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Feb

26

Options 101 Part 99

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There is a second method (which is probably more logical) for determining whether a vertical spread is bullish or bearish. This can be done as a two-step process. First, find out which option is most valuable and that is the one that controls the position. Second, find out whether that option is being bought or sold. Now just determine whether buying or selling that option by itself is bullish or bearish and you’ll have the correct answer.

For example, using our $50/$55 vertical call spread, we know the $50 call is more valuable since it is a lower strike. Once we have identified the more valuable strike, we then need to find whether that option is being purchased or sold. If the $50 call is bought then you are really buying a call, which is bullish. Therefore, buying the $50 call and selling the $55 call must be a bull spread since the trader is buying the controlling call option. Buying a call is bullish.

On the other hand, if you sell the $50 call and buy the $55 call then it is a bear spread since the trader is selling the controlling $50 call. Selling a call is bearish.

Identifying the controlling option is an easy way to identify long and short vertical spreads once you start trading them. For instance, assume you find a quote for the $50/$55 vertical call spread. If you buy the vertical spread, you will be buying the $50 call and selling the $55 call. Again, buying the spread just means you are buying the more valuable option. On the other hand, if you sell the spread, you will be selling the $50 call and buying the $55 call. Selling the spread means you are selling the more valuable option. Notice that it is the more valuable $50 call that determines whether the spread is being purchased or sold.

Let’s try it for the $50/$55 vertical put spread. The more valuable strike is the $55 strike. If you buy that strike then it is a bear spread since you are buying the controlling put. Buying a put is bearish. On the other hand, if you sell the $55 put then it is a bull spread since you are selling the controlling call. Selling a put is bullish.

While you are learning spreads, start by using the BLSH mnemonic to find if the strategy is bullish or bearish. But as you continue to work with spreads, gradually adopt the method of identifying which is the controlling strike and then identify whether you are buying or selling that strike and you will always be certain of your answer.

Rationale for Spreads
With this information, it is now easier to understand the rationale for vertical spreads. If you buy a vertical spread, you are buying the more valuable option. The sale of the other option is simply done to reduce the cost of the long option. Buying a vertical spread is a strategy, as we will discover shortly, that allows investors and traders to enter into long option positions they may otherwise consider too expensive. Long vertical spreads solve the expensive option problem.

On the other hand, if you sell a vertical spread, you are selling the more valuable option. Whenever you sell an option, you are accepting an obligation. By selling a call option, you have the obligation to deliver shares for a fixed price and there is no telling how high the price of that stock may be when it comes time to deliver the shares. Selling a put option gives you the obligation to buy shares at a fixed price and there’s no telling how low the price of those shares may be at that time. In other words, selling an option by itself (naked) entails a lot of risk. However, the vertical spread requires that you purchase another option, which acts as a hedge and completely defines the maximum loss. In other words, when you sell a vertical spread, you are really interested in selling the more valuable option. The purchase of the other option is done to reduce the risk of the short option.

Cheap or Chicken
We have shown that the debit trader is really interested in purchasing the more valuable option. By entering the spread, the trader can reduce the premium paid for this long position. For the credit spread trader, the goal is to sell the more valuable strike and receive a premium; however, the trader is now exposed to potentially unlimited losses. By entering a vertical spread, the trader takes some of the premium from the sale of the short option and buys another option to hedge adverse stock price movement.

There is a somewhat humorous, although valuable way of understanding the philosophies between credit and debit spreads. We can say the debit trader is “cheap” since he does not want to pay a lot for the long call position by itself. Selling the less valuable option reduces the price.

The credit spread is considered “chicken” as his goal is to sell the more valuable strike but he is fearful of the unlimited risk. Buying the less valuable option provides a hedge. So remember “cheap” or “chicken” to help identify the underlying philosophies.

Early Assignment
Traders new to vertical spreads are often concerned they may get assigned early on the short position. If so, does it pose a risk? Assume you buy one $50/$55 vertical call spread (buy the $50 call and sell the $55 call) for a net debit of $2. The very most this spread could ever be worth is the $5 difference in strikes, which would leave you with a $3 profit. Now assume that the stock rises above $55 prior to expiration and you are assigned on the short $55 call. If you are assigned on the $55 call, you are required to sell shares for $55 per share. However, if you do not have the shares then your broker will short shares in your account so that the stock can be delivered to the person exercising the $55 call. The end result is that you have a long $50 call plus a short stock position of 100 shares.

When you find out you have been assigned early, you can do one of two things. First, exercise your $50 call and cover the short stock position. This means you will have purchased shares for $50 and sold them for $55 thus locking in the guaranteed $5
maximum gain early, which is a very good thing. This shows that if the stock price is the same or higher the next day there is no risk to you. Simply exercise the long $50 call and collect the $5 maximum gain.

But what if the stock price is down? Put-call parity reveals that your combination of a long $50 call plus short stock is really a long $50 put in disguise. To verify, all we have to do is take the basic put-call parity equation S + P – C = 0 and rearrange it so that long call and short stock are on the same side of the equation and find that P = C – S. This means that you could do better than a $5 gain if the stock price falls, since long puts will rise in value. For instance, assume the stock price falls from $55 to $49 the day you find out about the early assignment. In this case, don’t exercise the $50 call. Instead, just buy the shares in the open market for $49 and deliver them against your short position at $55 and collect a $6 profit. The additional $1 gain is the effect of the synthetic $50 put against a $49 stock price. You would still be left with a free long call that may make even more money if the stock price should rise.

What if you had, instead, sold the $50/$55 call spread (sold the $50 call and bought the $55 call) for $2? Your maximum gain on this position is $2 and the maximum loss is $3.

Let’s assume the stock is $53 and see what your choices are now. If you think the stock will fall then you can hang on to the position and make a maximum of $2 if you are correct and the stock does fall below $50 at expiration. However, if you feel the stock will rise, then you could buy back the $50 call for more than $3 ($3 intrinsic value plus time value). So at this point, your two choices are to make a maximum of $2 or spend more than $3.

Now let’s assume that you are assigned on the short $50 call and see how that will affect your alternatives. You will be short stock at $50 and long the $55 call, which is a synthetic long $55 put. If you believe the stock will fall from this point, then hang on to the short stock and long $55 call combination and continue to profit in an unlimited fashion if the stock falls. If you were not assigned then you could only profit by $2.

However, if you believe the stock will rise, then buy the short shares back in the open market for $53 using the $50 credit balance from the short sale, which results in a net loss of exactly $3 on that transaction. If you had not been assigned, it would cost you more than $3. You can verify a similar set of transactions for the vertical put spreads. Early assignment will therefore never hurt you in a vertical spread. And it’s all because you understand synthetic options!

Feb

25

Options 101 Part 98 Max Gain, Max Loss, and Break Even

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Figure 9-2 shows that the trader does, in fact, have limited downside risk and limited upside reward as we suspected. The maximum loss, as with any long option position, is the amount paid for the position, which is $2 for this example. What is the maximum gain? If you remember Pricing Principle #6, you should know that the maximum value between any two strikes within the same month is the difference in strikes. Therefore, if you are long the $50 call and short the $55 call then the most that spread could ever be worth is $5. Because you paid $2 for it, the most you could ever make is $3, which is exactly what Figure 9-2 shows.

We can arrive at the same answer by checking our rights and obligations. By purchasing the $50 call and selling the $55 call, the trader has the right to buy stock for $50 and the potential obligation to sell it for $55. If you purchase stock for $50 and sell it for $55 then that is a $5 profit. In order to acquire this right, it cost you a net debit of $2 so the most you could make is $3. If you add the maximum gain and maximum loss together you will always find they equal the difference in strikes. The key point to remember is that if you buy a vertical spread then the most you could ever receive is the difference in strikes (your profit depends on the price paid for the spread). In other words, if you buy an asset, you expect a reward. If you buy a vertical spread, the biggest that reward could ever be is the difference in strikes.

The profit and loss profile for Figure 9-2 shows that the trader makes money if the underlying stock rises, and it is therefore called a bull spread. Specifically, if the stock rises above the $55 strike then the trader makes the full $5 on the spread ($3 profit). The trader can make a smaller profit for expiration stock prices below $55 down to the breakeven point. Where is the breakeven point? The trader is effectively long the $50 call for a cost of $2 and that means the stock must be at $52 at expiration in order for the trader to break even. If the stock is $52, the $50 call is worth the $2 intrinsic value and the $55 call expires worthless, which means the trader breaks even. So the trader makes a profit at expiration for all stock prices above $52 and makes a maximum profit for all stock prices above $55. The trader takes a loss at expiration for all stock prices below $52 and has a maximum loss for all stock prices below $50. The maximum gains, losses, and break-points are fast and easy to calculate if you understand the Pricing Principles discussed in Chapter Two.

Vertical Bull Spread Using Puts
Let’s now take a look at how we can construct the same profit and loss diagram using puts. If you buy the $50 put for $1 and sell the $55 put for $4 then the profit and loss diagram looks like Figure 9-3:

Notice that Figures 9-2 and 9-3 are identical. However, the way they arrive at the same shapes is a little different. If you buy a $50 put and sell a $55 put you will receive a credit for the trades since you are selling a higher-strike (more valuable) put. Buying the $50 put and selling the $55 put is therefore a short $50/$55 vertical bull spread.

By selling the $55 put, you have the potential obligation to buy shares for $55.
By purchasing the $50 put, you are assured that you can always sell shares for $50. If you buy shares for $55 and sell them for $50 then you have a $5 loss. However, since you were paid $3 for the spread position the most you could lose is $2. The important point to remember is that if you sell a vertical spread then the most you could ever lose is the difference in strikes (with your profit depending on the price received for the spread). In other words, if you sell an option, you have some type of potential obligation. If you sell a vertical spread, the biggest obligation you will ever face is to owe the difference in strikes.

Many traders make the incorrect assumption that credit spreads must be better than debit spreads based on the premise that it is better to receive money rather than spend it. The truth is that for any given strikes, debit and credit spreads are theoretically identical, which is confirmed by the profit and loss diagrams. In practice though, professional traders will choose one over the other due to slight favorable pricing variations that can occur for a number of reasons. For instance, using the call and put examples above, you may find that one has a maximum loss of $2 and a maximum gain of $3 while the other has a maximum loss of $1.90 and a maximum gain of $3.10, which is slightly better. But a professional trader would never choose the credit spread “just because” it produces a credit. You must always check the maximum gains and losses to determine which is better at that time.

We just showed that we can create a vertical bull spread by using calls or puts. Notice that there is a similarity between the two versions in that both are created by purchasing a lower strike option and selling a higher strike option. This is easy to remember if you look at the first letters of the phrase “Buy Low, Sell High,” or BLSH, which resembles the word “bullish.” Any time you buy a lower strike option and sell a higher strike option of the same type (call or put) then you create a vertical bull spread.

Of course, if you do the reverse and buy a high strike and sell a lower strike, then that is a bearish position and you’d need the underlying to fall. Bear spreads work identically to bull spreads but in the opposite direction. It is crucial to understand that buying the vertical call spread is identical to selling the corresponding (same strikes) vertical put spread.

Vertical Bear Spreads
Let’s now take a look at examples of how to create vertical bear spreads, which we found are created by purchasing an option and selling another at a lower strike. Using our previous example, you could create a vertical bear spread by purchasing the $55 call and selling the $50 call for a net credit of $2, which means it is a short position. How do we know this trade can be executed for a net credit of $2? It should make intuitive sense because it is just the opposite side of the trade. In the bull spread example, we assumed the trader bought the $50 call and sold the $55 call for a net debit of $2. Therefore, the trader on the other side must be selling the $50 call and buying the $55 call in exchange for the $2 that the long trader is paying. It is just two traders taking opposite views of the market and trading “packages” of options rather than a single call or put.

The profit and loss diagram for the short $50/$55 vertical call spread looks like Figure 9-4:

Figure 9-4 shows that the trader needs the stock price to fall in order to make money on the spread, which is why it is a bear spread. Specifically, the stock needs to fall below $50 at expiration in order to gain the maximum profit. With the stock below $50, both call options expire worthless and the trader keeps the $2 credit. If the stock rises above $50 though, he will be facing an adverse stock price movement. Because of the $2 credit, the trader can afford to have the stock price rise $2 above the $50 strike, or $52, in order to break even at expiration, which is confirmed by Figure 9-4.

Let’s work through the rights versus obligations to further understand what is happening. If you sell a $50 call, you have the obligation to sell shares at $50. If you buy the $55 call, you have the right to buy shares for $55. Therefore, if you buy for $55 and sell for $50 then you have a $5 loss. But because you were paid $2 to put the trade on then the maximum you can lose is $3. As with the bull spreads, notice that the maximum gain ($2) and maximum loss ($3) must add up to the difference in strikes ($5).

We can also accomplish the same profit and loss diagram by using puts, which is done in exactly the same way as the calls – buying one strike and selling lower strike. Using our previous put example, you could create a vertical bear spread by purchasing the $55 put for $4 and selling the $50 put for $1. Because this results in a net debit, it is a long vertical bear spread. If you buy the $55 put and sell the $50 put, the profit and loss diagram will be identical to that of Figure 9-4.

To understand why, let’s check the rights and obligations of the trade. By purchasing the $55 put you have the right to sell stock for $55. Selling the $50 put gives you the potential obligation to buy stock at $50. If you buy for $55 and sell for $50 then you have a $5 gain, but because you paid a net debit of $3 for the spread, the most you can make is $2.

As with the call spread, both versions of the bear spreads should theoretically produce identical maximum gains and losses. Buying the vertical put spread is identical to selling the vertical call spread.

Buying the vertical call spread is identical to selling the corresponding vertical put spread.

Buying the vertical put spread is identical to selling the corresponding vertical call spread.

While the call and put versions of each spread are theoretically identical, small pricing discrepancies will cause one to be a little better than the other and that’s the one the trader should choose. Again, do not choose the call version “just because” it produces a credit. Credits are not necessarily better than debits as the profit and loss diagrams show. It is the interaction between the right to buy and the obligation to sell that makes the strategy work.

We have shown that vertical bull spreads are created by purchasing the lower strike and selling the higher strike, or BLSH, which is bullish. On the flip side, vertical bear spreads are done by purchasing the high strike and selling the low strike. The problem with this mnemonic is that it relates to strike prices and not the option prices. If you buy the low priced option and sell the high priced option, you won’t necessarily get the right answer (you’ll be right for put spreads but not call spreads).

Feb

24

Options 101 Part 97 Chapter Nine Vertical Spreads

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Up to now, we have learned to use long or short options in conservative ways. Chapter Seven showed how to sell a call option against long stock to create a covered call. Chapter Eight showed how to purchase a call or put as a substitute for long stock or short stock positions. Both of these chapters, however, involved the use of a single option.

As you gain experience with options, you will find there are many strategies that involve the use of two or more options at the same time. While these are considered intermediate-to-advanced-level strategies, we want to touch on a very popular one so you can gain an appreciation of the versatility of options. That strategy is called a vertical spread.

There are many “spread” strategies you can use with options. Regardless of the strategy, all spreads have one thing in common: They always involve the purchase of one option and the simultaneous sale of another of the same type (call or put). In other words, if you are using a spread strategy, you will be long and short the same type of option at the same time.

There are various names for these strategies depending on which option you are buying and which you are selling. These names can be confusing for new traders since there are no standardized names, and you will see multiple names for the same strategy. However, there is a standard from which all names for spread strategies are derived. The strategy names came about from the way option quotes used to be printed at the exchanges prior to electronic quotation systems. Traders would create a grid by (usually using chalk boards along the walls of the trading floors) listing the various months across the top and the strikes along the side and then write the quotes in the appropriate boxes as shown in Table 9-1:

If you buy and sell different strikes within the same month then it is called a vertical spread. For example, using Table 9-1, if you buy the January $50 call for $13.25 and sell the January $55 call for $10.25 as shown by the vertical oval, then it is called a vertical spread since the prices are listed vertically in the grid. A vertical spread is also known as a price spread since it is the prices on the vertical axis that are being spread (bought and sold).

On the other hand, if you buy the March $50 call for $18.10 and sell the February $50 call for $16.25 then it is called a horizontal spread since the prices are listed horizontally in the grid. Horizontal spreads are also called calendar spreads, since it is the calendar months being spread, or time spreads, since the calendar months also measure time. So horizontal spreads, calendar spreads, and time spreads are three different names you will see that all represent the same strategy (calendar spread is probably the most commonly used).

Finally, if you buy and sell different strikes within different months then it is called a diagonal spread. If you buy the March $60 for $9.40 call and sell the February $65 call for $4.90 as shown by the diagonal oval then it is a diagonal spread.

While all of these are fascinating strategies, we are only going to focus on one of them since our goal is to introduce you to strategies where two options are used at the same time. Of these strategies, the simplest is probably the vertical spread so that’s where we will focus the rest of the chapter.

Vertical Spreads
As stated earlier, all spreads are constructed by using all calls or all puts. In other words, if you buy a call you must sell a call. If you buy a put, you must sell a put. Spreads never involve the use of calls and puts at the same time.

The vertical spread is constructed by purchasing one call (or put) within a given month and selling a different strike call (or put) with the same expiration. For example, buying a January $50 call and selling a January $55 call, or buying a March $70 put and selling a March $75 put are vertical spreads. The strike prices can be separated by any amount but, in practice, most traders use sequential strikes. Just understand that spreads are very flexible and you can buy and sell any strikes. Whichever strikes you choose, the options are always bought and sold in a 1:1 ratio which simply means that you are selling one option for every option you buy.

As a matter of notation, if you buy the $50 call and sell the $55 call it is called a $50/$55 vertical spread. Because you purchased the $50 call and sold the $55 call it is a “long” $50/$55 vertical spread. Why is it considered a long position? Because you bought the more valuable option (lower strike call) and that means that money must be spent to buy the spread. Any time you spend money to acquire a position, it is considered a long position. Consequently, long vertical spreads are also called “debit” spreads. If you buy a $70 put and sell the $75 put it would be considered a “short” $70/$75 vertical spread. This is a short position since you sold the more valuable put (higher strike), so you collect money for entering the position. Any time you receive money to enter the position, it is considered “short.” Short vertical spreads are also called “credit” spreads.

Hopefully you’re starting to see why it’s so important to understand the Pricing Principles we discussed in Chapter Two. Investors who try to memorize these strategies (as well as more advanced ones) have a difficult time and are prone to making mistakes. By understanding the Pricing Principles we discussed in Chapter Two, you will always be able to determine with confidence if a particular vertical spread is long or short.

What does the profit and loss profile look like for a vertical spread? You know that long options have limited risk. You also know that selling an option (such as with the covered call) limits potential gains. Therefore, if you combine a long and short option within the same expiration month, you will get a profit and loss profile with limited risk and limited reward.

For instance, if you buy the January $50 call for $3 and sell the January $55 call for $1 then your profit and loss curve looks like Figure 9-2:

Notice that this is a “long” $50/$55 vertical call spread since you paid money to acquire it. We would say the trader is long the $50/$55 vertical call spread at a cost, or net debit, of $2. Again, the “net debit” just means it is the net amount spent on the trade. It doesn’t matter if the trader spent $3 for the $50 call and sold the $55 call for $1 or if he paid $10 and sold for $8. The profit and loss diagram looks the same because the “net” amount spent in both cases was $2 and that is all that matters to the trader.

Vertical spreads offer limited risk and limited rewards.

Feb

23

Options 101 Part 96 Chapter Eight – Answers

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1) You wish to buy shares of AGN stock and would like to buy a call option instead. You believe the stock will rise slowly over the next month. Which strike should you buy?
a) $105
Because you are uncertain about the speed at which the stock’s price will rise, you will want to purchase a call that has a relatively high delta (relatively small time value). Because no delta values are shown, we can find a put that has about 30- or 40-cent time value above the cost of carry. Because there are 43 days until expiration, we can ignore the cost of carry and find a put with roughly 30 to 40 cents in time value. There aren’t any in that range but, for the quotes given, the strike closest to that is the $105 call.

2) Assume you decide to buy THREE contracts of the April $105 calls “at market.” Which of the following is the correct order?
b) Buy to open, three contracts, April $105 calls at market.
You are buying the contract and you are “entering” or “increasing” your position so it is an “opening” transaction.

3) Assume you are filled at the asking price, how much will the trade in Question 2 cost not counting commissions?
d) $2,520
The asking price on the $105 call is $8.40 so three contracts will cost 300 * $8.40 = $2,520 not counting commissions.

4) What is the breakeven point for the $105 call assuming you purchased it for the asking price?
a) $113.40
Because you paid $8.40 for the $105 call, the stock must be at $105 + $8.40 = $113.40 at expiration in order for you to break even on the trade. If the stock is $113.40 at expiration, the $105 call is worth the intrinsic value of $8.40 and you would just break even.

5) What is the breakeven point for the $120 call assuming you purchased it for the asking price?
b) $120.90
The $120 call will break even at $120 + 0.90 = $120.90 at expiration.

6) Why is the breakeven point higher for the $120 when compared to the $105 call?
b) The $120 call is riskier
The $120 call costs only 90 cents which may make it appear less risky. However, once we check the breakeven point we find it is $120 + 0.90 = $120.90 and realize the stock price must move much higher at expiration before you would break even on the trade. The $120 call has a much better chance of expiring worthless so it is riskier than the $105 call.

7) How much time value is in the $105 call?
d) $1.80
With the stock at $111.60, the $105 call has $111.60 – $105 = $6.60 intrinsic value. Because it is trading for $8.40 the additional value of $8.40 – $6.60 = $1.80 must be due to time value.

What is the true risk of the $105 call compared to the stock?
a) $1.80
The true risk of buying the $105 call rather than the stock is the $1.80 time value.

9) Why is the risk of the $105 call NOT the full $8.40 value?
a) There is $6.60 of intrinsic value that is also at risk if you owned the stock
Even though the option is trading for $8.40 and could end up worthless, the full $8.40 is not the total risk of the option. This is because if the stock price falls below $105 at expiration then the stock buyer and the $105 call buyer both lose $6.60 worth of intrinsic value. That intrinsic value is a risk that is common to both the option and the stock. The only risk over and above the stock is the $1.80 time premium.

10) You own three $105 calls and wish to sell them “at market.” Which of the following is the correct order?
a) Sell to close, three contracts, April $105 calls at market.
You are “exiting” or “reducing” your position so it is a “closing” transaction.

11) Assume you purchased the $105 call for $8.40 and sold it for the $10.70 bid. What is the return on your investment?
b) 27%
The return is found by taking the ending value and dividing it by the beginning value and subtracting one. In this case, $10.70/$8.40 = 1.27. After subtracting one, we find the return is 0.27, or 27%.

12) What would your return be if you had purchased the stock for $111.60 and sold for $114.49?
a) 2.5%
Buying the stock will always produce a smaller percentage return. In this example, $114.49/$111.60 = 1.025, or 2.5%.

13) If the $105 call expired right now, what would it be worth?
a) $9.49
With the stock at $114.49, the $105 call would be worth the intrinsic value of $114.49 – $105 = $9.49 if it expired this instant.

14) If the $120 call expired right now, what would it be worth?
a) $0
b) $1.50
c) $1.60
d) $1.90

15) If you purchased the $120 call for $0.90 and sold it for $1.50 your return would be 66%. Why is it so much higher than the return on the $105 call?
c) The $120 call is riskier and therefore has higher returns
Remember, as shown in Question 6, the breakeven point is higher so the $120 call has a much better chance of expiring worthless.

16) Assume you wanted to roll up from the $105 call to the $110 call “at market.” Which of the following is the correct order?
c) Sell to close the $105 call and simultaneously buy to open the $110 call
When you are rolling up a call option, you are selling a lower strike call to close and simultaneously buying a higher strike (usually the next higher strike). After the order is filled, you are left holding the higher strike call but you bring in a credit for doing so.

17) Assuming you rolled up from the $105 call to the $110 at the current bid and ask prices, the order would be filled for:
b) A net credit of $3.90
You could sell your long $105 call for the current bid of $10.70 and use that money to buy the $110 call for the $6.80 asking price, which leaves you with a net credit of $10.70 – $6.80 = $3.90. This credit reduces your original cost basis and risk of your original principal.

18) Assume you owned the $115 call and rolled up to the $120 call at the current bid and ask prices. The order would be filled for:
b) A net credit of $1.90
You could sell the long $115 call for $3.50 and buy the $120 call for $1.60 thus receiving a net credit of $3.50 – $1.60 = $1.90.

19) Why is the net in Question 17 larger than that for Question 18?
b) The $105 and $110 strikes are in-the-money so they are more likely to expire with intrinsic value.
Because the $105 and $110 strikes are in-the-money at this time, they are more likely to expire with intrinsic value when compared to the $115 and $120 strikes. Because of this, the market will bid up their prices higher. Remember that the maximum difference for the $105/$110 roll is the $5 difference in their strikes. The very most you could even receive on this roll is therefore $5. The same is true for the $115/$120 roll. However, because the $115/$120 roll is less likely to have intrinsic value, its net difference will be smaller.

20) Assume you originally thought AGN was going to fall and, instead, purchased THREE of the $115 puts from the first set of quotes. You later sold them for the bid price in the second set of quotes. What is your overall gain or loss not counting commissions?
d) $510 loss
You would have purchased the $115 puts for the $5.00 asking price and sold them for the $3.30 bid price for a loss of $1.70 per contract or 300 * 1.70 = $510 for three contracts. Notice, however, that had you shorted the stock you would have sold $11.60 and purchased back for $114.49 for a loss of $2.89 or $867 for 300 shares. The puts reduced your losses for adverse movements due to the implicit call option they contain.

Feb

22

Options 101 Part 95 Chapter Eight Questions

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1) You wish to buy shares of AGN stock and would like to buy a call option instead. You believe the stock will rise slowly over the next month. Which strike should you buy?
a) $105
b) $110
c) $115
d) $120

2) Assume you decide to buy THREE contracts of the April $105 calls “at market.” Which of the following is the correct order?
a) Sell to close, three contracts, April $105 calls at market
b) Buy to open, three contracts, April $105 calls at market
c) Buy to close, three contracts, April $105 calls at market
d) Buy to open, three contracts, April $105 calls at $8.00 or better

3) Assume you are filled at the asking price, how much will the trade in Question 2 cost not counting commissions?
a) $270
b) $3,360
c) $690
d) $2,520

4) What is the breakeven point for the $105 call assuming you purchased it for the asking price?
a) $113.40
b) $116.40
c) $112.20
d) $105.00

5) What is the breakeven point for the $120 call assuming you purchased it for the asking price?
a) $122.40
b) $120.90
c) $119.10
d) $120.00

6) Why is the breakeven point higher for the $120 when compared to the $105 call?
a) The $120 call is less risky
b) The $120 call is riskier
c) The $120 call is equally risky as the $105
d) The $120 call has less time value so will have a higher break-even point

7) How much time value is in the $105 call?
a) $6.60
b) $8.40
c) $2.20
d) $1.80

What is the true risk of the $105 call compared to the stock?
a) $1.80
b) $8.40
c) $6.60
d) $2.20

9) Why is the risk of the $105 call NOT the full $8.40 value?
a) There is $6.60 of intrinsic value that is also at risk if you owned the stock
b) There is $1.80 of intrinsic value that is also at risk if you owned the stock
c) The stock has time value and the option does not
d) The option must expire with intrinsic value

Use the following table of quotes for questions 10 – 20:

10) You own three $105 calls and wish to sell them “at market.” Which of the following is the correct order?
a) Sell to close, three contracts, April $105 calls at market.
b) Sell to open, three contracts, April $105 calls at market.
c) Buy to close, three contracts, April $105 calls at market.
d) Sell to close, three contracts, April $105 calls at $11.50 or better.

11) Assume you purchased the $105 call for $8.40 and sold it for the $10.70 bid. What is the return on your investment?
a) 78%
b) 27%
c) 44%
d) 21%

12) What would your return be if you had purchased the stock for $111.60 and sold for $114.49?
a) 2.5%
b) 4.2%
c) 6.5%
d) 7.8%

13) If the $105 call expired right now, what would it be worth?
a) $9.49
b) $10.70
c) $10.90
d) $7.70

14) If the $120 call expired right now, what would it be worth?
a) $0
b) $1.50
c) $1.60
d) $1.90

15) If you purchased the $120 call for $0.90 and sold it for $1.50 your return would be 66%. Why is it so much higher than the return on the $105 call?
a) The $105 call is riskier because it costs more money and will therefore have lower returns
b) The $120 call is less risky and therefore has higher returns
c) The $120 call is riskier and therefore has higher returns
d) The $105 call and $120 call are equally risky. The increased return on the $120 call is due to volatility

16) Assume you wanted to roll up from the $105 call to the $110 call “at market.” Which of the following is the correct order?
a) Sell to open the $105 call and simultaneously buy to open the $110 call
b) Sell to close the $110 call and simultaneously buy to open the $105 call
c) Sell to close the $105 call and simultaneously buy to open the $110 call
d) Buy to close $105 call and simultaneously buy to open the $110 call

17) Assuming you rolled up from the $105 call to the $110 at the current bid and ask prices, the order would be filled for:
a) A net debit of $3.90
b) A net credit of $3.90
c) A net debit of $4.30
d) A net credit of $4.30

18) Assume you owned the $115 call and rolled up to the $120 call at the current bid and ask prices. The order would be filled for:
a) A net debit of $1.90
b) A net credit of $1.90
c) A net debit of $2.20
d) A net credit of $2.20

19) Why is the net in Question 17 larger than that for Question 18?
a) The $105 and $110 strikes are out-of-the-money so they are more likely to expire with intrinsic value
b) The $105 and $110 strikes are in-the-money so they are more likely to expire with intrinsic value
c) The $105 and $110 strikes are out-of-the-money so they are more likely to expire worthless
d) The $105 and $110 strikes are in-the-money so they are more likely to expire worthless

Answers to follow in next issue

Feb

19

Options 101 Part 94

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There are many times when you can execute roll-ups. You may decide to always roll up to the at-the-money option thus bringing in more cash (a bigger net credit) at the expense of needing bigger moves in the stock before rolling up again. It all depends on your goals and risk tolerances. Some investors will roll up sooner while some take a little more risk and roll up less frequently in the search for higher profits due to fewer bid-ask spreads and commissions.

For example, at the time of this writing, Google had released very positive earnings and was starting to move aggressively upward. In light of this news, you might decide to hold the option for longer periods of time to reduce the commissions you must pay to execute each roll-up. Let’s assume you decide to hang on for a while before rolling up again. Table 8-8 shows that one month later Google was trading for more than $380!

If you rolled up at this time, you’d want to roll up to a strike that is closer to the current price of the stock rather than rolling to the $320 strike, which is the next strike higher than the $310 strike we’re currently holding. The reason is that the $320 strike is very deep in-the-money, and we’d like to hold an option that is only one strike in-the-money or possibly at-the-money, which allows us to sweep more money out of the position. Let’s assume we decide to roll up to the at-the-money strike, which is the $380 strike. All you have to do is place the following order:

Sell to close, one contract, Google Jan. ’07 $310 call (OQDAB) and simultaneously
Buy to open, one contract, Google Jan. ’07 $380 call (OQDAU) at market (limit)

The net credit produced would be $37.80 as follows:

Sell $310 call = + $109.20
Buy $380 call = -$71.40
Net credit = $37.80

Prior to this trade, our cost basis was $48.60. After receiving the $37.80 credit, the cost basis is reduced to $11. Notice that we could choose to roll up to an out-of-the-money strike such as the $390 call. If we do, we’ll end up with a bigger credit from the roll since we are spending less money to buy the $390 call, which provides a bigger credit. The tradeoff is that the stock must now move higher before we’re able to execute the next roll-up.

Regardless of which choice you make, you still control 100 shares of Google but have taken a tremendous amount of cash out of the position. It is doubtful that the “conservative” stock owner would have held out for this much profit because there’s too much to lose as the stock price climbs to seemingly inexplicable levels. However, with options, we can sweep money out of the position and still control 100 shares by using options. As we’ve tried to point out, options can be used in conservative ways.

This example highlights the importance of rolling up at more frequent intervals. When we started this exercise, we purchased the Google $290 call for $58. After the last roll-up, we figure that the cost basis is now $11 which means we have taken $58 – $11 = $47 out of the position through several roll-ups. Using Table 8-8, notice that if we had never rolled up until now, we could have sold the $290 call for $122.70 and purchased the $380 call for $71.40, thus bringing in one giant credit of $51.30, which is not too far from the $47 we’ve pulled out so far. Why the difference? The reason is the bid-ask spread. Every time we buy or sell, we must pay the asking price and receive the bid price. These actions create a small leak in the total credits we receive. Commissions will obviously reduce the total credits even further. In this case, if we had waited until now to execute the roll-up, we would have received and additional $4.30 ($51.30 – $47 = $4.30). However, we must ask if that amount of additional profit was worth the risk of holding the $290 call while the stock climbed all the way to $380. Our first goal as option traders should be good money management and we need to do all we can to avoid the downside risk. Even though this example worked in our favor, there’s nothing that says it should. This stock could easily have moved against us at some point, leaving us with a $58 loss if we had never rolled up. That’s why good option traders roll up frequently. If there were no bid-ask spreads or commissions there would be no difference between rolling up frequently or infrequently. But if we wish to protect profits and reduce the risk of holding the stock, most option investors feel that the small losses from the bid-ask spreads and commissions are worth the reduction in risk that frequent roll-ups provide.

Long Puts
We’ve covered the basics of call options in detail. Once you understand the reasons for buying calls, you’ll automatically understand the reasons for buying puts. All of the benefits that apply to calls apply to puts – just in the opposite direction. But just to make sure you’ve got the concepts, let’s run through an example with puts.

Assume that your outlook on Google has turned from bullish to bearish. In fact, at the time that’s exactly what was happening. The stock was trading at $340 and on a quick, downward spiral from the recent high of about $390 (with the all-time high up over $475). This was due to negative outlooks issued by the company as well as analyst downgrades.

Let’s assume you are speculating on a short-term fall. If you wish to capitalize on the bearish outlook by shorting 300 shares of stock, you have unlimited upside risk. In addition, you’re going to have a large margin requirement (roughly $25,000) to short 300 shares. And if the stock rises past the price where you shorted it, you’ll end up with maintenance calls, which means you’ll have to send more money to your broker in order to keep the short position open.

Rather than shorting such a volatile stock, you can buy a put option. Because long puts give you the right to sell shares of stock they become more valuable if the underlying stock falls sufficiently. When you buy a put option, you are long the asset, which means you can only lose the amount you put into the trade. The put call-parity equation showed us that a long put is identical to short stock position plus a long call (P = – S + C) and it is the implicit long call in a put option that protects the put buyer from unlimited upside risk.

You can see that Google was trading for about $340. Just as with call options, there is a question you must answer before deciding which strike to buy. That is, are you expecting a slow fall or a fast, aggressive one? If the answer is slow, you should buy intrinsic value and find a relatively high strike (preferably a 0.80 to 0.85 delta). However, if you expect that it will be a fast, aggressive fall then you may opt for the at-the-money put. Because stock prices tend to fall much faster than they rise, the decision to buy an at-the-money put may be warranted in more cases than the at-the-money call. In addition, because volatility tends to rise quickly when prices are falling the at-the-money put will get a boost from that as well.

Let’s assume that you decide to buy the three April $340 puts (42 days until expiration) by placing the following order:

Buy to open, three contracts, Google April ’06 $340 puts (GGDPH) at market (limit)

If your order is filled at the $22.90 asking price, it will cost 300 * $22.90 = $6,870 and that is the most you could ever lose on the position.

If you decided to close the three contracts at this time, you would enter the following order:

Sell to close, three contracts, Google April ’06 $340 puts (GGDPH) at market (limit)

If the order is filled at the $24.40 bid then you purchased for $22.90 and sold for $24.40, thus profiting by $1.50 * 300 = $450.

The roll-up strategy we used for calls can also be applied to long puts as a roll-down. With a roll-down, you will sell your long put and simultaneously buy a lower strike put thus collecting a credit (since the higher strike put that you are selling must be more valuable). All of the principles and advantages we discussed for calls can be applied to puts.

Options create different sets of risks and rewards for investors and traders. It is up to the investor to decide which is best for him at the time. In the previous example, we showed that you could have captured a $1.50 profit on the three puts; however, the short stock seller would have collected $339.69 – $334.82 = $4.87. Does this mean the short stock position is better? No, it means there is more risk. At the time, Google had large gap openings (the stock opens at prices much higher or lower than the previous day’s close). If you were short 300 shares and the stock gapped up 10 points the next day you would have an unrealized loss of $3,000. The loss on the long puts would be nowhere near that since they would still maintain some time premium even though they are out-of-the-money. If you’re unsure that an out-of-the-money put on Google maintains significant time premium, check Table 8-10 and you’ll see the $320 put trading for $4.20 and that it is nearly 15 points out-of-the-money. So even though $6,870 was spent for the three $340 puts, it’s highly unlikely that you are going to lose anywhere near that much for a large, upward movement in the stock. Short stock sellers cannot make that assertion.

Options allow you to pick and choose which sets of risks you want to take. Before you put your money into long or short stock positions, be sure your account can handle significant adverse moves. No matter how small the probability may seem, large moves are more likely than you might suspect. On Friday, May 1, 1998 EntreMed (ENMD) closed a little over $12. Monday morning it opened at $83. If you are in doubt as to whether your account can withstand such adverse price swings then long calls and long puts will add a little certainty to a very uncertain world.

Key Concepts
1) Long options (calls and puts) provide protection, leverage, and diversification.
2) Buy 0.80 to 0.85 deltas if using long calls or long puts as long stock or short stock substitutes.
3) If you are willing to buy $10,000 worth of stock you should not put that much money into the options. Instead, buy options representing the same number of shares you are willing to hold.
4) To better diversify your portfolio, try to put a similar dollar amount into each option position.
5) Roll-up call options and roll-down put options when the proper opportunity arises.

Feb

18

Options 101 Part 93

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Rolling with Call Options
Options create tremendous possibilities for investors – far more than what is already apparent from the preceding chapters. The real power of options comes from our ability to alter risk-reward profiles as prices change and that is something you cannot do with stock alone. To demonstrate, let’s go through another long call example but this time we’ll show you the roll-up strategy. In the last chapter, we talked about the roll-up for covered calls, but let’s see what it can do for those holding long calls.

You are a long-term investor who is bullish on Google (GOOG) and wishes to buy 100 shares on August 8, 2005. Table 8-5 shows the stock was trading for about $293, which means it would cost $29,300 for the 100-share lot:

Rather than put that much money into one stock, you could, instead, just buy one call option. However, notice that the prices are expensive in terms of total dollars as the cheapest one (Jan. $300) is $53.30! This is due to the high volatility of Google along with the fact that there are nearly 1.5 years until expiration. This is one of those times that you may wish to buy a strike closer to at-the-money. Let’s assume we decide to buy the $290 call for $58, or $5,800 per contract to control 100 shares over the next 1.5 years. All you have to do is place the following order:

Buy to open, one contract, Google Jan. ’07 $290 call (OQDAR), at market (limit)

Once the order is filled, you are now long one contract and have the right to purchase Google at any time for $290 per share. Of course, your goal as an option trader is to simply trade the contract and never actually buy the shares of stock. For example, on September 12, just 35 days later, the stock had moved up sharply to $308.25 and the $290 call was bidding $64.20:

You could sell the contract to close and take your profits. If you choose to do this, you would place the following order:

Sell to close, one contract, Google Jan. ’07 $290 call (OQDAR), at market (limit)

You bought the contract for $58 and sold for $64.20, which is a profit of $6.20 ($620 per contract), or $64.20/$58 = 1.107 = 10.7%. Had you purchased the stock, you would have paid $293.07 and sold for $308.25, which is a profit of $15.18, or 5.2%. Once again, this clearly shows that the stock trader’s total profits are greater but represent a lower rate of return.

However, selling the option at the first sign of profit is usually a mistake. We’re not saying to never take profits but the fact is that trends generally last much longer than we expect. If you sell at the first opportunity for a profit, you will usually regret the sale at a later date no matter how many times people tell you, “You can’t go broke taking a profit.” The truth is that you can go broke taking profits if you tend to take them too early. A lot of tiny profits can easily be overcome by one single loss. Option losses will always occur, so it is up to you to allow your profits to run if you want to survive over the long run. This presents a dilemma though. After all, you are staring a sizable profit in the face. Does it really make sense to do nothing? You can do a little of both; you can take some profits and stay in the position by doing a simple hedging technique called a roll-up. If you are long a call option, you execute a roll-up by selling your current option and simultaneously buying a higher strike option.

For example, you can place an order to sell the $290 call and simultaneously buy the next higher strike, which is $300. To place this roll-up, you would simply enter the following pair of orders to be executed simultaneously:

Sell to close, one contract, Google Jan. ’07 $290 call (OQDAR) and simultaneously
Buy to open, one contract, Google Jan. ’07 $300 call (OQDAT) at market (limit)

One of the nice features of roll-ups is that they always produce a credit to the account since lower strike calls are always more expensive than higher strike calls (Pricing Principle #1 from Chapter Two). Because you are selling the lower strike (more valuable) and using some of that money to buy a higher strike option (cheaper), you will always get a net credit to the account. Table 8-6 shows the $300 strike was trading for $59.50 so in this case, you’d get a credit of $4.70:

Sell $290 call = +$64.20
Buy $300 call = -$59.50
Net credit = $4.70

If you were filled at the above prices, you would be long one $300 call plus have $4.70 * 100 = $470 sitting safely in cash. You have effectively “taken some money off the table” but still control 100 shares. You have now spent a total of $53.50 as shown by the total transactions:

Buy $290 strike = – $58
Sell $290 strike = +$64.20
Buy $300 strike = -$59.50
Net debit = $53.30

In other words, you still control 100 shares of Google but now have reduced the amount you have invested from $58 to $53.30. Granted, you own a higher strike which is less valuable than your original $290 strike, but you have done something more important in that you’ve reduced the risk. Every time you roll up, you slowly chip away at the cost basis of the option, thus removing some risk while staying in the position.

When Should You Roll Up?
The stock price at which you roll up depends on what you’re trying to accomplish. If you wish to keep your option at-the-money then you should roll up to the $300 strike when the stock is trading for $300. However, maybe you’re trying to hold a higher delta and only roll it to the next higher strike when it is $10 in-the-money. If so, you would want to roll up to the $300 strike once the stock price hits $310 and then roll up to the $310 call once the stock hits $320 and so forth. This way the option will stay ten points in-the-money thus providing a nice delta all while sweeping profits into the account. The choices are endless and that’s what makes options so powerful.

The desire to use the roll-up is the reason we elected to use slightly in-the-money options to start with. If we had used a far out-of-the-money option such as the $320 strike, we may not have been able to roll up at this time at a significant credit. Buying far out-of-the-money options means that the stock must make a far bigger move before you can roll the position up. Once again, the out-of-the-money options do not provide the same benefits as in-the-money options. Out-of-the-money options are riskier and the inability to roll up in strikes is another way of showing why.

Let’s assume we want to increase our delta position and roll up to the $300 strike when the stock reaches $310 as we have done in Table 8-6. With the stock at $308, you can see that we rolled up a little early. However, if you look at the net change, you’ll see the stock was up over nine points at that time, which is a healthy move even for a volatile stock like Google. This is where you must make some pragmatic decisions. Check the net credit you’re going to receive from the roll-up relative to your current cost basis and the commissions and see if it seems like a good business decision. If so, then it’s time to roll up. This means we may roll up for a $2 credit if we paid $5 for the option since $2 is 40% of the cost basis. At the same time, we would not roll for a $2 credit on a $58 option. You must balance the costs with the effects.

By holding the $300 call, you still control 100 shares of Google but for even less money than you originally invested. The net credit you receive ($470) can be used immediately to withdraw, invest, or simply leave in cash to be used at a later time.

As long as the stock moves in your favor, you should continue to roll it. Table 8-7 shows that Google was up more than seven points and trading for $317 so let’s roll it up again:

As before, we just need to enter an order to exchange the two options simultaneously:

Sell to close, one contract, Google Jan. ’07 $300 call (OQDAT) and simultaneously
Buy to open, one contract, Google Jan. ’07 $310 call (OQDAB) at market (limit)

Sell $300 strike = +$62.10
Buy $310 strike = -$57.40
Net credit = $4.70

Again, the net credit reduces our original cost basis. The cost basis prior to this point was $53.30 and is now reduced by another $4.70 to $48.60. The roll-up allows the investor to maintain the position for longer periods of time because it reduces the risk of investing – it reduces the fear of holding the position.

Feb

17

Options 101 Part 92

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Risky Uses of Leverage
Let’s take look at the consequences for someone who tries to control more shares with the same amount of money. In our example, the option trader could have invested the full stock amount of nearly $16,000 into the options, in which case he would definitely come out ahead of the stock trader in terms of total dollar profits. In that case, he’d truly be earning 21% on his stock investment instead of only 7%. However, if you are willing to put $16,000 into stock then you should in no way be willing to place that same amount into an option. Leverage is an incredibly powerful tool but it is a double-edged sword because it magnifies the losses with equal force.

For example, assume you put $16,000 of your allotted IBM stock funds into the April $75 calls. With the stock at $79.46, it would only need to fall to $75 or lower at expiration, or only 5.6%, and you’d lose 100% of your investment. If you had purchased the stock, you’d only be down 5.6%. If mechanical leverage is capable of moving the Earth, financial leverage must also be capable of destroying your account – if you are willing to give it a firm place to stand. If you place the total dollar amount that you’re willing to spend on a stock into an option then you’re providing a rock-solid foundation inside your account for leverage to stand.

Another reason for not investing the same dollar amount into options as you would for stocks is that you end up controlling a much larger number of shares than you’re comfortable holding. If you had placed your stock funds into the April $75 calls, you’d end up controlling $16,000/$830 = 19 contracts, or 1,900 shares. One tiny drop in the stock’s price and you greatly magnify the dollar swings in your account; there is simply too much leverage working against you if you are only willing to hold 200 shares.

In the previous example, we saw that option traders could spend the same dollar amount on options that they’re willing to spend on stock. This fits the first definition of leverage and is the one you want to avoid. However, by using options, we can also use the second definition of leverage and control the same amount of shares with less money. That’s the better way to use options as a risk management tool.

Conservative Uses of Leverage
As stated previously, one conservative use of leverage is to control the same number of shares with fewer dollars at risk. If you are willing to buy 200 shares of IBM and wish to buy calls, then stick with two contracts since that controls 200 shares. The leverage you’re getting is based on the fact that you’re controlling the same amount of shares for less money. You may not make as much in terms of total dollars as a stock trader but you won’t lose as much either.

There is another way you may wish to consider using leverage. This method allows us to buy more shares but without jeopardizing great losses. Let’s assume you are willing to buy 200 shares of IBM for about $16,000. At the same time, let’s also pick a level that you’re willing to lose, say 20%. From our previous discussions, we know that stop or stop-limit orders cannot guarantee a limited loss. However, you can guarantee a limited loss by using options. In this case, let’s take the 20% that you’re willing to lose, which is 0.20 * $16,000 = $3,200 and use that money to buy the options. In this example, you would buy $3,200/$830 = 3.8 contracts, which we must round down to three contracts since you cannot buy fractional contracts. You’d end up investing 300 *$8.30 = $2,490 and that is definitely the most you could ever lose. You could never define a loss this precisely for the traders buying 200 shares of IBM no matter how closely they may be placing their stop orders. Further, you gained some added leverage because you are now controlling 300 shares rather than 200. This is a nice method for those investors looking to increase their leverage a little while still managing the downside risk. The idea is that you buy options with the amount of money you are willing to lose with the stock. At the beginning of this book, we said that the risk in options depends on how they are used. Hopefully you’re starting to understand why. This section showed that we can definitely use them in risky ways, which are often the same ways that create sensational stories for the financial press when things go wrong. However, with a little understanding we can certainly use them in conservative ways.

Diversification
Our third reason for buying options is diversification. Diversification just means that you don’t put all your eggs into one basket. The idea is to spread your investment dollars through many different investments. Diversification is the sole reason for the creating of index funds. For instance, if you put $10,000 in an S&P 500 mutual fund and one of the stocks goes belly-up, your investment will not be affected too greatly since there are 499 other stocks to back you up. However, if you had unluckily placed all of your funds into that one stock then you’d have lost everything. By spreading your investment dollars across many stocks you get the benefits of diversification. Spreading the risk keeps you from having to guess which stocks will perform the best.

Many investors, especially when they are starting out, cannot adequately diversify simply because they do not have enough money to do so. For example, assume you have just $10,000 in your account and wish to buy stocks. If you buy 100 shares of IBM based on the quotes in Figure 8-1, you’d spend over $7,900 on that one investment, which doesn’t leave much money left over for anything else. However, because of the reduced cost of options and availability of longer terms to maturity, investors can spread their risk by purchasing call options, thereby controlling numerous stocks with relatively little money.

A Brief Detour on Diversification
Many investors buy a fixed number, say 100 shares, thinking this limits the risk. On one hand that’s true, as you are limited to $100 loss per $1 downward move in the stock. On the other hand, it’s deceptively false. Here’s why: Say you purchase the following portfolio of six stocks shown with their performances after one year:

Shares Purchase Price After 1 year:
100 20 Up 22%
100 18 Up 24%
100 190 Down 18%
100 45 Up 30%
100 15 Up 27%
100 22 Up 34%

On the surface, it certainly looks like an impressive year. There are five gainers and only one loser. Further, all of the gainers are up by a higher percentage than the one loser. But would you be surprised to find out that the overall portfolio is down? That’s right. The investor would have less money after one year than he initially invested.

The reason the investor lost money is because the total dollars invested in each position are not equal. The maximum amount of money placed among all the gainers was $4,500 (100 shares at $45) while the one position that lost had $19,000 invested (100 shares at $190). So even though there are more winners that are all up by higher percentages than the one loser, the overall result is a loss.

The moral of the story is that constant share amounts do not diversify your risk. If stocks are presumed to move in a random fashion, some will be winners and some will be losers. However, if you are placing a much higher investment in one particular stock, you are, in effect, pressing your bet on that one stock, which is not optimal in a random market. Think about it this way: If you walked into a casino to bet $10,000 on 10 spins of a roulette wheel, would you feel inclined to bet various amounts on each spin? Do you think your chances are better to win on, say the third spin rather than the eighth? If not, it should make sense to you to bet $1,000 on each spin so that you have constant risk across all spins. The same analogy can be applied to your investments. If you treat each investment as the “spin” of a roulette wheel, you should not bet more money on some spins versus the others.

You will do much better with your investments over time if you pick a dollar amount, not share amount, which you are comfortable investing on each trade. Use that dollar amount for all investments and let the number of shares (or contracts) fall where they may. Let’s use the same portfolio we used earlier but, instead, use constant dollar amounts and see what happens.

The portfolio at the beginning had $31,000 invested in six positions. That’s an average of about $5,165 for each position. So let’s build the portfolio with a constant dollar amount of $5,165 per position:

Shares Purchase Price After 1 year:
258 20 Up 22%
286 18 Up 24%
27 190 Down 18%
115 45 Up 30%
344 15 Up 27%
234 22 Up 34%

Notice how the number of shares is allowed to fluctuate. We buy more shares when the stock is cheap and fewer shares when it’s expensive. We will buy 258 shares of the first stock ($5,165/$20), but only 27 shares of the third ($5,165/$190). What is the result with constant dollars? Now the portfolio is up a healthy 20% instead of the slight loss using constant share amounts.

The constant-dollar method can be used for options as well. If you find that you seem to be correct in your outlooks but find that your option trades are netting losses there’s a good chance the problem is having unequal “bets” throughout your trading. If you always buy a fixed number of contracts, say five contracts, it’s certainly a different dollar amount if you pay $3 for an equity option versus $80 for a Nasdaq 100 index option. Instead, pick a dollar amount you’re willing to risk with each trade and put that amount into each option trade; let the number of contracts fall where they may. You will likely see a big difference in your performance when you’re not trying to guess which trade will be the bigger winner. Let the averages work for you by using constant dollars.

Because options allow investors to control the same number of shares for less money (our conservative definition of leverage), you have a better way to diversify your portfolio.

At any time, you can choose to get out of the contract by selling it in the open market. If the option is in-the-money then it is worth the intrinsic value at expiration. If it is prior to expiration, it is worth the intrinsic value plus some time value. If it is not in-the-money when you sell it, then it is worth the time value and it is up to the market to decide what that is worth. Regardless of price, you would enter the following order to exit the contract:

Sell to close, two April $75 calls, symbol IBMDO, at market (or limit)

We’ve just worked through a simple buy and sell order for a call option as well as our motivations for doing so. Now that you understand the motivations for buying calls – protection, leverage, and diversification – let’s work through another example but this time we’ll show you an even more fascinating side of options trading – how to hedge the contract.

Options provide protection, leverage, and diversification.

Feb

16

Options 101 Part 91

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In order to truly understand the leverage of an option, we must compare “dollar equivalent” exposure. For example, let’s assume the $75 call trading for $8.30 has a delta of 0.60. For the next one-dollar move, this option’s price will rise by the delta, or 60 cents, from $8.30 to $8.90. This 60-cent move is equivalent to $60 per contract. Now let’s see what a stock investor must spend to get this same $60 gain from a one-dollar move in the stock. A stock buyer must buy the delta equivalent number of shares, which is 60 shares of stock that would cost 60 * $79.46 = $4,767.60. So if an option trader buys the $75 call and a stock trader buys 60 shares of stock, then both will capture a $60 profit on the next one-dollar move in the stock. Now we just need to compare the costs of these dollar equivalent exposures. The stock trader spends $4,767.60 while the option trader spends $830, which means there is $4,767.60/$830 = 5.7 times as much leverage in the option as compared to the stock. (But keep in mind that this number will change as the delta of the option changes. We’re just saying this is how you’d need to calculate the leverage in the option at this point in time.)

Other Views of Leverage
Although the above calculation is probably best for comparing the true leverage of an option there are other views we could take.

For example, say a stock is trading for $100 and a $100 call is trading for $5. One way to view the leverage is to realize that the option trader, in this example, has leveraged the returns by a factor of 20. That is, for every 100 shares the stock investor buys ($10,000 worth), the option buyer can buy 20 contracts ($10,000/$500 per option = 20).

Let’s assume that the stock now rises from $100 to $115. If the stock trader buys 100 shares then the total value would be 100 * $115 = $11,500, which leaves a profit of $1,500. With the stock at $115, the $100 call would be worth $15, or $15 * 2,000 = $30,000 for the 20 contracts.

If we multiply the $1,500 profit of the stock trader by 20 we end up with $30,000, which is the value of the option trader’s total position. In this example, the option trader’s total value will always be worth 20 times the stock trader’s profit, assuming the $100 call option has intrinsic value. This is a somewhat awkward view of leverage since we’re comparing the profit of the stock trader to the total value of the option trader. Still, it is a very common use that you will encounter.

It’s important to understand that this method only works in such a straightforward way if we compare at-the-money options. Using our IBM example, the stock is $79.46 and the $75 call is trading for $8.30, which means the option trader has leveraged the returns by a factor of $79.46/$8.30 = 9.5 times. Once again, this means that for every 100 shares the stock investor buys ($7,946 worth of stock) the option buyer can control 950 shares since $7,946/$830 = 9.5 contracts, or 950 shares. (You cannot buy fractional contracts but we must assume this to make the comparisons.) Now we should expect that for any given gain in the stock’s price, the option’s total value would be 9.5 times as great as the stock trader’s profits.

Let’s see if it works. Assume the stock rises from $79.46 to $85 by expiration. The stock trader invested $7,946 and can sell for $8,500 for a total profit of $554. With the stock at $85, the $75 call would be worth $10, or a total value of 950 shares * $10 = $9,500. However, we see that $9,500/$554 = 17 times. Why does it not equal 9.5 times? The reason is that this option is not at-the-money. The stock is $79.46, which means this $75 call has $4.46 worth of intrinsic value that we must take back out. The value that must be subtracted from the $9,500 total option value is then 950 shares * $4.46 = $4,237, which leaves us $5,263. If we take $5,263/$554 we get leverage of 9.5!

Gearing
The leverage described above is known as gearing and is actually just an old British term that means leverage. It is not uniquely defined but the two most common definitions are (1) The stock price divided by the option price or (2) The strike price divided by the option price.

Using definition 1, the way to find gearing is to simply divide the stock price by the option price:

Gearing = Stock price / option price

In our first example, the stock was $100 and the option was $5 so $100/$5 = 20. This is just another way of saying the stock trader required 20 times the amount of capital to control the same amount of shares.

Using the second definition, gearing would be:

Gearing = Strike price / option price

This gives the same answer of 20. But if the strike was $110 then the gearing is $110/$5 = 22. In this way, the option trader may pay $110 for the stock but is controlling it for $5, so it is leveraged by a factor of 22. Many of the trading software you will encounter will have a column labeled “gearing” and it simply shows one of these definitions of leverage.

Omega
There is another term you may see that describes leverage and is called omega. Omega measures the relative percentage changes between the stock and the option, which is called an elasticity measure. For instance, assume the call in the above example has a delta of 0.50. With the stock at $100 and the call at $5, if the stock were to move $1 (a 1% move) the call will move roughly one half of a point from $5 to $5.50 for a 10% increase. Because the option moved 10 times faster relative to the stock (10% compared to 1%), the elasticity (omega) is 10.

Omega = Delta / option price
1 / stock price

This numerator of this formula simply compares the “share equivalent” terms of the option to its price (delta / option price). The denominator just compares one share of stock to its price (1 / stock price). Omega simply finds the ratio of these two values.

Omega can also be written as (stock price / option price) * delta. Using the earlier example, we have a $100 stock price divided by a $5 call option with delta of 0.50 so $100/$5 * 0.50 = 10. Regardless of which measure you use, don’t forget the most the most important concept: The higher the leverage the more speculative the position.

The option’s leverage comes from the fact that the strike price is simply a partition of the stock price. In this example, if you buy shares of IBM at $79.46, you get all of the upside gains but are also exposed to all of the downside losses. That’s because a long stock position contains value for all stock prices above zero. In fact, Pricing Principle #5 from Chapter Two showed us that an option with a zero strike price and infinite time to expiration would be trading for the same price as the stock. A long stock position can therefore be thought of as an option with a zero strike price and no expiration date.

However, if you are holding the $75 call at expiration, it will not have value for all stock prices above zero. Instead, it will only have value for all stock prices above $75. The $75 strike simply splits the stock into two parts: All prices below $75 and all prices above $75. When you buy the $75 call, you’re only participating in the gains if the stock rises above $75 but not if it falls below, which is why long call options have an asymmetrical payoff to their profit and loss diagrams.

So option returns appear much higher because we’re partitioning the stock’s price. In this example, the stock buyer must pay $79.46 but the option trader only pays $8.30 to participate in the gains for all stock prices above $75. It is this difference in bases – $79.46 compared to $8.30 – that creates the leverage. A one-dollar gain to the stock trader produces a much smaller percentage gain than a one-dollar gain to the option trader. However, the total dollar gain to the stock trader will be larger than the total dollar gain to the option trader since the option trader loses out on the time premium.

Many investors get attracted to options because they hear about the high leverage and think they will make more money by trading options rather than stocks. It would be easy to think you would have done much better with options since you would have earned 21% on your money rather than 7% in our example. However, this is really a misperception and comes from the fact that option traders have a much smaller dollar amount of money invested if they are trading an equivalent number of shares in the options. True, their percent returns are higher but the investments are smaller but the total dollars earned will be less than those investing in stocks. In this example, the stock buyer earned 7% on a $16,000 investment while the call buyer earned 21% on a $1,660 investment. The important point to understand is that if you trade the contract equivalent number of shares with options that you will have higher percentage returns but lower total dollar returns (assuming that both the stock and options are profitable).

Couldn’t we get a 21% return on our investment if we had purchased $16,000 worth of options? The answer is yes; however, that is a very dangerous (although quite common!) way to use leverage.

There are actually two definitions of leverage that you need to understand:

• Control more shares with the same amount of money (risky use)
• Control the same amount of shares with less money (conservative use)

The great mathematician, Archimedes, once said, “Give me but one firm spot on which to stand, and I will move the earth.” He was, of course, talking about the enormous power of the lever. Investors who do not understand the difference between the above two definitions will eventually find out just how powerful a force it is.

Feb

15

Options 101 Part 90

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In Chapter Five, the put-call parity formula showed us that if you were absolutely certain that a stock was going to rise that you should either buy the shares with borrowed funds or buy the call and sell the put. Figure 8-4 shows why. The reason is that the long call buyer will always underperform the long stock buyer by the amount of the time premium for all regions above the strike price. Notice that above the $75 stock price, the two profit and loss curves run parallel to each other. Those two lines will never meet at any higher stock price and that’s a way of showing that the long call buyer will never get the time premium back. However, since we don’t know for sure whether a stock will rise, the call option provides a lot of protection by removing all of the downside risk that we showed in Figure 8-3. The time premium is the cost of that protection.

If the call buyer performs worse than the stock buyer by the amount of time premium then why would anybody buy the call option? Because it’s that same $3.84 time premium that provides the downside protection. Option traders give up a little bit of upside profit potential in exchange for greatly reducing the downside risk.

If you look to the left of the crossover point in Figure 8-4 you’ll see that if the stock falls below $75, the call owner will lose less than the long stock owner. With the stock below $75 at expiration, the call owner loses all intrinsic value in the option but also loses the $3.84 time premium, which means the total loss would be $75 – $3.84 = $71.16, which is exactly the crossover point that we previously calculated.

So protection is one of the big benefits of buying options. Call options provide protection from the downside risk of the stock. In this example, you can spend $79.46 per share today for the 200 shares of IBM and take a very big chance that the stock’s price will fall by more than the $8.30 cost of the $75 call option. Or you can spend $8.30 today for the call option and fully benefit if the shares rise or even if they fall below $71.16 at expiration.

How does the call option protect us from the large downside risk of a stock? Our put-call parity formula showed us that it comes from the fact that call options are really leveraged long stock plus a put option in disguise:

C = S – Pv (E) + put

If you own a call option, you are effectively borrowing money to buy stock, S – Pv (E), and then buying a put option to protect your downside. Long stock owners do not have the put option, which is why they have a much bigger downside risk.

Let’s see if the put-call parity formula holds true. At this time, the risk-free rate is roughly 3%, which means the effective interest rate for 230 days is .03 * (230/360) = .0192. Therefore, the present value of the exercise price is $75/1.0192 = $73.59. Using the quotes in Table 8-1 we see the $75 put is worth $2.45. Using our put-call parity formula, the value of the call must be S – Pv (E) + P, or $79.46 – $73.59 + $2.45 = $8.32, which is very close to the $8.30 quoted call price. This shows that when you pay the $8.30 price for the $75 call that the $75 put is included in that purchase.

This clearly demonstrates our first motivating factor for buying calls – protection from large losses. It also shows that call options with high deltas and long terms to expiration can be viewed as less risky than long stock purchases. Your maximum risk is much smaller and known up front and that is something we cannot say for stock owners.

Leverage
Leverage is our second motivating factor for buying call options. Leverage is a term borrowed from physics, which is simply defined as a mechanical advantage that allows the user to magnify a force. For example, if you need to change a car tire, you can lift a car off the ground with very little effort with a jack. The jack provides a tremendous mechanical advantage to the user making a seemingly impossible task easy enough to do with one hand.

In a similar way, options provide tremendous financial leverage to the user. For any given stock price movement, you can create a bigger “force” and get a bigger return from a fixed amount of money. For example, let’s revisit a comparison we made between the two investors in the last section. The stock investor buys shares of IBM at $79.46 while the option buyer pays $8.30. Now let’s assume that IBM closes at $85 at expiration. To the stock trader, that represents a return of $85/$79.46 = 1.069, which is approximately 7%. With the stock at $85 at expiration, the $75 call is worth the $10 intrinsic value. The return to the call trader is then $10/$8.30 = 1.205 = 20.5%, or roughly 21%. In other words, a 7% increase in the stock’s price led to a 21% return on the option. Just as with mechanical leverage, the option was able to take a tiny “force” of 7% and magnify it nearly three-fold.

Leverage is an elusive concept though. To many investors, it sounds as if the option trader performed better simply because of the higher returns. After all, it appears obvious that you would make more money with a 21% return on your money rather than only 7%. That would be true if we were investing the same dollar amounts. But if you work through the numbers, you’ll find that the dollar amounts are vastly different. In this example, we assumed the stock rose from $79.46 to $85, which is an increase of $5.54. The stock trader therefore makes a profit of 200 shares * $5.54 = $1,108. At expiration, the $75 calls are worth 200 * $10 = $2,000 and cost $1,660, which means the profit to the call buyer is only $340. If the option trade performs better in terms of percentages, why doesn’t it perform as well as the stock in terms of total dollar profit?

Again, this is a direct result of the $3.84 time premium in the option; that amount is never returned to you. If the option trader had this time premium returned when the option was sold then there would be an additional profit of 200 * $3.84 = $768. Notice that if we add this amount back to the $340 profit we get $768 + $340 = $1,108, which is exactly the same profit of the stock trader. We can look at this relationship another way. Assume there was no time premium in the option when it was purchased, which means it would have been trading for only the intrinsic value of $4.46 rather than $8.30. When it was sold for $10 at expiration, the net gain to the option trader would be $10 – $4.46 = $5.54, which is exactly the same dollar profit as the stock trader. This clearly shows that all intrinsic value is returned to you at expiration, which is why it is less risky to “pay” for intrinsic value. As long as the underlying stock does not move adversely then all intrinsic value remains with the option. The time value, however, is never returned to you under any circumstance.

To be continued…

Feb

12

Options 101 Part 89

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On the other hand, an option with a much lower delta, say 0.50, has a lot of time premium and therefore behaves more like an option rather than stock. When we say “behaves like an option,” we really mean that it doesn’t respond too systematically with the stock. Its price can also be greatly affected by time decay as well as volatility. The important point is that you want to initially purchase an option that behaves much more like the stock.
Fig 8-2

If you are buying call options as a means of stock replacement, then buy relatively high deltas in the 0.80 to 0.85 range.

Now that we’ve located the proper strike ($75), we simply place the following order:

Buy to open, two April $75 calls, symbol IBMDO, at market (or limit)

Of course, you could place a “limit order” rather than a “market” order to assure the price, but then you cannot guarantee that the order will fill. By placing a market order, we are allowing some price fluctuations while the order is being routed but are also guaranteed to get the order filled.

Once the order is filled, we are effectively controlling 200 shares of stock for up to the next 230 days. We do not need to remain in the contract for the full term as we can certainly exit the contract at any time by selling it.

Assume that the order is filled for the $8.30 asking price. Your account will be debited 200 * $8.30 = $1,660 plus commissions. Notice that it was going to cost you nearly $16,000 to buy 200 shares of stock, but you can effectively control those same shares for only $1,660. And it is this difference in prices that represents the protection you get from call options, since the most you can lose with the call is $1,660. Figure 8-2 shows the profit and loss curve for our two IBM April $75 calls:
Notice the flat part of the profit and loss curve to the left of the $75 strike. This shows that our maximum loss is defined and that is the absolute most we can lose. In other words, the call option provides protection. For example, assume that IBM has a bad earnings report and the stock plummets down more than 30% to $55, down $24.46. The stock trader is down 200 shares * 24.46 = $4,892. The option trader is down only $1,660. If the stock price continues to fall, the stock trader continues to lose money while the option trader’s losses are capped at $1,660. The option trader’s maximum loss is 100% defined the second the trade is placed.

There may be those investors who believe this is an unrealistic comparison because they would never allow this type of loss to happen to them because they use stop orders. But as our discussion in Chapter Four showed, stop orders do not prevent losses. In most cases, stop orders can work reasonably well but the point is that they are not guaranteed to limit you to a fixed amount of loss. Call options will. In this example, the call trader is 100% certain that the maximum loss is $1,660 while the stock trader cannot make any such claim.

Another reason that options provide better protection than stop orders is that stop orders are “path dependent” while options are “time dependent.” This simply means that the performance of a stop order depends on the “path” the stock takes. While it is possible for a stop to protect you, it is equally likely that it may force you to sell too early. For instance, assume you have the previous 200 shares of IBM and place an order to sell your shares at a stop price of $78. The stock might take the path of falling to $78 – thus forcing you to sell your shares – and then immediately turn around and climb much higher. In this instance, the stop order did prevent you from losing but it also forced you to miss future gains because of the particular path the stock took. Had you been holding the $75 call however, you never would be “triggered” out of the position just because of the path of the stock. Instead, by holding the call, you are locked into the $75 buy price over a period of time. Only if the stock’s price rises after the call option expires will you miss out on future gains. In other words, you are constrained by time, which is why we say that options offer protection that is time dependent while stop orders offer protection that is path dependent. Unfortunately, most of the major losses in stocks come after the close and there is nothing you can do with a stop order but wait for the opening price. Stop orders are not an equal substitute for options.

In order to be fair with our comparisons, isn’t it possible that our call option could expire worthless at expiration but then the stock could rise thus making the stock trader better off? That’s true, but in many cases the call buyer has the ability to buy the stock at the lower market price. For example, let’s go back to the beginning when we were deciding on whether or not to buy the stock. At that time IBM was trading for $79.46 and the April $75 call was trading for $8.30. If you have $79.46 available per share to buy the stock but decide to only spend $8.30 to buy the call then you have $79.46 – $8.30 = $71.16 in cash that can earn interest. Now let’s assume that the stock price falls to $70, which makes your call option expire worthless at expiration. It appears that the stock owner is better off because at least he has shares that might rise in the future while you have lost 100% of your investment with the $75 call. However, if you are still bullish on the stock at that time, you can buy the shares at $70 market price out of the $71.16 that you have sitting in cash.

The $71.16 price is the crossover point between the two strategies of buying 200 shares of stock versus buying two April $75 calls as shown in Figure 8-3:

In Chapter Five, the put-call parity formula showed us that if you were absolutely certain that a stock was going to rise that you should either buy the shares with borrowed funds or buy the call and sell the put. Figure 8-4 shows why. The reason is that the long call buyer will always underperform the long stock buyer by the amount of the time premium for all regions above the strike price. Notice that above the $75 stock price, the two profit and loss curves run parallel to each other. Those two lines will never meet at any higher stock price and that’s a way of showing that the long call buyer will never get the time premium back. However, since we don’t know for sure whether a stock will rise, the call option provides a lot of protection by removing all of the downside risk that we showed in Figure 8-3. The time premium is the cost of that protection.

To be continued

Feb

11

Options 101 Part 88 Chapter Eight Long Calls & Long Puts

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In the last chapter, we found out that the covered call strategy relies on the purchase of stock and the sale of a call. We also found that the strategy has a potentially large downside risk since you must buy the stock and the sale of the call may only provide a relatively small downside hedge. Holding stock creates one of the biggest risks for investors, whether using covered calls or not.

Short stock positions create an equally big risk for short-sellers wishing to capitalize on a fall in the stock’s price. Investors and speculators can get the nearly the same benefits of long and short stock positions but with far less risk by understanding the strategies of the long call and long put.

As we learned earlier in the book, puts work in exactly the same way as calls but in the opposite direction. So for this chapter, we have combined the strategies of long calls and long puts rather than presenting them separately. If you understand the motivation and techniques for buying and rolling call options, you will also understand how to apply those techniques for puts. So to make better use of our time, we’re going to look at the long call strategy in detail and close with a quick example using puts.

One way that investors can greatly reduce the downside risk of stock ownership is to simply buy calls rather than stocks. But downside protection is not the only benefit that investors get by purchasing call options. They also gain tremendous leverage and the ability to better diversify their investments. So there are three main reasons why investors and traders buy calls rather than stock:

• Protection
• Leverage
• Diversification

Which reason is most important depends on what type of investor you are and what you’re trying to accomplish. While any one of these benefits may appear to be the best to you now, it’s equally important to understand the other two, so let’s take a look at each in turn.

Protection
Let’s assume you are bullish on IBM, you believe it will rise sharply over the next six months and wish to buy 200 shares. Table 8-1 lists the current stock price along with some April IBM option quotes with 230 days until expiration:

If you buy 200 shares of stock it will cost about $16,000, which also represents the maximum amount you could lose on the investment. Although it would be hard to imagine that IBM becomes worthless, you’d certainly have to agree that a loss of, say, 30% or $4,800 is not out of the question. Let’s see if we can construct a more favorable risk-reward profile for less money by purchasing call options.

In this example, we’re assuming that you’re bullish on IBM, which is a directional outlook. In other words, you are buying the call option as a near substitute for a stock, and you are not attempting to trade the volatility component of this option. The only decision you’ve made is that you think the stock’s price will rise. With this one-dimensional outlook in mind, make sure you buy an option that has a high directional or stock component to it. Chapter Six showed us that if you wish to buy a call as a stock substitute that you should look for one with a delta in the 0.80 to 0.85 range.

As stated in Chapter Two, your brokerage firm should certainly supply the delta values. However, if the firm does not, you can find them at a number of online resources, free of charge, such as at the Options Industry Council’s (OIC) site at www.888options.com, from PCQuote at www.pcquote.com, or from the Philadelphia Stock Exchange at www.phlx.com.

If not, that same chapter showed that we can find a sufficiently high delta by looking for a put option with about 30 to 40 cents above the cost of carry. The corresponding call (same strike) will have the delta we’re looking for. So which strike is this? At the time these quotes were taken, the risk-free interest rate was about 3% so the cost of carry for a $79.46 stock for 283 days is $79.46 * .03 * 283/360 = $1.87. If we tack on 40 cents to this price, we get $2.27 and the closest put to that value is the $75 strike.

We can also find a close approximation for the delta in a roundabout way by using a little theory we learned in Chapter Two. There we learned from Pricing Principle #6 that the difference between any two call (or put) prices cannot exceed the difference in their strikes. We can use this principle to give us a reasonable estimate of the delta. For example, look at the asking prices for the $50 and $55 calls, which are $30.50 and $25.70, respectively. The difference in these prices is $30.50 – $25.70 = $4.80. The maximum that difference could ever be is the difference in strikes, or $5. So the average delta between these two strikes is $4.80/$5.00 = 0.96. This tells us that the delta of the $50 call (lower strike) is somewhat higher than 0.96 while the delta for the higher $55 strike is somewhat less. Regardless, the delta of the $50 call is too high.

As we check the other combinations, we find that the $70 and $75 calls are $12.20 and $8.30, respectively. The difference in their prices is $12.20 – $8.30 = $3.90. If we divide that by the $5 difference in strikes, we find that the average delta is $3.90/$5 = 0.78. This means that the $70 strike has a somewhat higher delta and the $75 strike has a somewhat lower delta so the $75 strike looks like the one we’d want to trade. In fact, at the time these quotes were taken, the delta on the $75 strike was 0.73.

If you buy a strike lower than $75, you are paying for additional intrinsic value unnecessarily. If you buy a higher strike, there is too much time premium in the option and it may not respond to smaller changes in the stock’s price. (And that means you could lose on the option even if the stock price rises.)

It’s very important to understand why we choose a strike with a delta of roughly 0.80. The reason is that a call option with a delta of 1.0 is no longer considered an option; it is now a perfect stock substitute. There is no time premium in a call option with a delta of 1.0 and it will rise and fall dollar-for-dollar with the underlying stock. Keep in mind that this is only true as long as the delta remains at 1.0. It could decrease if the underlying stock price falls sufficiently. However, a call with a delta of 1.0 contains a lot of intrinsic value that we would rather not pay for. So you do not need to find a delta of 1.0 but should get close; and the 0.80 to 0.85 range will suit your needs as a means for stock replacement.

To be continued….

Feb

10

Chapter Seven Answers

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1) You own 300 shares of ABC stock, trading for $60, and have written 3 $65 calls. You have the:
d) Obligation to sell 300 shares of ABC for $65
Writing calls creates the potential obligation to sell your shares for the strike price. It is a potential obligation because you’re only required to if the short call exercises. You can also get out of the obligation by buying the $65 call to close.

2) You purchased 200 shares of stock at $40 and have written two $40 calls for $1. Your cost basis on the stock is effectively:
a) $39
Because you wrote a contract equivalent number of calls against your shares, the premium can just be subtracted from the cost in order to find the cost basis. In this example, you paid $40 for the stock and received $1 from selling the call, which means your cost basis is $39. We can show this another way too. You paid 200 shares * $40 = $8,000 for the stock and received 2 contracts * $1 = $200 for the options, which makes your total cash outlay $7,800. Because you own 200 shares, your average cost is $7,800/200 = $39 per share.

3) You have written 4 $50 call options against your stock. How much money will you receive if you are assigned?
d) $20,000
If assigned, you will sell 400 shares for the $50 strike, which makes the total you will receive equal to $20,000.

4) The risk of a covered call is that:
b) The stock price falls
The risk of a covered call is that the stock falls. Giving up your stock at an unfavorable price is a missed opportunity but certainly not a risk of principal.

5) Covered call writers should:
b) Write the month that brings in an adequate premium relative to the risk.
All else constant, short-term calls are good to write for many reasons. But you must remember that all strategies are tradeoffs between risk and reward. Short-term options do decay faster, but they do not bring in as much premium as longer-term options. It is up to the investor to find the right mix of premium and time so that he feels he is fairly compensated for the risk.

6) Assuming you are not looking for highly-speculative investments, one of the most important standards for selecting stocks to write calls against is for you to:
b) Write calls against stock that you are comfortable holding
If you are willing to hold the stock regardless of whether options are traded or not, then you are willing to assume the downside risk. Writing calls with this mindset means that the calls are generating income and reducing your downside exposure, which makes it a less risky position.

7) If you write a covered call and the stock’s price rises above the strike price prior to expiration, you should:
d) Only expect to get assigned at expiration if the stock’s price is still above the strike
No matter where the stock price may be, it is not in the long call holder’s best interest to exercise early. While it can happen, you shouldn’t expect to get assigned early.

You have written a $50 call against your stock, which is trading for $57 with 20 days remaining until expiration. If you decide to buy back the $50 call and simultaneously sell the $55 call (same expiration), what is this called and will is produce a net credit or debit?
b) Roll-up, net debit
You are rolling up from the $50 strike to a $55 so this is a roll-up. Because you’re buying back the lower strike price (more valuable strike) that means you will spend more money than you receive, which makes the trade a net debit. This trade will increase the cost basis of your long stock position but will also increase your potential selling price from $50 to $55.

9) You bought 200 shares of ABC stock for $30 and have written two calls against it for $1 each. The calls have expired worthless and you wish to write calls again for the following month. However, the stock has now dropped to $25 so you decide to write two $25 calls for $2 each. What is your new cost basis and what is your profit or loss if you are assigned?
b) $27 cost basis, $2 loss
Your original cost basis is $30 – $1 = $29. If you roll down to the $25 strike, you will receive $2 for it, which makes your new cost basis $27. However, by rolling down the strikes, you’re also getting less money from the sale of the stock if you should get assigned. Your cost basis is $27 but you’d only receive $25 if assigned, which potentially locks you into a $2 loss. It’s not a loss at this point as you could roll up to a higher strike at a later date. But if you were assigned at this point, you’d have a $2 loss.

10) You bought 1,000 shares of XYZ stock for $20 and wrote 10 $20 calls for $2. At expiration, the stock is trading for $15. What is your unrealized profit or loss at this point?
d) $3 loss
Your cost basis is $18 (paid $20 and received $2 for the calls) and the calls are worthless so you have no obligation to sell your stock. However, with the stock at $15, you are currently in a $3 loss if you should sell the stock for the current $18 stock price. This example shows that the risk of a covered call is that the stock falls.

11) You bought 100 shares of ABC stock for $50 and wrote the $50 call for $1. At expiration, the stock is trading for $55 and the call is trading at parity (worth the $5 intrinsic value). If you buy the call to close:
d) $3 loss
When you purchased the shares for $20 and wrote the calls for $2, your cost basis was $18 and you had the potential obligation to sell your shares for $20 at expiration. With the stock at $15 at expiration, you have a $3 unrealized loss at that point. In other words, because you effectively paid $18, if you sold those shares for the current market value of $15, you’d have a $3 loss.

12) If you write a covered call, you:
a) Can always exit it by purchasing the call back
You can always escape your obligations of a covered call (or of any option position for that matter) by entering a reversing trade. For the covered call, this means you would have to buy back the call since you originally sold it.

13) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your static return?
c) 7.1%
If you pay $30 for the stock and write the $30 call for $2, your cost basis is $28. The static return is measured assuming the stock is the same price at expiration, which is the current value of $30. So if you were to sell the stock at that moment, you’d have a gain of $2/$28 = 7.1%.

14) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your breakeven return?
b) 6.7%
You purchased shares for $30 and wrote the $30 call for $2, which makes your cost basis $28. This means the stock can fall from its current price of $30 down to your cost basis of $28, or 6.7%, and you’d just break even on the trade.

15) You bought 100 shares of ABC for $70 and wrote the $70 call for $3. What is your return if exercised?
d) 4.5%
You bought shares for $70 and wrote the $70 call for $3 so your cost basis is $67. If the long position exercises, you will sell your shares for the strike price of $70, which means your return is $3/$67 = 4.5%.

16) If you write an in-the-money call against your shares, you:
d) Can make money as long as a time premium is present
If you write an in-the-money call against your long stock position, you can still make money on the trade as long as the call has some time premium. For example, if you buy shares at $50 and write a $45 call for $6, then there is $1 time value on the call and that is the amount you could make by selling this call. Your cost basis would be $44 and you’d have the potential obligation to sell your shares for $45. The only time you cannot make money by selling an in-the-money call is if the option is trading at parity (exactly for the intrinsic amount). In this example, if the $45 call was trading for $5, then selling this call makes your cost basis $45 and you’d have the potential obligation to sell your shares for $45.

17) In the long run, covered calls must be:
c) More conservative and therefore have lower returns
Covered calls have less risk than a long stock position for the fact that you are reducing your downside risk by selling the call. If you have less risk, you must have lower returns. Again, this does not mean that a covered call writer cannot beat the long stock position in certain markets. But overall it is a less risky position and will have lower returns for the market as a whole.

18) Buy-writes are orders that are used primarily to:
b) Eliminate execution risk
Buy-writes allow you to simultaneously buy the stock and sell the call. This prevents adverse price movement between the trades. The buy-write therefore eliminates execution risk.

19) You purchased 100 shares of XYZ for $50 and sold a one-month $50 call for $2. The stock is $53 at expiration and you are assigned on the call. What is your ANNUALIZED rate of return?
c) 50%
By purchasing the stock for $50 and selling the one-month $50 call for $2, your cost basis is $48. If you are assigned, you will receive $50 per share, which means your simple return is $2/$48 = 4.17%. To annualize this figure, we must realize there are 12 one-month periods in a year so we’d multiply 4.2% * 12 = 0.50, or 50% annualized return. This just shows us that if we were able to continue this performance for one year we’d have a 50% return (not counting the compounding of returns).

20) What is the rationale for the covered call strategy?
d) To make more consistent returns and allow compounding to work for you
Covered call writers are trying to capture the more probable returns more often. This allows for more consistent returns and thus allows compounding to take effect.

Feb

9

Chapter Seven Questions

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1) You own 300 shares of ABC stock, trading for $60, and have written 3 $65 calls. You have the:
a) Right to buy 300 shares of ABC for $65
b) Obligation to buy 300 shares of ABC for $65
c) Right to sell 300 shares of ABC for $65
d) Obligation to sell 300 shares of ABC for $65

2) You purchased 200 shares of stock at $40 and have written two $40 calls for $1. Your cost basis on the stock is effectively:
a) $39
b) $41
c) $38
d) Cannot be determined

3) You have written 4 $50 call options against your stock. How much money will you receive if you are assigned?
a) $200
b) $5,000
c) $2,000
d) $20,000

4) The risk of a covered call is that:
a) You might have to give up your stock at a very unfavorable price
b) The stock price falls
c) The premium of the short call falls
d) The stock price stays the same

5) Covered call writers should:
a) Only write short-term calls since they are exposed to the sharpest time decay
b) Write the month that brings in an adequate premium relative to the risk.
c) Never write out-of-the-money calls
d) Never write in-the-money calls

6) Assuming you are not looking for highly-speculative investments, one of the most important standards for selecting stocks to write calls against is for you to:
a) Write calls that have large premiums
b) Write calls against stock that you are comfortable holding
c) Write calls on highly-volatile stocks
d) Write calls only on long-term options

7) If you write a covered call and the stock’s price rises above the strike price prior to expiration, you should:
a) Expect to get assigned on the ex-date
b) Expect to get assigned the following day
c) Expect to get assigned that day
d) Only expect to get assigned at expiration if the stock’s price is still above the strike

10) You bought 1,000 shares of XYZ stock for $20 and wrote 10 $20 calls for $2. At expiration, the stock is trading for $15. What is your unrealized profit or loss at this point?
a) $2 gain
b) $2 loss
c) $3 gain
d) $3 loss

11) You bought 100 shares of ABC stock for $50 and wrote the $50 call for $1. At expiration, the stock is trading for $55 and the call is trading at parity (worth the $5 intrinsic value). If you buy the call to close:
a) You will be left with a loss since you sold the call for $1 and bought it back for $5.
b) You will have a $1 gain
c) You will have a $5 loss
d) You will just break even

12) If you write a covered call, you:
a) Can always exit it by purchasing the call back
b) Must remain in the covered call until expiration
c) Can exit the position by exercising the call
d) Can exit the position by selling a put

13) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your static return?
a) 8.4%
b) 6.7%
c) 7.1%
d) 5.8%

14) You bought 100 shares of ABC for $30 and wrote the $30 call for $2. What is your breakeven return?
a) 8.4%
b) 6.7%
c) 7.1%
d) 4.8%

15) You bought 100 shares of ABC for $70 and wrote the $70 call for $3. What is your return if exercised?
a) 5.9%
b) 3.2%
c) 6.2%
d) 4.5%

16) If you write an in-the-money call against your shares, you:
a) Can only make the risk-free rate as a maximum return
b) Are guaranteed to make money on the position
c) Cannot make money on this position
d) Can make money as long as a time premium is present

17) In the long run, covered calls must be:
a) More risky due to the added risk of the short call
b) More risky due to the downside risk of the stock
c) More conservative and therefore have lower returns
d) More conservative and therefore have higher returns

18) Buy-writes are orders that are used primarily to:
a) Increase execution risk
b) Eliminate execution risk
c) Increase your cost basis
d) Increase the breakeven point

20) What is the rationale for the covered call strategy?
a) To make lower returns by increasing risk
b) To make higher returns by lowering risk
c) To make higher returns by increasing risk
d) To make more consistent returns and allow compounding to work for you

Feb

8

Options 101 Part 86

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In the Long Run, Covered Calls Are Less Risky

There are some studies that have shown where covered calls have produced superior returns to the market while reducing downside risk, which seems to go against the premise of the risk-reward tradeoff. But these studies are considering shorter time periods when the markets are relatively flat and, in these times, covered calls will outperform the market. But it’s a myth that they will always outperform the market while reducing your risk, which is what these studies lead many to believe. They are not taking into account the “homeruns” that stocks sometimes hit during good markets, and covered call writers will not participate in these to the same degree as long stock holders. In the long run, covered call writing is more conservative than owning stocks. As stated before, this doesn’t mean that there won’t be situations where the covered call writer outperforms the long stock holder. We just mean that you cannot consistently reduce your risk and increase your returns over time.

Despite this fact, covered call writing can be a very lucrative and rewarding strategy. In fact, in 2002, the CBOE created a buy-write index (BXM), which shows how a portfolio of covered calls would have performed over a given time period by writing slightly out-of-the-money calls against the S&P 500 Index. At certain times, the BXM can boast some pretty impressive results. Covered calls are also a good strategy that can be combined with other strategies; they do not need to be used as an independent strategy.

For example, rather than buying shares of stock, you could start by selling naked puts as a way to acquire the stock. Remember, if you sell a put, you create the potential obligation to buy stock. Selling naked puts is not a strategy that we will cover, but we’re just trying to make the point of how option strategies can be used in conjunction with one another. Continuing, once the stock is acquired, you could then write calls as a way to sell the stock. By adding the additional step of selling puts, the investor acquires at least two option premiums – one to buy the stock and one to sell the stock. He may acquire more if he’s able to write additional puts to acquire the stock and additional calls to sell the stock.

So while covered calls may be presented as a basic strategy, don’t think that experienced investors do not use them. They can be very powerful when combined in the right ways for specific situations. As with any strategy, there are many ways to fine-tune them to suit your needs. The important thing is that you understand the basics. Once you do, you’ll find that covered calls may not be so basic after all.

Feb

5

Options 101 Part 85

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Buy-Writes
There is a special order that allows traders to enter into a covered call as a “package deal” to the market maker, which is called a buy-write. With a buy-write, you can send an order to “buy” the stock and simultaneously “write” (sell) the call, which can be executed “at market” or as a “limit order.” Regardless of how the order is placed, any executed order results in a net debit (because the stock must always be more valuable than the call). Since you’re giving the market maker two trades rather than one, you will generally get a little better price for the package deal and every little bit helps.

Are Net Debits Confusing?
Sometimes new traders have trouble with the concept of net debits but it’s very similar in concept as when you negotiate with a car dealer to trade in a used car for a new one. If the dealer is asking $30,000 for a new car and you would like to receive $10,000 for your used car then there is a $20,000 difference between the two prices. You may, for example, try to make a deal by telling the dealer that you want to buy the new car by trading in your used car plus $18,000 cash. In other words, you’re telling the dealer you want to buy one asset and sell another for a net payment or “net debit” of $18,000. It’s should be of no concern to you if the dealer says he cannot sell the new car below $30,000 but is willing to give you $12,000 for your trade-in since that is still a net payment of $18,000 to you. Car dealers often work with the differences between the two cars.

This is exactly the idea behind the net debit with buy-writes. When you enter a buy-write, you’re telling the market maker that you don’t care what price they charge you for the stock or what price you receive for your calls as long as it is executed for a price less than or equal to your net debit limit.

The simultaneous execution of both positions eliminates execution risk, which is the result of adverse price movements. For example, assume the stock is $50 and you wish to buy the stock and then sell a $50 call, which is trading for $3. Notice that this means you are expecting to end up with a net debit of $47 for the two trades. However, if you place an order to buy the stock at market, you may get filled at a little higher price than $50, say $50.25. Then you immediately place the order to sell the $50 call and the stock’s price suddenly drops, which makes the call price $2.90. Because of the adverse price fluctuations, you paid more for the stock and received less for the call and end up with a net debit of -$50.25 + $2.90 = 47.35 instead of the expected $47. If you enter the two trades as a buy-write, you will not face this adverse movement. If the stock’s price suddenly jumps higher while the order is being executed, you’ll pay more for the stock but will also get more for the call. If the stock price drops lower during execution, you’ll get less for the call but also pay less for the stock. The result is that the net debit should stay pretty close to the same and not leave you with any unwanted surprise fills.

Incidentally, there is a mirror-image trade that allows the investor to simultaneously get out of a covered call, which is called an unwind. If you unwind a covered call, you will sell your stock and simultaneously buy back the call option. As before, the reason for doing both transactions simultaneously is to prevent execution risk. Most brokerage firms that offer buy-write screens also have unwind screens available online. If you are an avid covered call writer, you should strongly consider using the buy-write and unwind transaction screens if you are buying the shares at the same time you are writing the calls.

We said last blog entry that investors can write calls against shares they have been holding in the account. This is usually called overwriting and generally leads to a conservative use of covered calls since the investor is obviously willing to assume the downside risk. The buy-write, however, is typically used as a one-time strategy for the sole purpose of writing the call, which is a speculative use of covered calls. The buy-writer’s philosophy is usually (not always) to find a high option premium and then buy the stock and simultaneously write the call. After all, why would he need to buy the stock at that same moment? The answer is that he usually wishes to capture a premium-rich option and must buy the stock to cover the upside risk. Entering the orders together as a buy-write gives these investors a little added edge.

While buy-writes are generally speculative, they do not have to be. Some investors, as we discussed previously, may be perfectly comfortable holding a certain stock but wish to write in-the-money calls to provide for a bigger downside hedge. These investors often do end up getting assigned and losing the shares. Buy-writes can be a cost-efficient way to continually enter into new trades.

Regardless of whether or not you are comfortable assuming the downside risk, the buy-write can add a little edge for those times when you wish to buy the stock and write the call in the same transaction. You may wish to check with your broker to see if they offer a “buy-write” screen and get in the habit of using it whenever you wish to enter the two trades simultaneously. If you are entering buy-writes, just be certain that you have properly identified your reason for buying the stock. If it is purely for the ability to write the call, then understand that it is a speculative investment and adjust the size of your trade accordingly.

Roll-Outs
We learned earlier that it doesn’t really matter if the stock price rises above the strike of the short call at expiration since this is the maximum gain portion of the profit and loss curve. While it may not be the ideal situation, it is not a losing situation by any means. When this happens, most investors feel they only have two choices. First, they can let their shares get called away. Second, they can buy back the call and end up with an unrealized gain in the stock. However, there is a third and often overlooked strategy available, which is called a roll-out.

Assume that AGIX is $21 at expiration and the October $20 call that you sold is trading for $1 intrinsic value and November $20 call is trading for $3. You could buy back the October $20 call and simultaneously sell the November $20 call for a net credit of $2. In other words, you have rolled out to the following month. Effectively you sold another $20 call for $2, which again lowers the cost basis of your stock by the same amount.

Of course, you could choose to sell other strikes as well. If, instead, you sold the November $25 call you would be rolling out and up (rolling out in time and up in strikes). This strategy is used when the stock makes a significant upward move. For example, assume AGIX is trading for $25 at October expiration and the $20 call you sold is trading for the $5 intrinsic value. Further assume that the November $25 call is trading for $3. You could buy back the October $20 call and sell the November $25 call for a net debit of $2. Effectively, you have paid $2 for the chance to make an additional $3 (the difference in strikes less the $2 paid) if AGIX is above $25 at expiration.

In our example, you had a cost basis of $14.41 on the stock. If you buy back the $20 call and sell the $25 call then your cost basis increases by $2 to $16.41. You could make a maximum of $25 for a net gain of $8.59, which is $3 more than your previous gain. Rolling out or rolling up trades are collectively known as rolling trades and they allow investors to make another investment based on the same shares that are already in the account. If you don’t want to let go of your shares, you can always execute a rolling trade. The important point is that you make your decision based on sound objectives rather than rolling up just because you don’t want to see your stock taken away.

Roll-Downs
A roll-down is the reverse of a roll-up. With roll-downs, the investor buys back the existing strike but sells a lower strike call against the shares. Investors are often forced to do this when the stock price falls since the higher strike price may be trading for too low of a price to make it worthwhile. For example, assume AGIX is trading for $15 at expiration. The October $20 call you sold is close to worthless, but you may find that the November $20 isn’t commanding much of a premium either. You could execute a simultaneous order to buy back the October $20 call and sell the November $15 call.

The problem with writing the $15 call is that it reduces the potential sales price of the stock. By selling the $15 calls, you have the potential obligation to sell your shares for $15, which means the potential sales price is reduced by five dollars. You will always reduce your potential selling price when you roll down. For example, assume you can buy back the October $20 call and sell the November $15 call for a net credit of $2. Your cost basis on the stock is reduced from $14.41 to $12.41 but now you have the potential obligation to sell your shares for $15. In this case, the roll-down worked out okay but, depending on the cost basis of the stock you could lock yourself into a potential loss if assigned. For instance, if your cost basis on the stock was $18 and you rolled down for a net credit of $2 then your cost basis is $16 but you may have to sell the shares for $15.

Remember that the covered call strategy is a neutral to slightly bullish strategy. If the stock price is falling then you may be in the wrong trade and it’s usually not the best idea to try to “write” your way out of the loss by selling lower strike calls. In most cases, you just end up digging a deeper hole. But depending on your cost basis it can be a viable trade, so it’s worth understanding.

To be continued……

Feb

4

Options 101 Part 84

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Hedging with Covered Calls
Many investors are attracted to covered calls because of the immediate cash that can be generated into the account. Because of this, they tend to write the “full amount” of contracts against their shares. For example, if they own 500 shares, they will write five contracts. While this does maximize the amount of cash generated for any given strike (and create the largest downside hedge), it does have its drawbacks. That is, if the stock makes a sudden move upwards, then your gains are capped and the covered call writer often has regrets about having written the calls in the first place. One way to combat this potential regret is to not write the full amount of contracts against your shares. For example, if you own 500 shares, you may consider writing something less than five contracts – anything from one to four contracts. While you will not bring in as much money, you will keep some of the upside open in the event the stock does spike up. By writing less than five contracts, you are hedging your bet between writing no calls and writing the full amount. It’s just something to consider, especially in cases where you believe there is potential for the stock to break out of a range and continue higher. It’s very tempting to want to write calls but it may come with large regrets later. Hedging the position by writing fewer calls can be a simple solution. How does this affect the position? Take a look at Figure 7-6. The shaded line is the profit and loss curve for an investor who buys 300 shares of AGIX and writes three of the $20 calls for $4.40. The bold line is the curve for the investor who buys 300 shares but only writes two of the $20 calls for $4.40:

Notice that the profit and loss diagram for the bold line does not flatten out after the $20 stock price. The reason is that this investor purchased 300 shares but only wrote two calls so he is only obligated to sell 200 of those shares. This investor will always have 100 shares free and clear to participate in upside gains above $20.

The tradeoff between writing two calls instead of three is that you don’t get as much of a downside hedge since you receive less money. Figure 7-6 shows that the bold line doesn’t have as much downside protection. It is therefore riskier and that’s why it comes with a bigger reward.

This is a good example showing once again that all option strategies are about tradeoffs. Any time you buy or sell an option to create some type of advantage there must be a negative aspect somewhere. Do not enter into any strategy until you clearly understand what the benefits and drawbacks are. It is impossible to find a strategy that only offers benefits. It is also impossible to find a strategy that beats all other strategy for all stock prices. It is up to the investor to decide which benefits are worth having in exchange for the drawbacks.

Will I Get Assigned Early?
If you write a covered call, don’t expect to get assigned or “called out” early even if the stock’s price is well above the strike price. In Chapter Four, we showed that it is never optimal to exercise a call option early with the exception of collecting a dividend. With a covered call, you have a short call position; another trader somewhere has the long side of that trade. If it is not in his best interest to exercise that call early then you shouldn’t expect to get assigned early.

Now that you have a better understanding of covered calls, we can revisit that topic and gain a new appreciation why it is not in the best interest of the long call holder to exercise early. Assume that you buy stock for $100 and write a one-year, $100 call for $10. That means that the most you could make from this trade is $10 if the stock’s price is above $100 in one year, which would net you a 10% gain (actually, your gain would be higher than 10% since you’re collecting the $10 up front but we’re just trying to make the example simple to follow). But if you hold the position for less than a year, your gains are magnified. For example, if you are assigned after six months, then your annualized rate of return jumps to 20%. If you are assigned after three months, your annualized return is 40% and so on. This shows that the shorter time frame you hold the covered call, the better off you are since you were paid $10 to hold the stock for a full year but ended up holding it for less time. The better off you are then the worse off is the long call holder. Since the long call holder controls the right to buy stock (he controls the exercise instructions), he will not exercise early. This shows that you should not enter into a covered call with the intent of being called out early. Also remember that it is not your decision as to when to end the contract; that’s up to the long call holder.

As an example, I remember a client who once wrote covered calls with nearly a year until expiration. He collected a healthy premium but the stock quickly rose above the strike price, which means his account wasn’t reflecting any of the daily gains in the stock. He called in one day and said, “I think I’d like to be called out on this stock now.” After I explained that it was only the long position that could submit exercise instructions, he then realized the tradeoff of writing longer-term calls. While he did get a much higher premium for writing a longer-term contract, his money was tied up in the stock for that year. The investor could buy the calls back but then that cuts into the anticipated gains. So if you are writing longer-term contracts, you should not expect to get assigned until expiration. Also, you should not expect to get assigned even if a dividend is about to be paid. The reason is that upon exercising a call, the long position sacrifices the call (he cannot sell it) so he loses all of the time value in the call. If you are writing longer-term calls, the value of the time premium is probably far greater than the dividend.

However, anything is possible in the markets. We have seen people get assigned (called out) early on covered call positions. If this happens it is only an advantage to the call writer. Remember, if you get assigned early you just receive your money earlier rather than later. It’s a huge advantage to you. But again, this is why you shouldn’t expect it to happen.

How Will I Know If I’m Assigned (Called Out of a stock)?
If you are ever assigned on a call, you will be notified by your broker the following business day.

But be careful at expiration and do not assume that you will not be assigned just because the stock closed below the strike price on Friday. The reason is that many brokers allow you to exercise the call after the closing bell. It is possible that after-hours news could propel the stock to new higher prices and you could get the assignment notice on Monday.

Using our AGIX example, assume you have purchased 100 shares and sold one $20 call. It is now expiration day and the stock is trading below the $20 strike, say $19. Because its price is below the strike, you decide to not pay the commission to close the call and just let it expire worthless. However, after the close, a news story hits stating that the company will be bought out at $30 per share. Upon hearing this news, the long call holders who thought their $20 calls expired worthless could potentially make $10 just by exercising the call. All they have to do is call their broker and exercise the call option.

They will pay $20 but receive stock worth $30, which they can immediately sell for a $10 gain rather than the 100% loss they took by letting the option expire. Even if the call owners are afraid the stock might fall on Monday, they could short shares in the after-hours market for $30 per share and then cover it for $20 by exercising the option. That’s the risk-free route. The point is that there will be big demands to exercise the call and you can bet that assignment notices are likely to follow on Monday. If you do not have an assignment notice on Monday morning following expiration (assuming that’s not a holiday), you can be sure that you were not assigned on the call.

To be continued…..

Feb

3

Options 101 Part 83

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Covered Call Trap
At the beginning of this chapter, we said that covered calls can contain an unforeseen risk, and we’re now ready to show how investors unknowingly can take step right into a trap if they believe that all covered call positions are conservative.

Because most investors do not realize the downside risk inherent with covered calls, they unknowingly choose their covered call trades based on the volatility of the underlying stock. An investor new to the covered call strategy may hear that covered calls are conservative and, when searching for investment ideas, will end up choosing the call options that have the highest premiums. After all, if all covered calls are conservative, he feels he might as well choose the call option that brings in the highest premium. However, if you choose the call options with the highest premiums, you have automatically chosen the riskiest stocks since it is the higher-volatility (risky) stocks that command higher option premiums. The investor ends up holding onto a highly volatile stock that he otherwise would not be comfortable holding. These call writers are often called “premium seekers” since they seek out the options with the highest premiums and then they buy the stock for the sole reason of writing the calls. This is a high-risk way to use covered calls that can lead to disastrous results.

For example, assume that you are comfortable holding stocks in your IRA (Individual Retirement Account) such as Conservative Consolidated Company but not comfortable with highly-volatile stocks such as Gargantuan Growth Company. If you are new to options and decide to write calls, you would find that the premiums for Conservative Consolidated are not nearly as large as they are for Gargantuan Growth. The reason is simply that Gargantuan Growth is far more volatile. And when stocks are more volatile, option traders are willing to pay more for the options so that they don’t have to hold the stock. When you decide on which stock to buy in order to write calls, you may see a one-month, at-the-money call on Conservative Consolidated trading for 50 cents while an at-the-money call on Gargantuan Growth may be $5.

When faced with these prices, you may think that it doesn’t make sense to buy 100 shares of Conservative Consolidated and only receive $50 from the sale of the call when you can buy 100 shares of Gargantuan Growth and receive $500. So you decide to buy 100 of Gargantuan Growth and write the call to gain the $500. But look what just happened. You ended up with the stock that you weren’t comfortable holding. It was the high option premiums that lured you into buying the stock. That’s what happens when you let option premiums dictate which stocks to buy. Investors who base their covered call decisions on option prices end up taking far more risk than they intend and end up holding a risky asset that could fall substantially.

Example:
Around 1998, I remember one investor who bought 7,000 shares of Egghead Software (EGGS) at $53 during the “dot-com” craze. (To make matters worse, he bought the shares on margin or borrowed funds.) He thought he was laughing all the way to the bank when he discovered that a three-week option was bidding $8 for a $55 stock. “Wow, that is over 15-fold on your money” he exclaimed. “At that rate, it would take less than two and a half years to turn $1,000 into $1,000,000.”

The trader bought the shares and wrote the calls waiting patiently for his windfall to arrive. At option expiration, the stock was trading at $4. Yes, he did get to keep the entire $8 premium for the calls. I will let you decide if it was worth it.

This trader was correct in realizing that the $8 premium was tremendously high. But there was a reason the markets were bidding up the call options so high. They wanted someone else to hold the risky stock. The risk of a covered call is that the stock falls.

Notice how it’s possible for two investors to be using covered calls and yet be on nearly opposite ends of the risk spectrum. Options are risky only if used improperly. Don’t be misled into thinking that all covered call positions are conservative no matter how convincing the argument may sound. If any broker tells you that the risk of a covered call is that you miss out on upside gains then ask him why the strategy is called “covered.” He will immediately tell that it’s because you’re not at risk if the stock rises since you already own the stock. That’s the correct answer but it presents a dilemma since he also believes that you’re at risk if it does rise. The reason that people make this mistake is because they are confusing “risk” with “missed opportunity.” Once again, risk is never defined as missing out on some reward (missed opportunity). People who forget the simple risk-and-reward relationship are easily led to believe that the risk of a covered call is that they miss out on the upside gains and are inevitably led to writing calls on the riskiest stocks they can find. If the “risk” is that you may miss out on some upside gains, you might as well collect the biggest premium you can! These investors usually learn the hard way that there is a big difference between risk and missed opportunity.

The very best tip we can give you for writing calls in a conservative way is to be sure you’re buying stock that you wouldn’t mind holding anyway even if options were not available. That way, it shows you’re willing to assume the downside risk and the sale of the call does not change the risk. It simply provides a downside hedge. Don’t let the tail wag the dog by purchasing stocks based on the prices of the options. Of course, it doesn’t mean that it’s wrong to write covered calls because of the high premiums; it just means that it changes the nature of the strategy from conservative to speculative. The point to remember is that all covered calls are not equal. Just because you’ve written a covered call does not make it a conservative strategy. It is your reason for doing it that dictates the risk in the strategy.

Synthetic Positions
We can use put-call parity to show us added insights into any strategy so let’s see what it has to say about the covered call strategy. Let’s start with the basic equation found in Chapter Five (Formula 5-15):

S + P – C = 0

Now let’s solve it for a covered call. We know that a covered call is the combination of long stock plus a short call, so we need to get those two assets on one side of the equation. We can see that they are already on the left side, so let’s just move the long put to the right side and change its sign in the process:

S – C = -P

This equation tells us that the combination of long stock and a short call (left side) is equal to a short put (right side). Any broker will tell you that short puts are one of the riskiest strategies available. Brokerage firms will require your account to have the highest option approval rating along with significant equity before they will allow you to write naked puts. At the same time, they will tell you that the covered call is conservative in nature. Both statements cannot be correct. It depends on how they are used. If you want to use them in conservative ways, make sure you are buying stock you don’t mind holding.

Another way to verify if a particular covered call is suitable for you is to ask yourself if you would be comfortable selling naked puts at that time. If the answer is no, then you should not be using a covered call because it is exactly the same thing packaged a little differently.

To be continued….

Feb

2

Options 101 Part 82

Filed Under Option Trading Articles | Leave a Comment

Writing In-the-Money Calls
New investors often wonder how it is possible to profit by purchasing a stock for one price and giving someone else the right to buy it for less money. The answer is there is a time premium associated for that right that more than makes up for this loss. We know this from Pricing Principle #4 in Chapter Two which showed us that all call options must be worth their intrinsic value plus some time premium. If you sell an in-the-money call, you receive more money than the intrinsic value you’re sacrificing.

For example, using Table 7-1, you could buy AGIX for $18.81 and sell the $15 call for $6.20. Notice that you are taking a loss on $18.81 – $15 = $3.31 worth of intrinsic value but are paid $6.20, which more than covers the loss.

Pricing Principle #1 showed us that lower strike calls are more expensive. Therefore, writing in-the-money calls against your shares provides a bigger cushion if the stock price should fall. Even though in-the-money calls are more expensive overall, they carry a smaller time premium and it’s the time premium that reduces the cost basis of the stock. This is why writing in-the-money calls increases the downside hedge (they are more expensive) but provides lower returns (there is not as much time premium as an at-the-money call). In other words, investors who write in-the-money calls are taking less risk and will therefore get lower returns.

Buying the stock for $18.81 and selling the call for $6.20 gives you a cost basis of $18.81 – $6.20 = $12.61 and gives you the potential obligation to sell your shares for $15 call, which represents a 12.6% return.

Figure 7-4 compares the profit and loss diagrams for selling the $20 call (bold line) verses the $15 call (shaded line). You can see that the $20 call provides for a higher return but the $15 call provides better downside protection. Selling the $20 call carries more risk and more reward than sale of the $15 call:

If there were lower strikes available for AGIX, we would find that the returns would eventually converge on the risk-free rate. Notice this is consistent with our observations about time premium in Chapter One where we said that lower strike calls will have very relatively small amounts of time premium in them and it’s the time premium that creates the returns for the covered call strategy. Now that you understand the covered call strategy, you have another way of understanding why time premiums shrink as you move deeper in-the-money. If you write calls that are so far in-the-money then the shares will be nearly guaranteed to be called away and, as with any guaranteed investment, you will only receive the risk-free rate of return.

For example, assume a stock is trading for $100 and that a one-year $20 strike exists. Interest rates are 5%. How much should the $20 call be trading for? In this case, if you buy the stock for $100 and write the $20 call, the market would probably view this as being a nearly guaranteed sale for $20 in one year. If you are “guaranteed” to receive $20 in one year, then it is worth $20/1.05 = $19.05 today, which means there is a cost of carry of $20 – $19.05 = 95 cents. We know the call must also be trading for the intrinsic value so it should be worth $80.95. You can verify this by using a Black-Scholes Model with a volatility of 50% or lower so that our assumption of “nearly guaranteed” is valid. You’ll find the $20 call is worth $80.95. As a call writer, you’d only receive the cost-of-carry for this trade since you’re not taking that much risk in the eyes of the market. If you increase the volatility to something higher than 50%, you’ll find the time premium starts to increase showing these higher volatility levels are casting some doubt as to whether that option seller is guaranteed to receive $20 in one year.

Which Expiration Should I Write?
As with strike prices, there will be several expiration months from which to choose. All things being equal, you’re better off writing the shorter-term contracts for a couple of reasons. First, shorter-term contracts are exposed to a much more rapid pace of time decay. This means their value diminishes quickly, which is what you want to happen as the writer. A second reason is that short-term options are more expensive per unit of time, which we learned from Pricing Principle #5 in Chapter Two.

But this does not mean there’s no benefit in writing longer-term options. Longer-term options do provide more money and therefore provide a larger hedge if the stock should move against you. As we have shown, the risk of a covered call is that the stock falls and, by bringing in higher premiums, longer-term options help to hedge against this risk. Also, what if it takes a while for a fallen stock’s price to recover? During the recovery time, you may not be able to write the strike prices you had hoped and may end up not able to write any calls until the stock recovers (if at all). By writing longer-term options, this risk is mitigated.

Every option strategy in the world is a unique tradeoff between risk and reward, so it’s not correct to say you should only write short-term options. We’re just saying all things being equal you’re better off writing shorter-term calls. And having the stock price remain the same month after month is one of the assumptions in the phrase “all things being equal.” If the stock price is very volatile, you may consider writing a longer-term option against it to further hedge the downside risk. When people tell you to only write the short-term options, they are implicitly assuming the stock price will remain fairly constant and they will be able to write calls month after month. If that turns out to be false, then writing a longer-term option may end up being the better strategy. So when deciding which month or strike to write, just be sure to take all risks and rewards into account and make sure they are in line with your outlook on the stock.

Regardless of which month or strike you choose to write, most covered call writers wait for the time value to get near zero, which will be close to expiration, and then write another call at that time. The idea is to continually collect premiums over time. The covered call strategy is usually not used as a “one-time” strategy although it certainly could be used in that way or for shorter-term applications. But for the most part, the strategy is designed to be a long-term, systematic way to continually collect premiums and reduce the cost basis of your shares and enhance returns.

Covered Call Rationale
Now that you understand the profit and loss profile of the covered call, we can answer one of the most frequently asked questions about the strategy. Many investors wonder why anybody would write a covered call since it limits your upside potential. They reason that it doesn’t make much sense to take in a couple of bucks up front in exchange for limited upside gains and therefore, it must be a bad strategy.

But let’s take a little different view by considering the fact that for any stock price, there is a range of possible stock prices that fall into a bell curve pattern. So while “unlimited” upside gains are a possibility, they do not come with equal probability. Each successive higher stock price is less likely than the previous price. Figure 7-5 compares a long stock position in AGIX (shaded straight line) to the long stock + short $20 call position (bold line). We have also overlaid a bell curve at the current stock price of $18.81 to simulate the possible range of stock prices at expiration:

Now we see a different picture. If the range of probable (not possible) prices falls under the bell curve, notice that the covered call beats the long stock position for the majority of the ranges under the curve. In other words, the bold line lies above the shaded line for nearly all stock prices under the curve. This means that over time, the covered call will provide more stable returns and will provide higher returns most of the time. However, this does not mean that the covered call strategy produces higher returns for less risk. The covered call writer attempts to keep a steady increase in the returns while allowing the compounding of those returns to work to his advantage.

While it may be the winning strategy for some stocks (or for some periods of time) it cannot always be the higher return strategy for the market overall. The reason is that you will miss out on occasional homeruns by continuously staying in the covered call. Notice though, that these “homeruns” occur well outside of the bell curve, which means these homeruns are more like lottery tickets and that you shouldn’t invest with the expectation of those returns. Covered call writers are looking for steady gains month after month. And when it comes to investing, slow and steady can produce remarkable returns especially when you consider the compounding effects over time. It is often the strategy that wins the race and is one of the strongest motivations for using covered calls.

To be continued….

Feb

1

Options 101 Part 81

Filed Under Option Trading Articles | Leave a Comment

Which Strike Should I Write?
One of the first questions new traders have is which strike they should write. There really is no correct answer although, upon reflection, some strikes will certainly sound better to you than others. If you remember the covered call is a premium collection strategy it makes sense to sell an option that is rich in time premium; hopefully you remember that is the at-the-money strike. It would also make sense to sell a relatively short-term option, say 30 days to expiration or so since these options are hit hardest by time decay. By selling a short-term, at-the-money option, you have a mathematical advantage by bringing in a relatively large premium that will quickly lose its value, which is good for you as the covered call writer.

However, different investors have different objectives and every strategy comes with a unique set of risks and rewards so we can’t really say that selling the at-the-money option is “the best.” It’s just that it has a lot of nice characteristics but there are always tradeoffs.

Which strike to write boils down to different philosophies of why you’re writing the calls in the first place. Because options are classified as out-of-the-money, at-the-money, and in-the-money then those are the different scenarios we can create with covered calls. Each comes with its own philosophy and sets of risks and rewards so let’s look at each in detail.

Writing Out-of-the-Money Calls
One of the most common approaches is to write calls against your long stock position but with the intent of never losing the shares. These investors usually write short-term, out-of-the-money (higher strike) calls. Investors who write out-of-the-money calls are really hoping the stock will rise to the strike price (or very close) but still leave the call out-of-the-money at expiration. In the AGIX example presented earlier, we assumed the investor wrote the $20 call for $4.40. This investor would ideally want the stock to rise to $20. If the stock’s price does not exceed $20 at expiration, there is no reason for the long call holder to exercise the call since they could just pay $20 in the open market. The $20 call expires worthless but the covered call writer enjoys the price appreciation of the shares plus the premium received from the sale of the call yet is never forced to sell the shares. Avid covered call writers with this philosophy hope this situation happens time after time so they can write new calls when the current call expires while continuing to hang on to the shares. The sale of many call options can greatly enhance the returns that you may otherwise receive from holding onto the shares alone. In fact, if you successfully write calls month after month, you may even write your shares into a negative cost basis.

For example, assume an investor buys the stock at $18.81 and writes the $20 call for $4.40. Let’s assume the stock rises during this time very close to $20 at expiration. Because the stock price doesn’t exceed $20, the call will expire worthless and the investor keeps his shares and can write another call the following month. With the stock near $20, perhaps the investor will write a one-month, $22.50 call. The price received obviously depends on the price the market is placing on that call at the time. But let’s say it is trading for $4. If the investor writes this call, the cost basis for the stock falls by another $4 to $14.41 – $4 = $10.41. The investor then hopes the stock will rise but close near $22.50 at expiration. At that time, the investor may write a $25 strike for $4 thus making his cost basis $6.41 and so on. Of course, hoping a stock will behave this well for sustained periods is an unrealistic expectation but the covered call strategy will still work even under less favorable assumptions. We’re just saying this is the ideal situation for those investors who choose to write out-of-the-money calls.

The covered call strategy would also work with the stock price remaining the same. In the previous example, we had written the cost basis down to $6.41 with the stock price near $22.50 at expiration. Obviously, there’s nothing wrong with this cost basis if the stock’s price had remained at $18.81.

Investors who never want to lose their shares tend to write out-of-the-money call options. They are willing to take a small chance for the stock’s price to exceed the strike in exchange for collecting monthly premiums.

The problem with the philosophy of writing covered calls with the intent of never losing the stock is that you are really acting like a “naked” call writer even though you also happen to own the underlying stock. A naked call writer, as we said earlier, is one who writes calls but does not own the underlying shares. This is a high-risk strategy since there is no limit as to how high the shares may be trading if you are forced to deliver them. Naked call writers definitely do not want the stock to rise. If you are writing call options against your stock but do not want to lose the shares, then you are acting like a naked call writer. Because of this, you will tend to write short-term, out-of-the-money calls to reduce the chance you’ll lose your shares. But when you write short-term, out-of-the-money calls, you will usually not bring in much premium either (since higher strike calls are cheaper), but you still have the potential obligation to sell your stock.

Because there’s not much time premium involved, you will not have a lot of downside protection either. Writing out-of-the-money calls can yield very high returns but most of those returns are due to stock price movement and not from the sale of the option. So for many investors, writing out-of-the-money calls doesn’t make a lot of sense no matter how small the chance of getting assigned (“called out”) may seem.

Writing At-the-Money Calls
If there were such a thing as a textbook definition of a covered call, it would probably be defined as one where the investor writes the front month, at-the-money call. Remember, the idea behind the covered call is to collect a relatively large premium from an option that will quickly decay in value. The strike that carries the most time value and sharpest decay is the at-the-money strike. Investors who write at-the-money calls collect the highest amount of time premium and also create a lower cost basis on the stock, which provides a little bigger downside hedge.

Investors who write at-the-money calls will not have the room for capital appreciation like out-of-the-money call writers. However, at-the-money calls provide a little more downside protection so they are less risky.

Risk of Covered Calls
As Figure 6-2 showed, the covered call writer is exposed to all of the downside risk of the stock (less the premium received from the option). The one thing you don’t want to have happen as a covered call writer is for the stock’s price to fall below the cost basis. This also corresponds to why we said that covered call writers should have a neutral to slightly bullish outlook. You do not want to write a call if you think the stock is going to crash. However, many new investors believe that you should write calls against stocks that you think are about to fall. You must remember when combining assets in a portfolio (such as shares of stock plus short calls) that it is the overall behavior of all assets that counts. When new investors learn about options, they learn that selling a call is bearish so they immediately infer that the covered call strategy is bearish since they are selling a call. But this ignores the fact that the covered call writer is also long the stock. In Chapter Two, Pricing Principle #5 showed us that the maximum price for a call option is the price of the stock. This shows that the call option will always be worth less than the stock. So if you own the shares and write the calls, you are holding an asset (stock) that is far more valuable than the calls. The last thing you want is for the price of that asset to drop significantly even if that action may be beneficial for the lesser-valued option.

Obvious as this may seem, there are many “professional” brokers of financial planners who will emphatically tell you that the risk of the covered call is that you give up potential price appreciation. In fact, here are three samples found on three different financial sites on the Internet:

• Since the short call is covered by the portfolio, this strategy has no downside risk. The only upside risk is that you give up the price appreciation above the strike price of the call; however, the call premium paid at the outset may compensate for this risk.

• While the covered call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large run-up in price, and calls are nearing expiration with a strike price that is even slightly in the money, those calls will be exercised before they expire, i.e., the covered call writer will be forced to deliver shares (known as having the shares “called away”).

• Writing covered calls (i.e., call options over stock that you own) is perhaps the safest of all options strategies and possesses minimal risk. The aim is to generate income through premiums with the potential to collect capital gains as well, should the share price remain below the exercise price.

You can see that the suggestion or tone of many “professionals” is that covered calls are essentially risk-free. In fact, the first and second examples state that the risk is that you miss out on large gains. As we said before, the risk of any financial asset is never defined as missing out on some reward, and you must question the judgment of anyone who tells you that it is. If that were true, then the risk of buying Microsoft at $30 is that you might sell it later for $35 only to see it trading higher. Missing out on potential gains is always a regrettable possibility with any asset – but it is not the risk. To combat the downside risk of the covered call, many investors write in-the-money calls and there are many benefits to considering this often-overlooked variation.

The risk of the covered call is that the stock price falls. The risk is not getting assigned on the short call and selling below market price. That is a missed opportunity and risk is never defined as missing out on some reward.

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