximum amount you can lose regardless of how low the stock declines, even if it goes as low as zero. This is what is meant by maximum protection.
In every protective put position it is possible to calculate your anticipated maximum loss. Use the formula: (stock price minus strike price) minus the option’s price equals total maximum loss.
For example, suppose you paid $30.00 for your stock. You bought the front month 27.5 put for $1.00. Next, assume the stock closes at $27.50 on expiration day.
Your maximum loss calculation would be:
$30.00 (stock price) minus 27.5 (strike price) equals a $2.50 capital loss. Do not forget that with the stock at $27.50, the 27.5 puts will be worthless.
Add the capital loss ($2.50) plus the option loss ($1.00). The total is $3.50 which is your maximum possible loss in that position. This formula will work every time.
Looking at the three hypothesized scenarios, we find that only one scenario, the “up” scenario, can produce a positive return and that’s only when the stock increases more than the amount you paid for the puts.
The other two scenarios produced losses. If the stock is stagnant, you lose the amount you paid for the put. If the stock goes down, you lose again- but the loss is limited. It is the limiting of loss that makes the protective put an attractive and useful strategy.
Oct
14
October 14, 2007 Market Report
Filed Under Market Snapshots | Leave a Comment
Fundamentally speaking, the bulls appear to be a little bit uneasy about their additional 50 basis points cut that most expected to be a sure thing before the end of the year. Slightly stronger than expected data in the weekly jobs report and retail sales and PPI numbers point to a possibility that the much feared recessionary boogey man could be avoided. Add to that the rumblings from
Technically the Dow ended the week up a meager 28 points for the week although there were several days of tremendous volatility, and the index closed above the very important level of 14,020, although not decisively enough for me to turn bull nor was it on impressive volume. Looking to the SPY, the sell off that occurred on Thursday was on almost twice the volume that the rally days of the week had. Energy and commodities continue to soar, and earnings are looming. Monday, Citigroup will report before the bell with 44 cents per share expected, and Intel will report after the bell on Tuesday with an expectation of 30 cents per share.
In a market environment like this, with cheap volatility and violent intraday swings, the long gamma trading strategy can be quite profitable if the trader is vigilant. A trader can use his gamma position(by purchasing options) to flip stock throughout the day and not have to exceed much in the way of his short theta (decay), because the price he paid for that gamma is relatively cheap.
There are two things one might consider going into this week. First, will the devalued dollar serve to enable company earnings to be over inflated and therefore exceed expectations? Secondly, E-Trade Corp. reports earnings after the close on Wednesday. If they soundly exceed expectations, could that lead one to believe that more retail long players are entering the market, leading one to believe that we may be looking at the top in US equities? Or would we be better off to continue to be indecisive?
Gregory Wolfe
The
Oct
14
The Protective Put Strategy
As a reminder, a put gives an owner the right but not the obligation to sell a certain stock, at a specific price, by a specified date.
For this opportunity, the buyer pays a premium. The seller, who receives the premium, is obligated to take delivery of the stock should the buyer wish to sell the stock at the strike price by the specified date. A strategically used put offers maximum protection against substantial loss.
The Protective Put, also referred to as a “married put,” “puts and stock” or “bullets,” is an ideal strategy for an investor who wants full hedging coverage for their position.
Whereas the Covered Call Strategy will cover an investor down only as far as the premium he receives, the protective put strategy will protect the investor from the breakeven point down to zero.
This strategy’s philosophy is different from the covered call (buy-write) strategy in two major ways.
The covered call is a premium selling strategy, while the protective put is a premium purchasing strategy; and the covered call is most effective in a less volatile situation while the protective put is more effective in high volatility situations.
When an investor purchases a stock, he can either sell the call (buy-write) or buy the put (protective put) to provide a proper hedge. The construction of the protective put position is actually quite simple. You buy the stock and you buy the put on a one to one ratio meaning one put for every one hundred shares.
Remember, one option contract is worth 100 shares. So, if we have 400 shares of IBM then you would need to purchase exactly four puts.
From a premium standpoint, we must keep in mind that by purchasing an option, we are paying out money as opposed to collecting money. This means that our position must “outperform” the amount of money that we put out which is the opposite side of what we did in the covered call strategy.
If we were to pay $1.00 for a put and we owned stock against it, we would need to have the stock increase in price $1.00 just for us to break even. Unlike the covered call, the protective put strategy has the premiums working against it, thus the stock needs to move more to offset the cost of the put.
This is why long option strategies need more volatility than short option strategies. Earlier we talked about the covered call strategy needing to be done over a decent period of time (a year or so) in order to take advantage of the odds.
We stated that selling options and collecting the premium was the right thing to do 75% – 82% of the time. If this is true, then buying an option and paying out premiums is only going to be right 18% – 25% of the time.
Those are not good odds. So, you should try to stay away from employing this strategy over a long period of time to avoid having the odds fall against you. However, employing a protective put can be extremely effective in the proper situation.
Let’s take a look at the risks and rewards of the protective put strategy over three different scenarios.
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