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Aug
22
Rolling Covered Calls - Options Mastery Series Lesson 40
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Rolling Covered Calls
Writing covered calls has become a popular way for more conservative investors to make use of stock options. As a matter of fact, even retail brokerages like the strategy. This says volumes because most brokerages usually try to keep the average investor away from stock options. This is due to the fact that stock options are more complex than stocks and most brokers don’t have the training in options.
As you already know, a covered call is long stock and short call. You sell the options, collect premiums and if the stock doesn’t move much and the option stays out-of-the- money, you keep the collected premiums from selling the calls at expiration. If the stock stays stagnant, you can repeat this process over and over again. But what happens if the stock moves into-the-money?
If the short call goes into the money, the chance increases that the call option will be exercised. Moreover, it becomes more expensive to buy out of the position (buying back the short call). As a result, you consider “rolling” the position if it appears that the stock isn’t making a second or third standard deviation type move. “Rolling up” involves buying back this month’s option and selling the call for the next strike up in the next month.
Keep in mind that the stock you hold as part of the covered call position has also appreciated in value and this will usually more than offset the costs of closing out the short option position. Of course, when you roll up and sell the new call, you collect the premiums again. If the stock keeps moving up, you can also keep rolling up. So, even though premium collection is mainly for range bound, stagnant stocks, you can also roll up as the stock moves up. OK, but what happens if the stock starts trading down?
When the stock moves down, we don’t roll the position. Why is that? In a covered call strategy, you get out of the call. The covered call strategy no longer applies. If the stock looks like it’s breaking down, you could then buy puts if you intend on keeping the long stock.
As a matter of fact, you can close out the short call by purchasing the corresponding put. (The corresponding put is the put opposite the call-same strike and month). However, if you plan on keeping the stock, just buy two corresponding puts and you will end up with long a put. Of course, you are in a one-to-one ratio with the stock and options. So, if you were long 500 stocks you would have 5 long puts. When you “morph” a position it is also called a continuation strategy.
As Ron Ianieri, stock option guru and founder of the Options University states: “I might roll up strikes as the stock is going in my direction but when the stock stops going in my direction and heads the other way, it’s time to close out unless I have the wits about me to say that the reason I’m closing this position is the stock broke its up trend. It can’t be that it’s just trading down just a bit. It has to be a technical break like when that stock moves below the 50 day moving average and then follow through the next day down further.
I can close out my buy write with the purchase of the first corresponding put, but I can actually get short by buying a second corresponding put and then play the downward movement; that’s called a morph and completely changes the position with just one little trade. I went from being in the wrong covered call position with a stock that’s broken its up trend and has now broken its up trend and is breaking down.
For information, online classes, mentoring and all things stock option, contact the Options University at www.optionsuniversity.com
Aug
21
More on Stock Option Premium Collection - Options Mastery Series Lesson 39
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More on Stock Option Premium Collection
If you insist on owning stocks in your portfolio, a covered call strategy should be an important strategy to pull out of your investor tool box when the stocks you own hit a stagnant period. Being able to capitalize on covered calls can add significantly to the overall return of the stock by adding premium collections during slow times to the gains made in times of the stock appreciation.
As with most stock option positions, each strategy has a sister position. As you may recall, a covered call is constructed of long stock and short calls in a one-to-one ratio. So, what is the sister of the covered call? Well, it is the opposite of the long stock-short call and is short stock and long call, normally referred to as a Synthetic Put. When you sell the call, you collect premiums. With the synthetic put, instead of writing for a premium, you pay for the put options. In other words, a covered call creates a credit to your trading account and a synthetic put creates a debit. Typically, because you are long call, the synthetic put anticipates a slight bias for a slow up trend in the stock. However, the long call is more of insurance and the real philosophy behind the synthetic put strategy is that the stock will make a rapid drop.
So, even though the positions between the covered call and its sister synthetic put are opposite, (long stock-short call; short stock, long call), the philosophy behind the strategies are a bit different. The covered call anticipates little stock movement, whereas the synthetic put anticipates a downward movement in the stock. Moreover, the covered call strategy is a premium collection strategy and the synthetic put is more of a directional play.
An important thing to remember is: the odds are in favor of the seller of an option. You see, stocks are typically range bound more than they make large moves. If this is the case, could a strategy of continuous premium collection-month after month- be an effective strategy? Even though profits are limited on a month by month basis, if they can be repeated with frequency, this can be a very effective long term strategy.
As you can see, a buy-write (aka covered call) strategy can be good strategy particularly when hedged by a long stock position. The worst that can happen is that you lose the potential future profits from the stock if the call buyer is able to exercise the call option you sold them.
This premium collection strategy has become further refined by the creation of certain combinations of stock options, which can replace the need to be long or short stock. These option spreads make it possible to participate in premium collection with much less capital investment. Two of the most popular premium collection spread strategies are the “Bear call credit spread”-usually used in flat to slightly down markets and the sister strategy the “Bull put credit spread” which is usually used in flat to slightly up markets.
For information on just about everything concerning stock options, contact the Options University at www.optionsuniversity.com
Aug
20
More on Covered Call Writing - Options Mastery Series Lesson 38
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More on Covered Call Writing
As you know, an option can have two types of value: intrinsic and extrinsic value.
Intrinsic value is achieved when the option moves into-the-money. If the strike price was $50 and the stock price moves to $51, the call option will have $1 of intrinsic value. If the option is out-of-the money, it has some value because it has a chance of going into-the- money. This option has no intrinsic value; just extrinsic value for its potential. However it’s important to understand that all extrinsic value decreases as time runs out for the option period.
Extrinsic Value Decay
About 20 days out from the expirations date, chances for moving into-the-money become reduced and there are fewer buyers for that month’s option at that strike price. Option traders will move on to other further out months. As a result, demand for these options fall as does the option premiums. This happens to all out-of-the money options. As a matter of fact, during the last ten days or so of the option period, the drop in premium prices accelerates to zero as the option heads to expiring worthless; after all, there will be no premium left because there will be zero chance of getting into-the- money and producing any intrinsic residual value.
If you plan to sell an option, you are always best to sell at-the-money options because they have the highest amount of extrinsic value. After all, just a bit more and the option gains intrinsic value; needless to say, there is more demand for these options and premiums are priced accordingly.
If you plan to write an option to collect premium, you are best advised to sell a front month option at-the-money. In this way, you can ride the decay as extrinsic value goes to zero and the option stays out-of-the-money. By writing short term contracts with the anticipation of not going into-the-money, you can take advantage of the ability to use this strategy repeatedly so that even small gains can compound over time.
In the “Options Mastery Course” offered by the Options University, the case is established that you are mathematically better off writing front-month contracts than writing out-month contracts.
Profit, loss and breakeven when writing Covered Call options.
The first thing you need to find out is the breakeven; the point that your position makes zero gain or loss. To figure out breakeven, all you need to do is take the stock price and subtract the call price. For example, if you sold a call for a $2 premium, and the at-the-money- strike is at $40, your breakeven would be at $38 for the stock. If the stock goes down to $38, you would lose $2 but you received $2 for selling the options, which would offset the loss.
When you write an option, your maximum profit is the premium collected. If the option goes into-the-money and is exercised, your loss will be the stock you hold, which may not be a loss at all; however, any potential gains from owning the stock is lost due to giving up your stock. Of course, the premium collected helps to offset any losses.
For more information about all things options, go to www.optionsuniversity.com
Aug
19
Making Money with Stagnant Stocks - Options Mastery Series Lesson 37
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Making Money with Stagnant Stocks
Most stock investors can become comfortable investing in stock options. The fundamentals are easy to understand and usually, once an investor has purchased stocks on margin, it becomes a fairly easy transition to stock options. However, to make the process of transitioning to options easier, it’s a good idea to start using stocks and options in combination.
One of the most simple and conservative ways to incorporate options into a trading strategy is to use what is called “Covered calls” (aka “Buy-write”).
Covered Call/ Buy-Write
This basic options strategy is made up of buying stock and then writing a call; “writing” means selling. This strategy is also called a buy-write because stock is owned or purchased and calls on the stock are sold on a one-to-one ratio. In other words, if you purchase or already own 500 shares of IBM, to set up a covered call position you would sell (write) 5 IBM calls (each contract is 100 shares). In exchange for selling the rights of your shares to the call buyer, you receive payment. This payment is referred to as the premium. If the premium for one share of IBM is $4.00, you would receive $400 for each contract or in the case of our example a total of five contracts is $2,000.
If at the end of the option period the IBM stock hasn’t gone into-the-money, you get to keep all of the premiums you collected. If IBM stock is currently worth $ 120, your 500 shares would be worth $60,000. If your covered call strategy works as you hoped, the $2,000 premium collected yields a 3.3% return based on the value of the stock. Not bad for one month seeing that this strategy can be repeated time and again with the same stock. Of course, if you were successful for 12 straight months, your return would be 39.6 %. So, if your long term hold stocks aren’t performing and you don’t want to sell them, consider writing covered calls while you’re waiting for them to appreciate.
But what happens if the options you sold go into-the-money? Well, first the buyer of the option must exercise their rights by requesting the stock you owe them at the strike price you sold the options for. For example, if you sold 5 options contracts of IBM with a strike price of $125, you would be required to transfer 500 shares of IBM stock at a value of $125 per share. So, if you had purchased the stocks at $110, you would make the $15 profit per share and also keep the $2,000.
However, if IBM continues skyward, that would be your opportunity cost of being forced to hand over your stock. By the same token, if IBM goes down in value, you suffer the loss of the stock, but the premium you collected helps to mitigate the losses. For instance, on the $2,000 premium you collected in the example, the IBM stock would have to go down $4.00 to breakeven. So, in effect a covered call strategy does provide some limited downside protection associated with the holding of the stock. Because of these fairly benign consequences, the covered call strategy (or buy-write) is considered a conservative position and is allowed by most retail brokerages.
When to use the Covered Call strategy
This strategy is called a premium collection strategy and gains are based on the non movement of the stock. Normally, stock investors think of a gain as something coming from the appreciation of the stock (if long) or devaluation of the stock-if short. Rarely does it occur that money can be made by no movement at all!
For information on stock options-from beginner to expert-contact the Options University at www.optionsuniversity.com
Aug
18
Understanding Synthetics: the Basic Formula - Options Mastery Series Lesson 36
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Understanding Synthetics: the Basic Formula
Let’s talk about put/call parity. Say What? You remember that’s the fact that a corresponding call and put are equal to the parity of the stock at that strike price. In other words, a corresponding call/put will be mathematically related to the current value of the underlying stock. This is key to understanding the option strategy of stock replacement.
In Options University’s Options Mastery course, this relationship is expressed in a formula: Call price-Put price= Stock price-Strike price.
So, when we look at this base formula and we see the call price minus the put price, what we’re doing is canceling out the extrinsic value of that strike and only leaving the intrinsic value of that strike. When we do this, we are left with just intrinsic value of the strike. After all, only one of the corresponding call or put can have intrinsic value.
Likewise, when we subtract the strike price from the stock price, we are left with intrinsic value if the strike is in the money.
The following example taken from the Mastery Course will help to prove the point. For example, let’s take the June 70 calls with the stock at $69.50. From here let’s go back and plug in our numbers and see what we get. We’ll go back for our call price and put price but we know the strike price was $70 and we know that our stock price is $69.50. What type of value do we get, a minus .50 cents, simple math.
Now, let’s look at our call price minus our put price. Our call price is going to be $1.65 and our put price is going to be $2.09, so let’s plug that in, $1.65 for the call and $2.09 for the put. What we come up with is a minus .44 cents. You may say wait, the two of those aren’t equal. That’s because we haven’t adjusted for interest rate and dividend. The bottom line is that if you buy a call and sell the corresponding put, it will create a long synthetic stock position; however, there is no adjustment for interest rate or dividends.
Of course, the same holds true if you want to create a short synthetic stock; buy the put and sell the call. Moreover, we can create the six synthetic stock positions. For example, by either buying stock and buying puts, which will give a long call position, we can create a short call by selling the stock and selling the put. You can create a long put by selling the put and buying a call. Key to making this work is using corresponding options in a one to one ratio.
According to Ron Ianieri, author of the Mastery Course, “These six majors are critical because everything else that we’re going to be doing is going to involve synthetic relationships at some level. This is what separates the men from the boys and the women from the girls. This is what separates people that really understand what they’re doing in options and those who don’t. This is what separates the people who make money in options and the people who lose money in options.”
For information on everything stock options, contact the Options University at:
Aug
17
More on Synthetic Stock Positions - Options Mastery Series Lesson 35
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More on Synthetic Stock Positions
Anything synthetic is made up of components that when put together in the right way can make up a completely different object. Often times, synthetic products are produced because they accomplish the same thing as the “real thing”, but there are distinct advantages in using the synthetic over the real. In the case of creating a synthetic stock position, stock options have some real advantages for certain situations.
Stock options and stocks are mathematical entities made up of certain measurable entities. For example, one stock has a Delta of 1.0. It is totally correlated to itself. A stock option, on the other hand, has the relational factors of Delta, Gamma, Vega and Theta, which define a specific option (derivative) with its underlying stock. When we want to create an investment in a synthetic stock position, we use stock options that will exactly mimic the movements of the actual stock. From a mathematical standpoint, we want the total Deltas of the options to match the total Deltas of the stock.
For example, if you have 1000 shares of XYZ stock, you would have a total amount of 1000 Deltas. If you want to construct an option position that would exactly mimic the movements of the 1000 XYZ shares, you would need to create an option position which would also have a total of 1000 Deltas.
The Option Pricing Model, which is in constant evolution, mathematically defines the relationship between option derivative and the underlying stock. To construct a synthetic stock position, it is essential to understand how options relate to each other and the underlying stock.
According to Ron Ianieri, one of the founders of Options University, If you can understand synthetic positions, then not only is it going to help you make money but also it’s going to give you a much deeper understanding of options in general. If you can create the exact same position in two different ways, then there is a possibility that one of those ways might be cheaper than the other.
For example, you may often times find that creating a synthetic stock position is cheaper to buy than the underlying stock. If this is the case, than the corresponding ROI will be higher. By being less expensive, a synthetic position will also allow for lower entry and exit points. When talking about the nature of stock options, we talk about flexibility and synthetic positions are just one example.
In the Options University Options Mastery Course, the students learn that there are six basic types of synthetic positions:
· Synthetic long stock and synthetic short stock; by using a combination of a call and its corresponding put you can recreate a long stock position or a short stock position just using a call and a put.
· Synthetic long call and synthetic short call; using a combination of the corresponding put and the stock you can create a long call or a short call simply using the corresponding put and the stock.
· Synthetic long put and synthetic short put; by using a combination of the stock and the call, you can create a long put or a short put, depending on the combination I use.
For everything you want to know about stock options, contact the Options University at:
Aug
16
Rolling-up
What happens if your timing is off and the stock replacement strategy you established looks to expire before the move you anticipated has been completed? Do you have to bail out of the position? The answer is no; you can roll it.
When an option trader wants to maintain a position into a new option period, they can “roll up” the call by selling it and buying the next strike up (if the stock is moving up). Of course, you will be selling a more expensive call and buying a cheaper call. This will create a credit. That credit is actually taking part of the profit you may have made up to that point. This is very different from selling a stock.
When you take some profit from your stock position, you lose some of the position. You must sell the stock. In the case of rolling, you keep a bit of your profit and maintain the same position. Rolling-up allows the option trader to extend the same position and take some profits at the same time.
Morphing
In their Options Mastery Course offered by the Options University, the many ways that an option trader can close out of a trade are explained. For example, if you have established a vertical spread and are considering how best to close out a call spread, you find there are three possible outcomes.
First, the spread can finish out-of-the-money and become valueless. For a call spread, this scenario occurs when the stock closes at or above the strikes of the spread. In order to close out the spread, an option trader would just let it expire. Both options finish out of the money so there is no residual position left over. Say goodbye the premiums you paid to get into the position.
Now, if the spread finishes in-the-money, meaning both options are in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
The last scenario is a bit problematic; what happens if a stock closes between the two strikes of the spread? This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. We know that when both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. But in the case of a closing price between both strikes, it’s different. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
In this situation, there are two actions possible. One is to trade out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid being caught “naked”. If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money.
For more on all things about stock options, go to www.optionsuniversity.com
Aug
15
Options Vs Stop Loss Orders - Options Mastery Series Lesson 33
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Options Vs Stop Loss Orders
There is a laundry list of advantages of holding stock options over owning the underlying stock. Everybody knows about the lower costs, higher ROI (Return on Investment), and multiple strategies available with using stock options, but few are aware of the risk management strategies that options also offer.
According the Options Mastery Course offered by Options University, options are immune from the flaw that stop loss orders can have. For example, the bad news came out before the opening and the stock drops like a rock as soon as the markets open. The news hasn’t really hit the wires and before any action can be taken, your stop loss has been trampled and the stock is ten dollars lower before your stop order is filled. It happens all the time.
Sometimes, a stop is like that wimpy usher that shyly whispers “you can’t go in there”. You laugh and push yourself by. So, when there is some surprising or catastrophic news which can cause big moves, your peace of mind of having a stop loss in place is blown to pieces. You know, it isn’t the little losses that burn you; it’s the big ones where stop losses can be ineffective.
Options are different in that they are a “full time” stop that will work properly all the time. A strike price, once hit, becomes active from the get go. No worry about getting filled; either it is or it isn’t, period. Indeed, options were developed to become a perfect hedge.
For example, you think XYZ is going to be moving up within the next three months, so you decide to buy an at-the-money call. To protect yourself, you decide that you could accept a 5% loss so you figure out that buying a put that is $5 out-of-the-money will give you that down side protection during the option period. It doesn’t matter what happens, if the price hits the out-of-the-money strike, the put starts making money to help offset the losses suffered by the call. Of course, you must also figure in the cost of the put, which will lower the strike accordingly.
Brokerages recognize the safety of using an option as a stop to help reduce risk and can require much less margin to cover a trade. For example, suppose you set up a bear call credit spread where you sell a $50 call and buy a $52 call. The credit from the short sale usually more than offsets the cost of the long call so the risk is between $50 and $52; less than $200 per contract. Lower capital requirement also raises ROI.
Sometimes, setting up a bear call credit spread might require the precaution of setting up a stop for the short call if there is a significant spread between the short and the long.
For example, if you sell a $50 call and buy a $55 call, you might want to set a stop on the short call around $52 to get you out of the short and leave you long on the OTM call-or you can get totally out of the position. Why not just buy a $52 call? There may not be a strike at this price.
To find out more about all things stock option, contact the Options University for all of their online courses, webinars and mentoring services at www.optionsuniverstiy.com
Aug
14
More on Synthetic Stock - Options Mastery Series Lesson 32
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More on Synthetic Stock
We know that if we want to simulate an option position that will exactly mimic the movement of the underlying stock, we can but we need to buy an at-the-money call and also buy the corresponding put. We do this because corresponding option contracts produce 100 Deltas and cancel out all the other Greeks. In effect, the position becomes a low cost, time limited simulation of the stock. If the stock moves up $1 the position will move up $1. If the stock moves down $1, the position will move down $1. It is, indeed for the option period a perfect surrogate for the underlying stock.
OK, but why would an option trader want to use a synthetic stock position? As Ron Ianieri of the Options University states: “whenever a trader decides to use the synthetic position instead of the real position, it’s because there’s some type of “volatility skew” creating one way to be cheaper than the other way (owning the stock) yet we know that both ways are the same”. In other words, a synthetic position can provide better pricing and higher profits.
To be more specific, there is something called a “put/call skew”. There is a negative and a positive put/call skew. When a corresponding call is selling for a higher price than its corresponding put, you have positive skew or vice versa when you have a negative skew. Either way, the skew produces more favorable pricing which allows for more profit than the actual purchase of the stock. It’s not a huge amount, but for an active options trader, the advantage can add up over time.
Synthetic Short Stock
Just as we have a synthetic long stock, we also have a synthetic short stock position.
It’s no surprise that the construction of the synthetic short stock position is opposite the construction of the synthetic long stock position. In the synthetic short stock position, we’re going to be long the put and short the call in a one to one ratio.
So, to create a synthetic short, a trader would buy a put which makes you short and then sell the corresponding call which also makes you short. Needless to say, both put and call must be corresponding options and at a one-to-one ratio. Since they are corresponding, they have Deltas that will total negative 100 and Gamma, Vega and Theta that will cancel out. Let’s look at an example.
Suppose you sold a real stock for $67.50 and it went down to $63.50. In this case, you made $4. To construct a synthetic short position, you would pick the closest strike and go short the call and long the put. The closest strike is $65 and you sold the call for $3.32 and now it’s worth $1.09 In this case, you made $2.25 on the call. The put, on the other hand, you purchased for .77 cents and it’s now worth $2.53; a profit of $1.76. The call and the put equal a total profit of $4.01. >That’s the same as selling the stock; however, it was much cheaper to sell the call and buy the put. (Keep in mind that unless you actually own the stock, most brokerages will not let a retail client sell unhedged short positions.)
To find out more about synthetic stock and much more, contact the Options University at www.optionsuniversity.com
Aug
13
Synthetic Stocks - Options Mastery Series Lesson 31
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Synthetic Stocks
Personally, I prefer the name “shadow stock”; it sounds so much more romantic and mysterious compared to the rather sterile name of “synthetic stock”. I smacks of something you’d buy at Wal-Mart. But, undaunted, we press forward to discuss an important aspect of the many facets of stock options.
Creating a synthetic stock position-either long or short-has some distinct advantages when trading stocks. They’re cheaper, more flexible and have limited risk as opposed to the theoretical “unlimited risk” of actually owning the stock. Yes, an option has a limited life but we are talking a trading strategy and not a buy and hold scenario.
The first synthetic position we’ll talk about is creating the long synthetic stock. The major objective of establishing a synthetic position is to construct a position that will closely mimic the movements of the underlying stock.
Construction of synthetic long stock
In order to create a synthetic long stock position, you want to buy a call and sell the corresponding put in a one-to-one ratio. But how can an option position be just like a stock when you’re buying a call and a put?
What happens is that both option positions are identical because they are corresponding options, which means that both positions have the exact same Greeks, or in other words, the same risk factors and profit potential of the real long stock position; the synthetic long as created by the corresponding options will exactly mimic the real long position in all ways.
In the Options Mastery course offered by the Options University, they give an example of what you are looking for. Suppose you want to set up a synthetic long position for a stock currently trading at $65.50. First thing, you decide that you will hold the position for about three months, a time you estimate sufficient for the stock to do what we think will happen. Let’s say you pick a June option period. You look at the June $65 strike. You see that the call has 56 long Deltas.
However, you now need to sell a put at the same strike and month and you see that this put option will short 44 negative Deltas. If you sell the put, you will be short, which is also a negative and the two negatives of the put and the short sale equals a positive. At this point we are long 56 Deltas from the call and also long the 44 Deltas from the put. This means that the position made up of the corresponding call and put has 100 long Deltas; 100 Deltas means that the position is exactly correlated with the long stock position. This is no coincidence, you see, corresponding options will always sum to an absolute value of 100 Deltas. The relative value depends on whether the position is short or long.
Here’s the kicker, corresponding options also have the same Gamma, Vega and Theta but a real stock position only has 1.0 Delta for each stock. However, the long call and short put Gamma, Vega and Thetas cancel each other out; so, in effect, both the option positions now have only 100 Deltas (100 share contract) as will the 100 shares of underlying stock; therefore, they are both the exactly the same. When this happens, the option positions will match the underlying stock movement penny for penny.
Of course, to assume a synthetic position will cost a fraction of what buying the stocks would cost. This allows you to either “buy more stock” or diversify your capital into other investments. The only difference is time.
For more information on everything to do with stock options, go to: www.optionsuniversity.com
Aug
12
Timing Stock Options - Options Mastery Series Lesson 30
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Timing Stock Options
It’s an established fact that to get the best correlation for the buck, options traders should look for in-the-money options with Deltas around 80-85. In this way, you can capture at least 80-85% correlation with the movements of the underlying stock. OK, but what expiration month do you choose?
If you think the stock is going to make a similar type of downward movement it made in the past and it made the same downward movement seven months ago, again two years ago, and again four years ago, you think the current pattern is a close match to past patterns and this will be a good indicator of what might happen. In the past, each time it looked like it had taken two to two and a half months to complete the breakdown cycle. So, you decide to buy put options that fit that timing pattern. If you think that it should take about two and a half months to complete the pattern, you would decide to buy an option that expires in three months; in other words, you want to match the days to expiration on the option to the amount of time you think it’s going to take for the stock to make the anticipated movement.
Of course, you can be off a bit on both ends, but picking a month that is most likely to contain at least some of the movement we expect is the key.
In the case of a short stock position, you locate a put option that closely will mimic the short stock position. So, you go out three months and look for an in-the-money put with Deltas around 80-85; this is called “the sweet spot”. Now, you have a good idea of the timing and an option at the best price for what you want to accomplish.
Exception to the Sweet Spot
In the Options Mastery course offered by the Options University, it’s mentioned that there is a time when an option trader doesn’t want to use the sweet spot. That is when a stock is going through a breakout; you should consider buying an at-the-money put. Why is that?
An at-the-money option has a mix of intrinsic and extrinsic value. With extrinsic value, the stock has to perform better than at an in-the-money option to over come the extrinsic value cost; every penny of extrinsic value is one additional penny more that the stock has to move to start making a profit. When an option is deep in-the-money, option and stock prices move in lock-step. But there are times when you would want to capture the volatility of an option; it’s like catching a wave before it breaks.
A break down in a stock is normally a violent, aggressive movement lasting four to maybe eight days. If thisis the case, the problem of time decay is not a major concern because you won’t be in the position for that long. In this case, the at-the-money put becomes a better play. Break downs give you the opportunity to benefit from the volatility and not get hurt as much from the decay because break down stocks usually make their big moves within a short time span.
For a total knowledge of stock options, go to www.optionsuniversity.com
Aug
11
Puts, the Sweet Spot, and Other things - Options Mastery Series Lesson 29
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Puts, the Sweet Spot, and Other things
Let’s say you decided that you wanted to buy XYZ at a $40 but unfortunately it’s trading now at $50. XYZ is at $50; it’s running up, but if it ever came back down to $40 you’d love to buy it. Ok, here is one way to position yourself; you’re going to sell an out-of-the-money $40 put for XYZ and if the stock ever trades lower than $40 during the option period, then you’re going to own it as more than likely somebody will exercise their rights as the buyer of the put and place the stock with you-the seller. If the stock doesn’t reach $40, no big deal, you’re going to keep the entire premium from the put, a win, win situation, right?
That might be good for some stocks that are volatile but the real world may turn out to be different when you do get the stock when it hits $40. You see, something happened to make the stock move down $10 from $50 and that $40 strike price may just be another tick on the way down to some undefined bottom. In other words, why not just wait until you have an idea of where the bottom might be. So, this strategy of selling a put to buy on the cheap and collect a credit in the process may be more risky than you think.
Puts in Stock Replacement
Some brokerages have rules that prohibit clients from shorting stock. Other brokerages charge such a high margin for going short that it discourages most traders. But, alas, you can buy a put and solve both of those problems. You see, you can use puts as a stock replacement strategy trade, which replaces a short stock position.
Most traders have a pre-disposition to concentrate on making money on the way up. Few realize that they can double the amount of potential winning trades by being open to making money on the way down. Part of the tunnel vision is from the broker restrictions on shorting stocks; in other words, if you can’t do it, why learn about it?
The truth is that traders are passing up a huge opportunity to play both sides of the market. But with puts, no problemo, you can be right there by using a stock replace-ment strategy.
When looking for shorting opportunities, you use the same philosophy that you would use with shorting stock. You are looking for a break down technically or fundamentally-usually a combination of both. You identify your entry point and your protective stop. You establish a potential profit target but before you call your broker or click on the trade, you turn to a put purchase. You don’t short the stock but instead you purchase a put. As a matter of fact, puts are not only much cheaper than shorting the stock but also provides a defined maximum risk-the cost of the premium for the option contracts. However, you need to pick the right put to buy.
As we are using puts as a surrogate for being short stock, we want a put that will closely match the movement of the underlying stock. What we want is an in-the-money put with lots of Delta and not a lot of Vega, Theta or Gamma. We want an option that will mimic the movement of the stock and that means “hard” Delta.
Finding the Sweet Spot
When looking for the best in-the-money strike to buy, you need to find a strike that is not too deep in-the-money, which would be more expensive but not too close to at-the-money, which still has extrinsic value that evaporates away every day. So, you look for a strike contract that will have a Delta in the range of 80 to 85. That means that if the stock moves down $1, the option will move down 80-85 cents. In this way, you are- in affect- replacing the stock with options that mimic most of the movement of the stock. This strategy is much less expensive and with limited, defined risk.
For information on all things stock option, contact the Options University at www.optionsuniversity.com
Aug
10
Puts, Calls and Moneyness - Options Mastery Series Lesson 28
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Puts, Calls and Moneyness
In his Options Mastery Course at Options University, Ron Ianieri uses the term “moneyness” to describe out-of, at-the and in-the-money conditions of a stock option.
In-the-Money
A put is in-the-money if the strike price is greater than the current stock price. For example, if a stock is trading at $50 and the strike price is $60, the put is in-the-money. Another way to remember when an option is in the money-be it a call or put- is when you imagine what would happen if you exercised your position rights at the current price. In our example, if you were long a put and exercised, you would be able to get stock for the current $50 price and turn right around and sell the stock for the strike price of $60. You pocket the $10 per share difference less commissions.
Out-of-the-Money
If you buy a put, you are out-of-the-Money when the strike price is below the current price. For example, if you buy a put with a strike of $50 and the price is currently at $60 the stock must go below the strike price before it would be in-the-money. Imagine if you could exercise the $50 strike you would have the right to sell the stock for $50; why would you do that when the stock is at $60? So, because exercising the $50 strike put provides no benefit, the $50 put-in this case-is considered to be out-of-the-money because the strike price is less than the stock price. The stock price is the elevator and the strike is the floor. Before the door can open, the elevator must arrive at the floor. The analogy holds for calls, as well.
At-the-Money
The at-the-money put doesn’t mean that the put strike has to be exactly equal to the stock price. It doesn’t have to be equal; it just needs to be close. The at-the-money put is the put whose strike price is the closest to the current stock price.
In the Options Mastery Course, they give the example of looking at a $30 strike put when the stock is trading at $29. Even though the stock is a bit in-the-money, it is still considered at-the-money. Likewise, if the price were at $31, that would also be considered at-the-money. At-the-moneyis the put whose strike price is closest to the current stock price, not directly equal to it, just the closest. So, what that means is our at-the-money put might actually be slightly in-the-money or slightly out-of-the-money in real terms.
Another more subtle thing about being in-the-money has to do with having a “harder” Delta. This means that because an in-the-money put isn’t as susceptible to movements of time and volatility as the at-the-money put is, and probably not quite as much as the out-of-the-money put; we call the in-the-money put or call as having a “hard” Delta. The thing that‘s really driving that in-the-money put is the mostly just the stock price. When a call or put is deep in-the-money, Delta is close to 1.0 and the option moves in total sync with the stock price movement.
Not surprisingly, the out-of the money and the at-the-money puts and calls are called “soft” Delta. The values of these options are more susceptible to movements in volatility and time decay than movements in the stock.
To learn just about everything you need to know about stock options, find about the Options Mastery Course offered by the Options University at www.optionsuniversity.com
Aug
9
About Stock Option Puts - Options Mastery Series Lesson 27
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About Stock Option Puts
Simply put (no pun intended), a put gives the buyer the right-but not the obligation-to sell a certain security at a specified price within a specific time period. When you want to use a stock replacement strategy on a stock you think will move up in value within a specific time, you buy calls. Puts work the same way but are used when you think the stock will move down in value within a specific time. As Ron Ianieri of Options University says,” as a mechanism, puts are identical to calls in the way they operate and perform and how sensitive they are to different stimuli. They’re a lot more similar to calls than they are different”. Indeed, the only thing that separates the two is direction.
Another really big difference between the practical use of calls and puts is that a trader should stay away from selling naked puts. A naked call has a risk profile that has the risk limited to the premium paid and with an unlimited profit potential. On the other hand, a naked put has a completely different risk-reward profile. With a naked put, the risk is unlimited if the stock moves up. If the stock price moves down, the profit is limited to the premium collected if the stock stays below the strike by expiration. So, selling naked puts has an unlimited risk and a limited reward. So, stay away from writing naked puts.
Puts are a short instrument and are used when a trader is bearish. Puts benefit the trader when the underlying stock goes down in value. So, in a way, when buying puts a trader is in affect shorting the stock. As mentioned, aput enables the buyer to have the right but not the obligation to sell a specific underlying security at a specified price within a specified time period. In effect, what that means is that an owner of an in-the-money put can force somebody else to buy the stock. Of course the put has to be in-the-money and exercised but it’s important to know that there is no worry about liquidity thanks to the OCC (Options Clearing Corporation).
The risk-reward profile of buying a put is very similar to buying a call; that is to say, limited risk and “almost” unlimited potential. We say almost unlimited potential gain because a stock can conceivably only go to zero.
A buyer has rights and a seller has obligations. So, selling a put means that the seller can be “assigned” and forced to receive stock at the strike-no matter what the current market price may be. So, if the buyer of the put chooses to exercise their rights if the put is in-the-money, the seller is obligated to take delivery of the stock at the strike price. Another little talked about risk of selling a put is the lost opportunity if the stock makes a big upside move. Yes, as a put seller you would be able to collect the premium but that is all. If the stock goes sky high, a put seller must be satisfied with only crumbs but as a high probability trade, writing can be much more reliable even though there are no home runs.
Again, as Options University proselytizes, option traders should stay away from selling naked puts. However, there are some traders who will sell naked puts on cheap stocks. For instance, if a trader sells a naked put on an $8 stock, the loss is limited to $8.
For more information on stock options go to www.optionsuniversity.com
Aug
8
More about Stock Option Calls - Options Mastery Series Lesson 26
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More about Stock Option Calls
Most of the time, when buying a naked call to mimic the underlying stock’s movement, we need to locate the sweet spot; just far enough in-the-money to give about 80-85 Deltas. In this way, we don’t pay too much to mimic the stock’s movement. However, there are exceptions to using the sweet spot.
According to Ron Ianieri of the Options University, most break out type of movements usually take place in four to eight days. That means since it’s such a short period of time, we don’t really need to worry about time decay as we normally do. As you recall, if a stock needs time to make the anticipated move, we don’t want to buy a lot of extrinsic value just to have it decay day- by-day. Moreover, we need high Deltas to make sure that we are closely mimicking the stock.
However, if we are talking about a break out move, we don’t need to be so concerned about time decay if the move takes just 4 to 8 days. In the Mastery Options course presented by Options University, they put forth the idea that in this particular situation.
We can look for the at-the-money option, which will give us the best bang for the buck
Needless to say, a breakout normally is accompanied by an increase in volatility and seeing that Vega is highest at-the-money (remember Vega is the option price change with a change in volatility) and having a sensitive long Vega will be a plus.
Options University makes it very specific when it comes to selling naked calls. “Do not sell naked calls, period”, says Ron Ianieri. (Going “naked” in option lingo means being unhedged). Selling an unhedged call exposes the seller to an unexpected upward surge; indeed, the risk is unlimited. However, buying naked long calls are ok because the maximum risk is the premium paid if the call never gets into-the-money and expires worthless, no matter how low the price goes. So, with limited risk, the position can be considered hedged to a degree and limited to the premium loss.
For new option traders, being long calls is exactly like purchasing stock when buying in the sweet spot-(slightly in-the-money with Deltas of 80-85). The main differences being that the option position has a limited term (LEAPS can have a period of over 2 years before expiration) but the capital required is much, much less. The main point being that when the underlying stock moves up, the option will mimic the move. The following is an example taken out of the Options Mastery course offered by Options University.
Let’s say the stock is trading at $65.50 and we think the stock is going to run up. If we spend $2.04 for an option with a $65 strike, we’ve got to understand that there’s only .50 cents of intrinsic value in the $65 strike. That means there is $1.54 of extrinsic value and our stock has to move up at least $1.54 by expiration to just break even. However, if we bought this option at the June 60s at $5.74, there’s only .24 cents of extrinsic value there. By expiration, we only need the stock to trade up .24 cents, from $65.50 to $65.74 for us to start seeing a profit. Which would you prefer? If you answered the $65 strike, read this article again.
For just about everything about stock options, go to www.optionsuniversity.com
Aug
7
Stock Replacement - Options Mastery Series Lesson 24
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Stock Replacement
If you are a stock trader, thinking about getting involved in options, stock replacement strategies will make a lot of sense. If an investor thinks that they want to make money on a stock within a time frame of a month to three years, it makes indisputable sense to use stock options. The reason: if done properly with stock options, the same results can be purchased for about 15%-20% of the capital required to buy the stocks themselves, which means a tremendous boost in Return on Investment (ROI). Or, an investor can have the benefits of owning many times as much stock for the same amount of capital. Moreover, to put the icing on the cake, when owning stock, the investor may face unknown significant losses in value whereas stock options have a known maximum loss.
So, according to Option University’s Stock Option Mastery Course, “for a stock trader and someone who is very good at picking stocks, using a stock replacement strategy using stock options can be a very easy, safe, cost efficient way to reduce risk, increase profits and obtain a much higher return on investment. It’s as simple as that”.
Stock replacement strategy combines the exact same philosophy and analysis that a stock trader uses to find opportunities but is just a different way of executing that opportunity. As a stock trader, you do your analysis and decision making in the same fashion but it is the last step in acquisition that changes when using options to replace stock. Instead of purchasing the stock, you will purchase a call option (if you would be long the stock).
In the stock replacement strategy, a trader wants to accomplish the same thing as if they own the stock and we want the option to act just like the stock. If the stock moves up $1, we want the option to also move up $1. The key to the stock option strategy is to purchase an option contract (100 shares) with a Delta very close to 100 Deltas for the contract (close to one Delta per share). That means that the option will closely mimic the movement of the underlying stock.
Let’s use an example taken from the Options University Mastery Classes. Say you were going to buy an $80 stock because you thought it was going to run up $10 and let’s say you were right. You bought the stock for $80 and it ran up to $90. You’ve got a $10 return on an $80 investment, 12.5% return; nice job.
What if you can replace that stock with an option that costs only 25% of the stock price but mimics the stock movement to 80%? Hence, you have an 80 Delta, $80 option. So now when the stock runs up $10 your $80 option (purchased for $20) is going to mimic that stock’s movement to about 80%. If the stock runs up $10 your option that you spent $20 for is going to increase by $8 (80% of the stock movement); that’s what an 80 Delta does.
You now have an $8 return on a $20 investment and that’s a 40% return on capital invested and that’s a lot better than the 12.5% return when the stock was purchased outright. You only had to put up $20 freeing up another $60 to do something else or you could have invested a little bigger. Either way, you have a much better return for much less capital.
But why pay such a high price for an option when there are much cheaper options? The answer is simple and important. To replace, or closely mimic the movement of the underlying stock, you need to buy an in-the-money option; the higher t