Mar

10

Options 101 Part 107

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Assume you purchased this stock during the uptrend at $55; it would certainly be tempting to take the profit at $70. After all, eBay made a substantial move and it’s sensible to think it will pull back. But if you accept the fact that you’re probably not at the very top, the more prudent move is to stay in the trade but protect the existing unrealized profits. We can do that by utilizing a stock swap strategy. It’s very simple and here’s what you do: Sell all your shares and buy an equivalent share amount of call options. In effect, you are “swapping” your stock for calls.

Incidentally, these two trades, selling your stock and buying calls, can be executed simultaneously through most brokers. Let’s assume you originally purchased 300 shares of eBay at $55 and it’s now $70. That means you have an unrealized profit of $15, or $4,500. To execute the stock swap, you’d sell your 300 shares and simultaneously buy three calls. If our goal is to get a lot of cash off the table, we would probably consider buying the at-the-money $70 call. The actual quote for an eBay January $70 call at that time was $2.75.

Selling your shares will bring in $21,000 (300 * $70) cash and buying 3 $70 calls costs $825 (300 * $2.75), which means you get a net credit of $20,175 cash to your account. The shares originally cost $16,500 ($300 * $55) so you’ve now locked in a profit of $20,175 – $16,500 = $3,675, or 22%. But not only did you lock in a profit, you are still effectively long 300 shares of stock. Any increase in eBay only increases your profit, and there is no risk of losing your original principal; it’s sitting safely in the money market. Figure 10-2 shows graphically the effect of our hedge:

The straight shaded line represents the original long stock position at $55. The solid line is our new long $70 call including the net credit we received from selling the stock. Effectively then, we own 300 shares of stock at a cost better than free; we cannot lose and we may make more. Notice that the trade eliminates the downside risk at the expense of reducing the upside potential, which fits our definition of hedging. In other words, for all stock prices above the $67.25 crossover point we would be better off holding the stock as its profit and loss curve sits higher on the chart. But it’s not the fear of lost opportunity that drives us to get out early; it’s the fear of loss and the stock swap hedge removes all that fear. Now we’ve changed our perception of the trade and made it less risky. We can now stay in for much longer than we normally would and possibly catch a huge homerun trade.

Notice, too, that the hedge does not rely on timing. With the stock at $70, are we at the top of a peak? Statistically speaking, probably not. It’s much more likely that we didn’t sell at the highest point. However, our risk-averse nature prods us to take the sure $15 profit and run. Rather than take the $4,500 gain, we hedged the position and captured a sure gain of $3,675. We now can gamble in hopes that we were not at a peak and try for some real money.

As the stock rises, we would continue to roll the calls up as discussed in Chapter Eight. Each roll-up generates more cash and shifts the profit and loss curve higher. For example, assume that eBay moves from $70 to $75 and we roll the position up for a net credit of $3.50. While this is a hypothetical credit, we can use some option-pricing theory to justify it. To roll the position up you would sell the $70 call to close and simultaneously buy the $75 call to open. Now, just look at that trade disregarding the “opening” or “closing” designations. The trade is selling the $70 call and buying the $75 call – a short $70/$75 vertical call spread.

What is this spread worth? To make it easier, imagine that you were long the $70/$75 spread with the stock at $75. We know it must be worth more than $2.50 (the halfway point) but less than the full $5 difference in strikes. So to buy this spread would cost somewhere between say $2.50 and $4.50 depending on how much time is remaining, which is why we assumed $3.50. Therefore, if you sell this spread, you will receive a credit in the same amount. If we were looking at actual quotes, you’d find that the roll-up must be executed at a price very close to this. Again, this is why it is so important to understand the fundamentals presented in this book as the strategies will become second nature to you.

If you roll up for a net credit of $3.50 on 300 contracts, that will generate an additional 300 * $3.50 = $1,050 to your account. You had locked in $3,625 from the first roll to the $70 call and have now locked in another $1,025 from the second roll to the $75 call for a total guaranteed profit of $3,625 + $1,025 = $4,650. However, because you are still effectively long 300 shares (long 3 $75 calls) you will continue to profit if the stock price should continue to climb. The profit and loss graph will shift from the shaded line to the bold line as shown in Figure 10-3:

Notice that the new bold line has been shifted higher as shown by Arrow A representing the higher guaranteed return. No matter how low the stock’s price may fall you are now guaranteed to receive $4,650. And if the stock price rises, you will benefit in an unlimited way. The tradeoff is that the bold line has been shifted to the right as shown by Arrow B. For all stock prices above the $73.42 crossover point, the previous profit and loss curve would have performed better. But notice the relatively small space lost by the shift at Arrow B compared to the relatively large space gained by Arrow A. It is a small sacrifice of upside potential in exchange for a much higher guaranteed return. You have hedged your investment and it was done without losing control of the 300 shares.

What if you were more concerned about protecting profits? We could use other hedging strategies as well. For instance, when you rolled up to the $75 call, you could also sell the $80 call, thus creating a $75/$80 vertical call spread. Assume that you could sell the $80 for $1. Selling three of these calls would generate an additional 300 * $1 = $300 profit but it would also limit your upside potential. If you rolled up to three of the $75 calls and sold three of the $80 calls then the profit and loss curve in Figure 10-3 would look like the one in Figure 10-4:


Figure 10-4 shows that you have increased your guaranteed return by another $300 at the expense of limiting your profits for all stock prices above $80. If you don’t think the stock price will rise above $80, why not sell that part of the range to someone else in the market? Try doing that with stock.

If the idea of completely capping your upside potential is unappealing, then you can hedge that bet, too, and roll up to three of the $75 calls but perhaps sell only two of the $80 calls. Your profit and loss curve would then look like Figure 10-5:

The bold line has shifted higher by $200 from the sale of the two $80 calls at $1 each. Because you control 300 shares and have sold off 200 shares, you are still net long 100 shares for all stock prices above $80 and that’s why the profit and loss curve doesn’t flatten out like it did in Figure 10-4. The possibilities are endless once you understand the fundamentals of options.

Figure 10-6 shows why hedging is usually the best choice. Trends usually last longer than most people expect and eBay was no exception. The arrow shows the point where we were considering selling the stock. But the stock swap and subsequent roll-ups allowed us to capture a guaranteed profit and hold on through August to the price of $110 (eBay had a 2:1 split at this time, so Figure 10-6 only shows a $55 price):

Mar

9

Options 101 Part 106 What Kind of Risk Takers Are We?

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Every day we’re faced with making decisions about risk. You may not realize that you do, but subconscious calculations are always taking place regarding which risks to take and which to avoid. Walking across the street is, technically, risking your life to get to the other side. On one hand, you may think that sounds farfetched, but it is the worst thing that could happen from crossing the street. However, despite the risk, we walk across streets countless times because, intuitively, we know the probability of that worst-case scenario is very, very low. It’s an acceptable risk, so we choose to take it. Depending on the situation, people tend to avoid risk, accept risk, and in some cases, even seek to take risk.

Psychologists have created three general categories to classify these risks:

1) Risk-averse (those who avoid risk)
2) Risk-neutral (those who accept reasonable risks)
3) Risk-seeking (those who accept high-risk situations)

You are risk-averse if you buy insurance and you are a risk-seeker if you skydive. You are probably risk-neutral about crossing the street. In most cases, people have different attitudes toward risk and it’s not easy to say if they are risk-averse, risk-neutral, or risk-seeking for a particular event. That is, until it comes to money. When it comes to money, people become very predictable and display a consistent view of risk. It is this view of risk that causes many mistakes in trading. Do you fall into the same category as most people? Here’s how to find out: An eccentric millionaire asks you to choose between the following two choices. You only get to play the game once. Which would you choose?

A) $500 gain for sure
B) Flip a coin and get $1,000 if heads and nothing if tails

Both choices are similar in the sense they have the same long run average. In mathematical terms, they are said to have the same expected payoff, or expected value, which is nothing more than a mathematical long-run average. If you were allowed to play this game thousands of times, you would expect to be up $500 per try regardless of which alternative you choose. Obviously, Choice A always yields $500 with each try. Choice B, on the other hand, yields $1,000 half the time and nothing half the time so, in the long run, you’d be up $500 per try.

A risk -verse person will only take Choice A while risk-seekers will choose Choice B. A risk-neutral person would be indifferent between the two choices.

We Really Despise Risk
Dr. Robert Anthony said, “Most people would rather be certain they’re miserable, than risk being happy.” Sadly enough, most of the research in the field of behavioral finance shows this to be true. In fact, in 1979, two famous psychology researchers, Daniel Khaneman and Amos Tversky, published an influential paper in The American Psychologist showing our risk-averse natures – and with a remarkable twist. In that study, the researchers gave subjects a choice between the following two alternatives that we saw earlier:

A) $500 gain for sure
B) Flip a coin and get $1,000 if heads and nothing if tails

Most people picked Choice A without hesitation. This was no surprise to the researchers as they were aware of our risk-averse tendencies. However, the researchers added an interesting twist and asked the following intriguing question:

C) Take a $500 loss for sure
D) Flip a coin and lose $1,000 if heads and nothing if tails

By similar reasoning with the first set of choices, the second set encompasses an average loss of $500 regardless of which you choose. The difference here is that Choice C results in a guaranteed loss. Choice D may be a $1,000 loss, but it could also result in no loss, both with equal probability. The two researchers expected that if subjects displayed a risk avoidance behavior as with the first set of questions, they should still avoid risk and accept a $500 loss for sure. But oddly enough, the researchers found that most subjects selected Choice D – they accepted the gamble to try and avoid the loss! This means that investors’ aversion to loss overcomes their aversion to risk. The paradox is that we detest risk so much that we’re willing to take risk to avoid it.

This is a fascinating observation about human nature that demonstrates why it’s so important to hedge trades. If a trade is moving against us, it’s our nature to try to gamble our way out. It goes against our makeup to take the for-sure loss. Likewise, when we have winning trades, it goes against our nature to hang on – we’re too afraid of losing the gains we already have. Hedging your positions prevents both of these behaviors and allows you to capture bigger profits.

How many times have you heard “you can’t beat the professionals” or “the market makers always win” or other similar phrases? The reason they are basically true is that professionals know how to hedge. Retail investors end up taking the risky side of the bet and are in trades too soon and out too early. They rely too much on timing and direction and end up losing. Add to this our risk aversion and willingness to gamble our way out of losing situations and you have the very reason so many investors and traders miss their goals with investing.

Hedging is a powerful tool and the key to financial success. Options were designed to hedge. It’s now time to discover the option secrets used by professional traders.

Stock Swap
Of all the hedging techniques, this is the probably the simplest and most useful for most traders so it is a great place to start. Unfortunately, it’s also the least used. Anybody who trades stocks needs to understand this strategy.

To be continued……

Mar

8

Options 101 Part 105 Chapter Ten Hedging with Options

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The last chapter showed that option trading goes far beyond the purchase of calls and puts. We can mix and match calls and puts, longs and shorts, different expirations, different quantities and so on to create truly unique strategies and opportunities. But would you believe that is not the true power of options? The true power is realized once you understand how to hedge with options to shift your profit and loss curves in different directions as the underlying stock is moving.

This chapter is not intended to be a full course on hedging but rather a way to close our introductory journey into the world of options. Once you understand how options allow us to hedge, we believe that you will be in a better position to make your own decision as to whether options are risky or not.

Hedging
To get started, let’s define what we mean by hedging. The word “hedge” is borrowed from early farmers who used to plant shrubs along the perimeter of their farm to create a protective barrier or fence. In the world of finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk of another investment. In other words, it’s an investment that forms a protective barrier around your portfolio.

To fully appreciate what it means to hedge, let’s assume you must take the following 10-question matching exam and match the answers in the right hand column to the questions in the left hand column. You must get a 90% or higher to pass the class:

1) Call option _____ A. Exercise price
2) Put option _____ B. Right to sell
3) Strike price _____ C. Long stock + short call
4) Expiration date _____ D. ∂∆/∂s
5) Long options _____ E. Long and short options
6) OCC _____ F. Right to buy
7) Covered call _____ G. ∂c/∂s
8) Vertical spread _____ H. Third Friday
9) Formula for delta ______ I. Clearing firm
10) Formula for gamma ______ J. Convey rights

You start running through the questions: Number one, call option is F, the right to buy. Number two, put option is B, right to sell. Number three, strike price is A, exercise price and on down the list you go.

You easily move through the first eight questions apparently on your way to acing the test with a score of 100%. That is until you come to questions nine and ten: The formulas for delta and gamma? What is that?

You know they must correspond to answers D and G but have no idea which is correct. But now you have a little dilemma. Either question nine is D and question ten is G or vice versa. If you guess correctly, you will score 100 on the quiz and get an A. But if you guess incorrectly, you will score an 80 and fail the class and there is a 50-50 chance of either outcome. So now you’re thinking how unfortunate it is that passing the class has come down to a guessing game – effectively the toss of a coin. Is there anything you can do to improve your outcome? What would you do?

The correct answer is to hedge your bet and guess “D” for both questions nine and ten (or “G” for both). Doing so assures you that you will receive the necessary 90% and a passing grade. Notice what the hedge did for you. By sacrificing the 100%, you guaranteed the necessary 90%. If your goal is to pass the class then what difference is a 90% or a 100%? There is no difference. Yet many students lose sight of the true goal of passing the class and try to reach for the 100% grade. There is no benefit in getting a 100% but there are big negative consequences for not getting 90%. It only seems rational that you should hedge yourself and sacrifice the 100% in exchange for the guaranteed 90%. Rather than take the 50-50 chance of passing, you have effectively bet against yourself – a hedge – and created guaranteed success.

If you can understand that analogy then you understand what it means to hedge your financial portfolios. All of you have some type of goal, whether it is to increase your account by so much per year, generate monthly income of a certain amount, or to have a certain amount at a future point in time, for examples. Whatever your goal happens to be, don’t lose site of it. Those who lost site that the goal was to pass the class (90% grade) on the exam may have ended up in failure by guessing at the correct answer. Guessing is no way to pass an exam. Investors who lose site of their goals and do not hedge their bets may end up missing their goals or even in bankruptcy by trying to reach for maximum profits. Guessing what will happen in the market is no way to accomplish your financial goals.

Betting Against Yourself
Any hedge, whether with investing, betting, insurance – or taking exams – serves the same purpose. Hedging means we give up some upside potential in exchange for less damage to the downside. For our exam, we gave up the chance of a 100% score in exchange for not getting 80% – we have hedged the score. With investing, hedging means we will give up some upside profits in exchange for removing some downside risk. In other words, a hedged portfolio means we bet against ourselves much like the exam. If we are bullish on the market, we may add a few bearish investments to hedge our bets.

Hedging is not a new concept for most fields but seems to be an elusive concept for many when it comes to finance. Here’s another simple example of the power of hedging. Does your office have a football pool? You can even hedge to give yourself an edge there too. To make the example easy, assume there is only one game being played, which we’ll say is between the Tampa Bay Buccaneers and the Atlanta Falcons. It costs $5 to play. You have a small office and the only person willing to play so far is Sam, who has bet $5 on Tampa Bay. The sign-up sheet has made it to your office and you have a decision to make. You can either bet on Tampa or Atlanta. If you also bet on Tampa and they win then there will be $10 in the pot, which will be split between Sam and you leaving you each with $5. However, since you each put $5 in the pot, there’s no way you’ll make money from that bet. What happens if you bet on Atlanta? If Atlanta wins, you’ll win the entire $10 as Sam’s $5 will go to you. But if Tampa wins, your money will go to Sam and he’ll take the $10 pot. So if you bet on Atlanta, you’re faced with a 50-50 shot of winning (assuming the teams are equally matched). You’ll either double your money or lose it all. If you take the opposite side of Sam’s bet every week, you’ll end up breaking even in the long run, which doesn’t sound very appealing either. Most people would see these two alternatives (either betting on Tampa or Atlanta) as their only choice. But there is a third choice you can do. You can hedge your bet by betting against yourself. Although it doesn’t sound like a way to make money, hedging is your best long-run alternative. Instead of betting on one team or the other, you simply put $10 in the pot and bet on both teams – you bet $5 on Tampa and $5 on Atlanta.

If Tampa wins, then you and Sam each hold a winning ticket and will split the $15 pot and each get $7.50 – you’ll lose $2.50 overall. If Atlanta wins, you’ll have the only winning ticket and keep the entire $15 pot thus making $5 overall. So half the time you’ll lose $2.50 and half the time you’ll win $5:

0.5 * (-$2.50) = -$1.25
0.5 * (+5.00) = +$2.50
Expected value = +$1.25

By hedging your bet, you’ve changed your long-run average from zero to +$1.25. This means that you will make, on average, $1.25 per game in the long run (assuming you and Sam are the only ones betting and that Sam doesn’t catch on to your hedging scheme). Think about how powerful that is. If you bet on the same team as Sam, you’ll end up with nothing. If you bet against Sam, you may win some money in the short run, but over the long haul, you’ll end up with nothing. However, if you hedge your bet and bet against yourself, you can swing the odds in your favor. Strange, huh? Hedging is powerful because it works.

In this example, you put up 2/3 of the money pool in exchange for guaranteeing a winning ticket. You’ll either lose 25% of your money or gain 50% on your money, thus giving you a long run average gain of 12.5%. The more elaborate the football pool and the more people who bet, the harder it becomes to hedge. For example, you may have to pick the winning team from among ten games that week. However, the idea is still the same. You’d just have to find the total number of combinations that could be made then find out which of those have been made. It’s not too hard from there to determine which combinations will hedge your bet.

Hedging is the key to making consistent money in the markets. But in order to further understand the importance of hedging, we need to find out what kind of risk takers we are.

To be continued…..

Mar

5

Options 101 Part 104

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Chapter Nine Answers

1) If you buy a $50 call and sell a $55 call it is a:
c) Long vertical call spread
Whenever you buy a vertical spread, you are always buying the more valuable option. For call options, that will always be the lower strike, which is $50. So buying the $50 call and selling the $55 call is a long vertical call spread.

2) Spreads always involve:
d) Buying of one option and the selling of another of the same type
There are many types of spreads but all of them involve the buying of one option and selling of another.

3) A vertical spread is:
a) Buying one option and selling another within the same month

4) If you are short the $100/$105 put spread you are:
b) Short the $105 put, long the $100 put
Short vertical spreads are always executed by selling the more valuable strike. For puts, that will always be the higher strike put. So if you are short the $100/$105 put spread, you are short the $105 put and long the $100 put.

5) If you buy the $100/$105 call spread you are:
c) Long the $100 call, short the $105 call
Whenever you buy a vertical spread, you are always buying the more valuable option. For call options, that will always be the lower strike, which is $10050. So buying the $50 call and selling the $55 call is a long vertical call spread.

6) Vertical spreads have:
d) Limited risk, limited reward

7) If you buy the $50/$55 vertical call spread for $3.50, the breakeven point is:
c) $53.50
If you buy the $50/$55 call spread you are effectively buying the $50 call for $3.50. The sale of the $55 call just helps to reduce the cost of the more valuable $50 call. If you pay $3.50 for the $50 call then the breakeven point is $50 + $3.50 = $3.50.

8) The maximum a vertical spread can be worth is:
b) The difference in strikes
The very most any spread can be worth is the difference in strikes.

9) If you buy a low strike option and sell a higher strike option of the same type and same expiration it is a:
c) Vertical bull spread
A vertical bull spread is always constructed by purchasing the lower strike option and selling a higher strike option.

10) Long vertical spreads are always constructed by:
b) Buying the more valuable option
Whenever you buy the more valuable option you have a long vertical spread

11) Credit spreads should be used:
b) When the risk is greater than the corresponding debit spread
Credit spreads should be used when it provides a greater reward than the corresponding debit spread.

12) If you buy the $70/$75 vertical call spread you have the:
c) Right to buy shares for $70 and the obligation to sell for $75
If you buy the $70/$75 vertical call spread you are long the $70 call and short the $75 call. You have the right to buy shares for $70 and the obligation to sell shares for $75.

13) Buying the vertical call spread is identical to:
a) Selling the corresponding put spread

14) Debit spreads are used to:
b) Reduce the cost of the long option
One of the motivations for using debit vertical spreads is that they reduce the cost of the long option.

15) Credit spreads are used to:
a) Reduce the risk of the short position
Credit spreads are initiated by selling the more valuable option which subjects you to unlimited risk. Buying the lesser valued option reduces the risk of the short position.

16) If you sell the $30/$35 put spread for $2, the most you can lose is:
b) $3
If you sell the $30/$35 put spread you are short the $35 put and long the $30 put. You have the obligation to buy shares for $35 and the right to sell shares for $30, which leaves you with a $5 loss. Because you were paid $2 for the spread, the most you can lose is $3.

17) ABC stock is trading for $74. What would you expect the value of the $70/$75 vertical call spread to be?
b) More than $2.50
If the stock were at the midpoint of the spread ($72.50) you would expect the $70/$75 spread to be worth $2.50. However, if the stock price were higher than $72.50, you would expect the value of the spread to be worth more than $2.50.

18) If you sell the $80/$85 put spread for $2, what is the breakeven point?
c) $83
If you sell the $80/$85 put then you are short the $85 put, which means the stock can fall by the $2 premium to a price of $83. If the stock is $83 at expiration, the long $80 put expires worthless and the short $85 put is worth the intrinsic value of $2. You could buy back the spread for $2 thus breaking even.

19) If both strikes are in-the-money, what happens to the value of a vertical spread near expiration?
d) Converge to the difference in strikes
If both strikes are in-the-money then the value of the spread converges to the difference in strikes as the time premium slowly decays.

20) The value of a vertical spread tends to change:
d) Slowly over time
The two options counteract each other as the stock price changes so the value of vertical spreads tends to change slowly over time.

Mar

4

Options 101 Part 103

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Chapter Nine Questions

1) If you buy a $50 call and sell a $55 call it is a:
a) Long horizontal call spread
b) Short horizontal call spread
c) Long vertical call spread
d) Short vertical call spread

2) Spreads always involve:
a) Buying of a put and call
b) Selling of a put and call
c) Buying of a call and buying of a call in a different month
d) Buying of one option and the selling of another of the same type

3) A vertical spread is:
a) Buying one option and selling another within the same month
b) Buying one option and selling another within a different month
c) Selling one option and selling another month and strike
d) Buying one option and buying another

4) If you are short the $100/$105 put spread you are:
a) Short the $100 put, long the $105 put
b) Short the $105 put, long the $100 put
c) Long the $100 put, long the $105 put
d) Short the $100 put, short the $105 put

5) If you buy the $100/$105 call spread you are:
a) Short the $100 call, long the $105 call
b) Short the $105 call, long the $100 call
c) Long the $100 call, short the $105 call
d) Short the $100 call, short the $105 call

6) Vertical spreads have:
a) Unlimited risk, limited reward
b) Limited risk, unlimited reward
c) Unlimited risk, unlimited reward
d) Limited risk, limited reward

7) If you buy the $50/$55 vertical call spread for $3.50, the breakeven point is:
a) $46.50
b) $51.50
c) $53.50
d) $58.50

8) The maximum a vertical spread can be worth is:
a) The strike of the short less the time value
b) The difference in strikes
c) The sum of the strikes
d) The strike of the long plus the time value

9) If you buy a low strike option and sell a higher strike option of the same type and same expiration it is a:
a) Neutral spread
b) Vertical bear spread
c) Vertical bull spread
d) Diagonal spread

10) Long vertical spreads are always constructed by:
a) Buying the lesser valued option
b) Buying the more valuable option
c) Selling the more valuable option
d) Selling the lower strike option

11) Credit spreads should be used:
a) Always because they are better than debit spreads
b) When the risk is greater than the corresponding debit spread
c) When the reward is greater than the corresponding credit spread
d) When there is a short time until expiration

12) If you buy the $70/$75 vertical call spread you have the:
a) Right to buy shares for $70 and the right to sell for $75
b) Right to buy shares for $75 and the obligation to sell for $70
c) Right to buy shares for $70 and the obligation to sell for $75
d) Right to sell shares for $70 and the obligation to sell for $75

13) Buying the vertical call spread is identical to:
a) Selling the corresponding put spread
b) Buying the corresponding put spread
c) Selling the corresponding diagonal spread
d) Buying the corresponding horizontal spread

14) Debit spreads are used to:
a) Reduce the cost of the exercise
b) Reduce the cost of the long option
c) Increase the premium you receive
d) Decrease the risk of early exercise

15) Credit spreads are used to:
a) Reduce the risk of the short position
b) Reduce the cost of the long option
c) Increase the premium you receive
d) Decrease the risk of early exercise

16) If you sell the $30/$35 put spread for $2, the most you can lose is:
a) $2
b) $3
c) $4
d) $5

17) ABC stock is trading for $74. What would you expect the value of the $70/$75 vertical call spread to be?
a) $2.50
b) More than $2.50
c) Less than $2.50
d) More than $5.00

18) If you sell the $80/$85 put spread for $2, what is the breakeven point?
a) $78
b) $82
c) $83
d) $87

19) If both strikes are in-the-money, what happens to the value of a vertical spread near expiration?
a) Converge to the difference in strikes less the premium
b) Converge to the midpoint of the strikes
c) Converge toward zero
d) Converge to the difference in strikes

20) The value of a vertical spread tends to change:
a) In a steady, reliable way toward the difference in strikes
b) Quickly for longer-term but not shorter-term spreads
c) Quickly over time
d) Slowly over time

Mar

3

Options 101 Part 102

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How Much Time?
When investors and traders learn about spreads one of the first questions asked is how much time to buy or sell. This is a very tough question to answer for spreads. As with any strategy, each set of strikes and time frames creates a unique set of risks and rewards. If both strikes are in-the-money then shorter time frames provide a better chance for the spread to expire with intrinsic value. In other words, if both strikes are in-the-money then shorter terms vertical spreads are less risky. As the risk-reward relationship shows though, these spreads may not provide a very big reward. If you wish to increase the reward for any given set of strikes then you will need to increase the expiration date.

For instance, assume ABC stock is trading for $54 and the one-month $45/$50 vertical call spread is worth $4.50, which means the most you can make is 50 cents per spread. A longer-term contract will trade for less than $4.50 thereby providing a larger reward. Why is this? It is riskier to hold with more time remaining. If the $45/$50 vertical call spread were to expire right now then the spread would be worth the full $5 value. However, as you increase the time remaining on the spread then that just provides a chance for the spread to fall out-of-the-money so it becomes riskier.

On the other hand, if you are buying out-of-the-money strikes then buying longer time frames will give you a better chance for the strikes to expire in-the-money. Providing a better chance for intrinsic value is the same as saying it is less risky, and that means the spread will not provide as much reward.

The trick is to balance the risk and reward to suit your tastes. In our Google example, most traders would never use a vertical spread with that much time remaining. However, by selling that much time, it allowed us to get strikes very deep-in-the-money and still provide a very nice return. If we would have considered a shorter time frame, we would find that the reward was less than $3. It’s all about risk-reward tradeoffs and it is up to the investor to decide which to buy or sell.

When it is time to exit the spread, you simply enter the reverse set of transactions that got you into the trade in the first place. For example, 35 days later, Google was trading for roughly $308. If you wanted to close the spread, you would enter the closing transaction in one of two ways depending on your broker’s platform:

1) Buy the Google January $250/$260 vertical put spread at market (or net debit limit)
2) Buy to close, Google Jan. $260 put and simultaneously sell to close the Google Jan. $250 put at market (or net credit limit)

Figure 9-9 shows that 35 days later the $260 put could be purchased for $20.90 and the $250 put could be sold for $17.40 for a net debit of $3.50:

This clearly demonstrates that despite a positive move in the underlying stock from $293 to $308 that the spread would not be profitable. The spread was sold for $3.00 and purchased back for $3.50, a loss of 50 cents per spread. The reason this happened is because there are still 494 days remaining until expiration and a $15 move in a stock like Google is not significant relative to that amount of time remaining. If there were a shorter amount of time remaining, say three months, then the spread would definitely be profitable. But at this time, investors and traders were bidding up the value for the out-of-the-money $260 put for insurance, and that created the 50-cent loss. In other words, on a net basis, the amount of time premium owed on the short $260 put increased, which is bad for you as the seller.

The main reason we explained this is to emphasize the fact that spreads need time to pass before they become profitable. Many traders who are short-term in nature are disappointed to find that the stock has moved in their favor yet the spread is at a loss. So be aware that you will need to wait until very close to expiration before you realize the full value of the spread.

Vertical spreads allow you to profit on outlooks covering specific ranges of stock prices. They are also a perfect solution for times when you find options that you may consider too expensive or too risky. Option trading goes far beyond the purchase of a call or put to capitalize on a directional outlook. The main purpose of this chapter is to allow new investors and traders a glimpse into the world of options trading at a higher level. Options create opportunities that cannot be found with stock or any other asset. Once you master the concepts presented in this book a new door will open and you will find that vertical spreads are just one of many fascinating opportunities available to you.

Key Concepts
1) Vertical spreads have limited risk and limited reward.
2) Vertical spreads have a bullish or bearish bias.
3) Vertical spreads allow investors to buy long options for less money (debit spreads). They also allow investors to sell options for less risk (credit spreads).
4) Buying the call spread is identical to selling the corresponding put spread and vice versa.
5) The higher the reward that a vertical spread offers the riskier the position.
6) Spread values tend to move slowly. If you wish to collect the full value of the spread (assuming it has moved in your favor) you must wait until very close to expiration. Otherwise, you will receive less than the maximum reward.

Mar

2

Options 101 Part 101

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Risk and Reward Revisited
Many traders who see spreads as in this example believe that it is a “terrible” or “unfavorable” risk-reward ratio. They reason that it doesn’t make a lot of sense to put $7.00 at risk in exchange for a $3.00 maximum profit. If you remember back to our lesson on risk and reward, you should realize that the reason the market has bid this spread to a relatively high level is because the stock price is $293 and is well above the short $260 strike. If the stock price rises, stays still, or even falls to $260 the trader will make the full $10 on the spread ($3.00 profit). When viewed in this light, you can see why the market is willing to pay a relatively high $7 price in exchange for a relatively low $3 reward. It is not an unfavorable risk-reward ratio but, instead, a reflection of the relatively low risk in the position.

You can verify this by considering a different vertical spread. Rather than selling the $250/$260 vertical spread, you could sell a set of strikes that are closer to the current stock price, thereby accepting more risk. For example, you may decide to sell the $280/$290 vertical put spread instead. You could sell the $290 put for the $38.50 bid and buy the $280 put for the $34.50 asking price for a net credit of $4.00. The profit and loss diagrams of the two vertical put spreads are compared in Figure 9-8:

Figure 9-8 shows that selling the $280/$290 vertical put spread (bold line) does have more reward than the short $250/$260 vertical put spread ($4 versus $3). Selling the $280/$290 vertical put spread also has less of a downside ($6 versus $7). On the surface it seems like you get the best of both worlds – more reward, less money to lose. However, you must remember that we are not comparing the same strike prices, which means there are different sets of risks and rewards. You are more likely to end up with losses on the $280/$290 spread because the short $290 strike is very close to the current stock price of $293. The $250/$260 spread will not fall into losing territory until the stock price hits $260, which is $30 away from the current price, which means it is less likely to happen. The $280/$290 vertical spread is riskier and that’s why it has a higher reward.

Don’t get trapped in believing that the spreads with the highest rewards and the lowest downside are superior. They are simply riskier and it is up to you to decide which sets of risks and rewards to take.

As a general rule, if the stock’s price is exactly halfway between two strikes, you will find that the maximum gain and loss will be equal to half the distance of the strikes. For instance, if Google was trading for $295, then it would fall exactly halfway between the $290/$300 strikes. Because there is a $10 difference in strikes, then half that amount, or $5, would be the maximum gain and maximum loss for the $290/$300 vertical spreads (calls or puts). In other words, if the stock’s price is exactly halfway between strikes there is a 50-50 chance that it will make or lose money so the cost will be 50% of the distance in strikes.

If the stock’s price were below the halfway point, you would find that the maximum gain for the bull spreads is greater than $5 (and the maximum loss is less than $5). Why does the maximum gain rise as the stock price falls further away from the strikes? If the stock price falls, the long call spread (bull spread) is becoming more out-of-the-money and is therefore riskier, so it will trade at a discount from $5. If you can buy the $10 call spread for less than $5 then you must end up with more reward. The long put spread, on the other hand, becomes more in-the-money as the stock price falls and trades at a premium to $5 since it is becoming less risky. Therefore, if you sell this spread (bull spread), you will be receiving more than $5, which is your reward. So the further below the stock price is from the strikes of the bull spreads, the riskier they become and the more reward they offer.

The opposite is true if the stock price rises above the halfway point of the strikes for the bull spreads. As the stock price rises, the long call spread (bull spread) is becoming more in-the-money and is therefore less risky. It will therefore trade at a premium to $5 and consequently have a reward less than $5. On the other hand, as the stock price rises, the long put spread becomes more out-of-the-money, which means it is worth less than $5. Therefore, if you sell the put spread (bull spread) your reward will be less than $5 just as if you had purchased the call spread. The further above the stock price is from the strikes of the bull spreads, the less risky they are and the less reward they offer.

Figure 9-8 confirms these risk-reward relationships and shows the $250/$260 vertical spread has less reward than the $280/$290 vertical spread. Why? Because the stock price is so much further above the $250/$260 strikes, which makes these strikes trade at a premium (gives you less reward) and makes the put spreads trade at a discount, which gives you less reward.

Let’s work through one quick example to be sure you understand how this principle applies to vertical spreads. Assume that ABC stock is trading for $47.50. What do you suppose the $45/$50 vertical call spread will cost? It should cost $2.50 and therefore have a reward of $2.50. However, if the stock is $55 the vertical call spread will cost more than $2.50 and offer a lower reward. The reason is that it is getting less risky since the call strikes are in-the-money. As the risk decreases, the price goes up. If the stock price is $40, the vertical call spread will cost less than $2.50 since the calls are out-of-the-money and the spread is relatively riskier. As the risk increases, price decreases.

Once you understand how these relationships apply to the long vertical call spread, the answers are opposite but work for similar reasons for the long vertical put spreads. For instance, if the stock price is $55, the long $45/50 vertical put spread is riskier since both strikes are out-of-the-money. It will therefore cost less and offer more. On the other hand, if the stock price is $40, the long $45/50 put spread is in-the-money and is therefore less risky. It will cost more than $2.50 and offer a lower reward.

Price Behavior of Vertical Spreads
Vertical spreads converge to a specific value as expiration nears. What is that value? Think back to the mechanics of long calls and puts. As expiration nears, all in-the-money options converge to intrinsic value while all out-of-the-money options converge toward zero. In the same way and for the same reasons, vertical spreads converge to either intrinsic value or zero.

For example, let’s go back to our $250/$260 vertical call spread that was trading for $7.20. With the stock at $293, both of these calls are in-the-money, which means the spread must converge to the $10 difference in strikes as time goes by. If the stock price remains at $293, the long $250 call is worth the intrinsic value of $43 at expiration while the $260 call is worth the intrinsic value of $33. Since you are long the $250 call you will collect $43; because you are short the $260 call you will owe $33 and your net gain will be $10. After subtracting the $7.20 cost, your profit is $2.80. As long as the stock price is above the short strike ($260) at expiration this spread will slowly start to increase to a maximum value of $10.

Why is the spread not worth $10 today? The answer is time value. The long call has time value of $37.40 ($80.40 premium – $43 intrinsic value). The short call has a time value of $40.20 ($73.20 premium – $33 intrinsic value), which is an amount you owe. Because you owe $40.20 of time value and own $37.40 worth of time value, the net amount you own is $40.20 – $37.40 = $2.80, which is exactly the amount of your maximum gain. Your maximum gain is simply earned by the passage of time. As the long and short time values fall toward zero, the amount you owe is reduced by a net of $2.80 and that’s when the spread will converge to the full $10 difference in strikes.

What if the stock price is between $250 and $260 at expiration? In this case, the vertical spread will converge on the intrinsic value of the long call. For example, if the stock is $258 then the long $250 call converges on the $8 intrinsic value while the short $260 converges toward zero since it is out-of-the-money. You will collect $8 and owe nothing for a gain of $8. After subtracting the $7.20 cost, you are left with an 80-cent profit.

If the stock price is less than $250 at expiration, both the long and short calls will converge toward zero since they are both out-of-the-money. As time passes, the value of the spread will therefore fall toward zero. The same reasoning exists for the vertical put spreads.

The important point to understand is that vertical spreads do not respond quickly to changes in the stock’s price. The reason is that vertical spread consists of a long and short option. As the stock price moves in any direction, one option increases in value while the other loses value so the net change to the vertical spread is small. Further, the time value does not become zero until expiration so the full value of the spread cannot be realized until expiration. (It is also for these reasons why it is not a big risk to enter a “market” order.) As with any option position, you can certainly close it prior to expiration; however, do not expect it to be worth the maximum value. While vertical spreads do allow investors and traders to enter into option positions cheaply, they do come with a drawback in that you should not expect to exit with a profit unless a very favorable price change has occurred relative the time remaining on the option.

To be continued…

Mar

1

Options 101 Part 100

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Vertical Spread Examples
Let’s go back to the Google quotes we used in the last chapter, which have been reproduced as Table 9-5 below:

Assume you are bullish on Google and wish to buy the $250 call but find that it is trading for $80.40 and decide that is too much to spend on the option. Rather than pass up the opportunity, you decide to use a vertical call spread to reduce the cost of the $250 call. This is the “cheap” version of the vertical call spread; you are selling another option to reduce the cost of the long position. If you buy the $250 call and sell the $260 call, then you are long the $250/$260 vertical call spread.

Depending on your broker’s trading platform, you would enter the order in one of two ways:

1) Buy the Google Jan. $250/$260 vertical call spread at market (or net debit limit)
2) Buy the Google Jan. $250 call and simultaneously sell the Google Jan. $260 call at market (or net debit limit)

If you place the order as a “market” order then you can currently buy the $250 call for the $80.40 asking price and simultaneously sell the $260 call for the $73.20 bid, which means a net cost to you (net debit) of $80.40 – $73.20 = $7.20. In most cases, the market order should fill at this $7.20 price. In some cases, you will pay slightly less since you are sending two orders to the exchange and may get a little better pricing. Of course, because it is a market order it is possible to be filled for a higher price than this as well. (Market orders guarantee the execution but not the price.)

On the other hand, you could decide to use a limit order and request to “Buy the $250/$260 vertical call spread at a net debit of $7.00,” for example. This order will only execute if it can be filled for $7.00 or less. The risk is that it may not fill. (Limit orders guarantee the price but not the execution.)

Once the order is filled, you are long the $250 call and short the $260 call. You have the right to buy shares for $250 and the obligation to sell them for $260, which means the most you could make is $10 on the spread. But because you paid $2.80 for the spread, the maximum profit is $10 – $7.20 = $2.80. We also know the breakeven point is the net debit added to the $250 strike, or $250 + 7.20 = $257.20. The profit and loss diagram in Figure 9-6 confirms the maximum gain, loss, and breakeven points we calculated based on our knowledge of option pricing principles:

Now let’s check the profit and loss profile for the corresponding put spread. Rather than buy the $250/$260 vertical call spread we know you could accomplish the same thing by selling the $250/$260 vertical put spread. Selling this spread means you will be selling the more valuable option, which is the $260 strike and that means you must buy the $250 strike.

According to the quotes, you can sell the $260 put for $25.80. However, this subjects you to unlimited downside loss, which is a frightening thought. To hedge this risk, you decide to use some of that premium to buy a lower strike put. This is the “chicken” version of the vertical spread. Your real goal is to sell the controlling $260 put but the purchase of the $250 put is done as a hedge. If you sell the $260 put and buy the $250 put, then you are short the $250/$260 vertical put spread. The order to your broker would be placed in one of the following two ways:

1) Sell the Google January $250/$260 vertical put spread at market (or net credit limit)
2) Sell to open, the Google Jan. $260 put and simultaneously buy to open the Google Jan. $250 put at market (or net credit limit)

If you place the order as a “market” order then you can currently sell the $260 put for the $25.80 bid and simultaneously buy the $250 put for the $22.80 asking price, which means the net credit to you is $25.80 – $22.80 = $3.00. As with any market order, this is not guaranteed to fill for this exact price but it should be very close. If you want to ensure that you do not receive less than $3.00 you would need to use a limit order with a “net credit of $3.00.”

Your broker will require a margin deposit for any credit spread equal to the amount of the maximum loss. In this example, if you sell one spread for $300, your broker will withhold $700 as a margin requirement (the $10 difference in strikes less the $3 credit). Again, this clearly shows that credit spreads are not better for the sole reason that it is better to receive money rather than spend it as so many traders adamantly believe. Credit spreads require a margin deposit exactly equal to the amount that debit spreads must pay to buy the spread. Whether it is called a debit or a margin requirement, both traders pay the same thing.

By selling the $260 put you have the obligation to buy shares for $260. Purchasing the $250 put gives you have the right to sell shares for $250. Therefore, it is possible you could end up buying for $260 and selling for $250, which creates a $10 loss on the spread; but because you were paid $3 for the spread, your maximum loss is $7.00. Figure 9-7 shows the profit and loss diagram for the short $250/$260 vertical call spread:


Notice that the shape of Figure 9-7 is identical to Figure 9-6, which confirms that selling the put spread is identical to buying the call spread. However, notice that the max gain for the put spread is $3 and is only $2.80 for the call spread, while the max loss for the put spread is $7.00 but is $7.20 for the call spread. In other words, the short put spread offers a higher reward for less risk. This would be a time to choose the credit spread over the debit spread. The reasons why these slight pricing discrepancies occur are beyond our scope but a simple explanation is that the puts are out-of-the-money while the calls are in-the-money. Most investors fear the downside risk of the stock and are willing to “pay up” for out-of-the-money puts for insurance against their long stock positions. The out-of-the-money $260 puts are bid up a little higher than the corresponding in-the-money $260 call which makes the credit spread a little better in this instance. Remember, this will not always be the case and sometimes the debit spread will be the better choice. (For instance, using Table 9-5, buying the $290/$300 call spread provides a maximum reward of $4.20 while selling the corresponding put spread yields a maximum or $4.10. In this case, it is better to buy the call spread.)

To be continued…

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.

8) 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

8) 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

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?
a) $360 gain
b) $360 loss
c) $510 gain
d) $510 loss

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.

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.)

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.

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.

To be continued….

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