be pricey and undesirable. If the stockis above the call strike at expiration, then we’re happy because our sold put expiresworthless, our sold call is exercised, and we simply deliver the stock we already own.I’ve seen Wall Street traders use this strategy for their own devices without realizing the downside risk to which they were exposing themselves. Although this isfar preferable to the Covered Short Straddle, there are still better ways to enhancethe income of a Covered Call, which we’ll go through later in this chapter.
Buy stock
Sell OTM put
Sell OTM call
Covered Short Strangle
Steps to Trading a Covered Short Strangle1. Buy (or own) the stock.2. Sell OTM (lower strike) puts with a strike price lower than where you think thestock will be at expiration.3. Sell OTM (higher strike) calls with the same expiration date.■
Generally, only sell the strangle element on a monthly basis. In this wayyou will capture more in premiums over several months, provided you arenot exercised. Selling premium every month will net you more over a period of time than selling premium a long way out. Remember that wheneveryou are selling options premium, time decay works in your favor. Timedecay is at its fastest rate in the last 20 trading days (i.e., the last month), sowhen you sell option premiums, it is best to sell it with a month left, anddo it again the following month.
■
Remember that your maximum gain is capped when the stock reaches thelevel of the call’s strike price.
■
You need to ensure that the put strike price is OTM and below the level atwhich you think the stock will be at expiration; otherwise the sold put willbe exercised, and you’ll have to buy more stock at the put strike price.
■
If trading U.S. stocks and options, you will be required to buy (or be longin) 100 shares for every options contract that you sell.
Income Strategies
Steps In■
Preferably between $10.00 and $50.00. Above $50.00, it would be expensiveto buy the stock.
■
Try to ensure that the trend is upward or rangebound and identify a cleararea of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock closes above the call strike at expiration, your call will be exercised. You will deliver the stock at the strike price and will have profitedfrom both the option premiums you received and the uplift (if any) in stockprice to reach the strike price. Exercise is automatic.
■
If the stock falls below the put strike, your put will be exercised, forcing youto buy more shares at the put strike price. This could become expensive.
■
If the stock is resting between the strike prices at expiration, then you’llkeep the premiums, but this is a dangerous strategy and is not recommended because of the downside risk.
2.8.2 ContextOutlook■
With covered short strangles, your outlook is bullish. You expect a steady rise.
Rationale■
With covered short strangles, you are enhancing the yield of a covered call byintroducing the sale of OTM puts in addition to the calls you have sold againstthe stock you have bought. This has the effect of increasing your (monthly) yield.
■
The hope is that if the stock rises, your sold puts will expire worthless, andyou will keep the premium, whereas if your calls are exercised, you alreadyown the stock to deliver. The biggest problem is that if the stock plummets,your sold calls will expire worthless, enabling you to keep the premium, butyou could be exercised on your sold puts, in which case you will have to buymore stock. Therefore, only use this strategy on stocks that you want tocontinue holding and adding to your position.
Net Position■
With stocks, this is a net debit transaction because you are paying for the stockand only taking in small premiums for the sold put and call options. You canincrease your yield by purchasing the stock on margin, thereby doubling youryield if you use 50% margin.
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Your maximum risk is the price you pay for the stock, plus the put strike price,less the premiums you receive for the sold call and put. This is a high-riskstrategy.
Effect of Time Decay■
Time decay is helpful to your trade here because it will erode the value of theoptions you sold. Provided that the stock remains between the strikes at expiration, you will be able to retain both premiums, thus reducing your originalcost of buying the share.
Appropriate Time Period to Trade■
Sell the options on a monthly basis.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Preferably between $10.00 and $50.00. Above $50.00, it would be expensive tobuy the stock.
■
Try to ensure that the trend is upward or rangebound and identify a clear areaof support.
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Put Strike—Look for OTM strike below the current stock price.
■
Call Strike—Look for OTM strike above the current stock price.
■
Expiration—Look for either of the next two expirations and compare monthlyyields. Use the same expiration date for both put and call. Look for over 5%monthly initial cash yield.
2.8.3 Risk Profile■
Maximum Risk
[Stock price paid  put strike price  put premium call premium]
■
Maximum Reward
Limited to the premiums received for the sold calls andputs  call strike price  the purchase price of the stock
■
Breakeven
Varies depending on the relationship between the stockprice, premiums received, and the strikes
Income Strategies
2.8.4 Greeks
Risk ProfileAs the stock pricerises above the callstrike, the positionreaches its maximumprofit potential. Asthe stock falls belowthe put strike, theposition falls at twicethe speed because ofthe sold puts.DeltaDelta (speed) is positive and falls to zeroas the asset price risesabove the call strikewhere the maximumprofit is achieved andthe position speedslows down.
Key:ExpirationToday – 1 monthTime(t) – 2 weeksRisk Profile
Theta
ThetaTheta is positive,illustrating that timedecay is helpful tothe position.
Delta
Vega
VegaVega is negative,illustrating thatvolatility is harmful tothe position.
Gamma
Rho
RhoHigher interest ratesare harmful to theposition when it isprofitable and helpfulwhen the position isunprofitable.
GammaGamma (acceleration)is always negativewith this positionbecause you are anet seller of options.
2.8.5 Advantages and DisadvantagesAdvantages■
Generate monthly income.
■
Greater income potential than a Covered Call.
■
Less risky than a Covered Short Straddle.
Disadvantages■
Risky if the stock falls. The sold put means that the risk is effectively doubled,and the rate at which you lose money in the event of the stock declining is alsodoubled.
■
Unless the stock price is between the strike prices at expiration, you face exercise of either the put or call. If the stock falls and the put is exercised, you’llhave to buy more stock at the strike price.
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Expensive strategy in terms of cash outlay.
■
Capped upside if the stock rises.
■
Uncapped downside potential. This is not a recommended strategy.
2.8.6 Exiting the TradeExiting the Position■
If the share rises above the call strike price, you will be exercised at expiration(or before) and therefore make a profit.
■
If the share falls below the put strike price, you will be exercised at expiration(or before) and will have to buy more stock at the put exercise price. Your soldcalls will expire worthless, and you will keep the premium.
■
If the share stays between the strike prices, you will have successfully reducedyour cost of entry because the premiums you took in will offset the price youpaid for the stock. You will retain the entire option premiums you sold becausethey will expire worthless.
Mitigating a Loss■
Either sell the share or sell the share and buy back the call option you sold. If theput is exercised, then you will be required to buy the stock at the put strike price.
■
Please note that covered short strangles are risky, and you should ensure thatyou have enough cash in your account to fulfill the exercise obligations youmay have on the downside.
2.8.7 ExampleABCD is trading at $28.20 on February 25, 2004.Buy the stock for $28.20.Sell the March 2004 27.50 strike put for $1.20.Sell the March 2004 30 strike call for $0.90.You Pay
Stock price  option premiums28.20  1.20  0.90  26.10
Maximum Risk
Stock price  put strike  put premium  call premium28.20  27.50  1.20  0.90  53.60Maximum risk of 53.60 is more than double your net debit here!
Maximum Reward
Limited to the options premiums received  the call strike priceless  the stock price paid0.90  1.20  30.00  28.20  3.90
Breakeven
26.80
Initial Cash Yield
7.45%
Maximum Yield on Risk
3.92%
Income Strategies
2.9 Calendar CallProficiency
Direction
Volatility
Asset Legs
N/AIntermediate
Bullish
■ Long Call
Max Risk
Max Reward
Strategy Type
Capped
Income
!
Capped
■ Short Call
2.9.1 DescriptionCalendar spreads are known as horizontal spreads, and the Calendar Call is a variationof a Covered Call, where you substitute the long stock with a long-term long calloption instead. This has the effect of radically reducing the investment, therebyincreasing the initial yield. However, this initial yield is not necessarily reflective ofthe maximum yield at the expiration of the short-term short call. The maximum yieldwill depend on both the stock price and the residual value of the long unexpired call.The problem with a Calendar Call is in the very essence of the shape of the riskprofile (see the following). What we’d like to do is create something similar to aCovered Call, but with a better yield and without the expense. The Calendar Callcertainly requires less investment; however, the shape is different. If the stock risestoo far too soon, then the Calendar Call can become loss-making. So even thoughyou got the direction of the trade right, you could still lose money! This happensbecause the long call, being near the money, only moves at around half the speed asthe underlying stock as the stock price rises. This means that in the event of exercise,if the stock has risen by, say, $10.00 from $30.00, and your option has only risen by$5.00, you may be exercised on the short call; therefore you buy the stock at $40.00and sell it at $30.00 (if that was the strike), yet your long call has only risen by $5.00,giving you a $5.00 loss. If you only received $2.00 for the short call, you’re lookingat a $3.00 loss on the trade.Both options share the same strike, so if the stock rises above the strike, yourshort call will be exercised. You’ll then have to sell the long call (hopefully for aprofit), use the proceeds to buy the stock at the market price, and then sell it back atthe strike price. Therefore, the best thing that can happen is that the stock is at thestrike price at the first expiration. This will enable you to write another call for thefollowing month if you like.
Buy call
Sell call
Calendar Call
Steps to Trading a Calendar Call1. Buy a long-term expiration call with a near the money strike price.2. Sell a short-term call (say monthly) with the same strike price.
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Steps In■
Try to ensure that the trend is upward or rangebound and identify clearareas of support and resistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock closes above the strike at expiration, you will be exercised. Youwill sell your long call, buy the stock at the market price, and deliver it atthe strike price, having profited from both the short option premium youreceived and the uplift in the long option premium. Exercise of the shortoption is automatic. Do not exercise the long option or you will forfeit itstime value.
■
If the stock remains below the strike but above your higher stop loss, letthe short call expire worthless and keep the entire premium. You can thenwrite another call for the following month.
■
If the stock falls below your lower stop loss, then either sell the longoption (if you’re approved for naked call writing) or reverse the entireposition.
2.9.2 ContextOutlook■
With a Calendar Call, your outlook is neutral to bullish. You expect a steadyrise.
Rationale■
To generate income against your longer term long position by selling calls andreceiving the premium.
Net Position■
This is a net debit transaction because your bought calls will be more expensive than your sold calls, which have less time value.
■
Your maximum risk on the trade itself is limited to the net debit of the boughtcalls less the sold calls. Your maximum reward is limited to the residual callvalue when the stock is at the strike price at the first expiration, less the net debit.
Income Strategies
Effect of Time Decay■
Time decay affects your Calendar Call trade in a mixed fashion. It erodes thevalue of the long call but helps you with your income strategy by eroding thevalue faster on the short call.
Appropriate Time Period to Trade■
You will be safest to choose a long time to expiration with the long call and ashort time (one month) for the short call.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward or rangebound and identify clear areasof support and resistance.
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—Look for either the ATM or just OTM (higher) strike above the currentstock. If you’re bullish, then choose a higher strike; if neutral, choose the ATMstrike.
■
Expiration—Look at either of the next two expirations for the short option andcompare monthly yields. Look for over six months for the long option.
2.9.3 Risk Profile■ Maximum Risk
Limited to the net debit paid
■ Maximum Reward
[Long call value at the time of the short call expiration,when the stock price is at the strike price]  [net debit]
■ Breakeven Down
Depends on the value of the long call option at the timeof the short call expiration
■ Breakeven Up
Depends on the value of the long call option at the timeof the short call expiration
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2.9.4 GreeksKey:ExpirationToday – 1 monthTime(t) – 5 daysRisk ProfileMaximum profit isachieved when thestock is at the strikeprice at the time ofthe short call expiration date. Any substantial move up ordown is dangerousfor the position.
Risk Profile
Theta
Delta
Vega
DeltaDelta (speed) is at itsfastest either side ofthe strike price, indicating the increasingspeed of the positionin one direction andthen the other.
ThetaTheta is positive,illustrating that timedecay is helpful tothe position aroundthe strike price,where the position isprofitable. Timedecay is not so helpful when the positionis unprofitable.VegaIncreasing volatility ishelpful because it willmean the long call’sresidual value shouldbe higher.
GammaGammaGamma (acceleration)peaks inverselyaround the strikeprice, showing wherethe Delta line issteepest.
Rho
RhoHigher interest ratesbecome more helpfulas the underlyingasset price rises.
2.9.5 Advantages and DisadvantagesAdvantages■
Generate monthly income.
■
Can profit from rangebound stocks and make a higher yield than with aCovered Call.
Disadvantages■
Capped upside if the stock rises.
■
Can lose on the upside if the stock rises significantly.
■
High yield does not necessarily mean a profitable or high probabilityprofitable trade.
Income Strategies
2.9.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the callsyou sold and selling the calls you bought in the first place.
■
Advanced traders may leg up and down as the underlying asset fluctuates upand down. In this way, you can take incremental profits before the expirationof the trade.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-leg.In this way, they will leave one leg of the spread exposed in order to attemptto profit from it.
2.9.7 ExampleABCD is trading at $65.00 on May 5, 2004, with Historical Volatility at 30%.■
Buy January 2006 65 strike calls at $12.50.
■
Sell June 2004 65 strike calls at $2.70.
At June Expiration1. Scenario: stock falls to $60.00Long calls worth approximately 8.40; loss so far  4.10Short calls expire worthless; profit 2.70No exerciseTotal position  12.50  2.70  4.10  11.10  loss of 1.402. Scenario: stock falls to $62.50Long calls worth approximately 9.80; loss so far  2.70Short calls expire worthless; profit 2.70No exerciseTotal position  12.50  2.70  2.70  0.00  breakeven3. Scenario: stock stays at $65.00Long calls worth approximately 11.40; loss so far  1.10Short calls expire worthless; profit 2.70No exerciseTotal position  12.50  2.70  1.10  14.10  profit of 1.60
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4. Scenario: stock rises to $70.00Long calls worth approximately 14.80; profit so far  2.30Short calls expire $5.00 ITMProcedure: sell bought calls; buy stock at current price and sell at strike priceExercised at $65.00Buy stock at 70.00Sell stock at 65.00Loss  5.00Sell long call for a profit  2.30Keep short call premium  2.70Loss on Exercise  5.00Total position  0.00 breakeven5. Scenario: stock rises to $75.00Long calls worth approximately 18.35; profit so far  5.85Short calls expire $10.00 In the MoneyProcedure: sell bought calls; buy stock at current price and sell at strike priceExercised at $65.00Buy stock at 75.00Sell stock at 65.00Loss  10.00Sell long call for a profit  5.85Keep short call premium  2.70Loss on Exercise  10.00Total position  1.45 lossIf you tried to exercise the bought call:Procedure: exercise bought calls at $65.00; deliver stock at $65.00 for exercisedsold callBuy call at 12.50Sell call at 2.70Net cost  9.80Buy stock at 65.00Sell stock at 65.00Net profit at 0.00Total  9.80  $0.00  loss of 9.80Lesson: Never exercise a long-term option because you’ll miss out on Time Value!
Income Strategies
Risk Profile
Profit / (Loss)2
Stock Price30
40
50
60
70
80
90
100
-2-4-6-8-10
2.10 Diagonal CallProficiency
Direction
VolatilityN/A
Intermediate
Bullish
Asset Legs■ Long Call
Max Risk
Max Reward
Strategy Type
Capped
Income
!
Capped
■ Short Call
2.10.1 DescriptionThe Diagonal Call is a variation of a Covered Call where you substitute the longstock with a long-term deep In the Money long call option instead. This has theeffect of reducing the investment, thereby increasing the initial yield. As with theCalendar Call, this initial yield is not necessarily reflective of the maximum yield atthe expiration of the short-term short call. The maximum yield will depend on boththe stock price and the residual value of the long unexpired call.The Diagonal Call solves the problems experienced with the Calendar Call, inthat the shape of the risk profile (see the following) is more akin to the Covered Call,which is what we want. Yet the Diagonal Call is going to be a far cheaper investment! If the stock rises explosively, then unlike the Calendar Call, the Diagonal Calldone correctly won’t become loss-making. The key is not to get too greedy!
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Let’s say we’re looking to do a Diagonal Call on a $25.00 stock. The two-year$20.00 call is say, $7.50, and we sell next month’s $27.50 call for $0.75, giving us aninitial cash yield of 10%. If the share rises to $40.00, within the next month, our longcall will be worth at least $22.00 ($20.00 intrinsic value alone!). We’ll have to buy thestock for $40.00 and sell it at $20.00 (making a $20.00 loss), but we’ll retain the $0.75from the selling the short-term OTM option. Total position is still profitable byaround $2.75.At the end of this section, we’ll go through a real example, but the main point isthis: Because we’re buying deep ITM calls, the long option will have a higher delta andwill move more in step (dollar for dollar) with the stock as it rises. This means that thestock rising explosively won’t damage our position, unlike with the Calendar Call.The bought option is long-term and deep ITM, and the short option is short-termand OTM. If the stock rises above the higher (short) strike, your short call will beexercised. You’ll then have to sell the long call (for a profit), use the proceeds tobuy the stock at the market price, and then sell it back at the strike price. The maximum profit occurs where the stock is at the short call (higher) strike price at the firstexpiration.
Buy call
Sell call
Diagonal Call
Steps to Trading a Diagonal Call1. Buy a deep ITM (lower strike) long-term expiration call.2. Sell a higher strike short-term call (say monthly).Steps In■
Try to ensure that the trend is upward or rangebound and identify a cleararea of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock closes above the higher strike at expiration, you will be exercised. You will sell your long call, buy the stock at the market price, anddeliver it at the higher strike price, having profited from both the optionpremium you received and the uplift in the long option premium. Exerciseof the short option is automatic. Do not exercise the long option or you willforfeit its time value.
■
If the stock remains below the higher strike but above your stop loss, letthe short call expire worthless and keep the entire premium. If you like,you can then write another call for the following month.
■
If the stock falls below your stop loss, then either sell the long option (ifyou’re approved for Naked Call writing) or reverse the entire position.
Income Strategies
2.10.2 ContextOutlook■
With a Diagonal Call, your outlook is bullish.
Rationale■
To generate income against your longer term long position by selling calls andreceiving the premium.
Net Position■
This is a net debit transaction because your bought calls will be more expensive than your sold calls, which are OTM and have less time value.
■
Your maximum risk on the trade itself is limited to the net debit of the boughtcalls less the sold calls. Your maximum reward occurs when the stock price isat the sold call (higher) strike price at the expiration of the sold call.
Effect of Time Decay■
Time decay affects your Diagonal Call trade in a mixed fashion. It erodes thevalue of the long call but helps you with your income strategy by eroding thevalue faster on the short call.
Appropriate Time Period to Trade■
You will be safest to choose a long time to expiration with the long call and ashort time (one month) for the short call.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward or rangebound and identify a clear areaof support.
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Lower Strike—Look for either the ATM or ITM (ideally about 10–20% ITMpreferred) strike below the current stock price. If you’re bullish, then choose alower strike; if neutral, choose the ATM strike in anticipation of writing morecalls in the future.
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Higher Strike—Look for OTM by more than one strike to enable the long callto rise in value if you get exercised on the short call.
■
Expirations—Look at either of the next two expirations for the short optionand compare monthly yields. Look for over six months for the long option.
2.10.3 Risk Profile■
Maximum Risk
Limited to the net debit paid
■
Maximum Reward
[Long call value at the time of the short call expiration,when the stock price is at the higher strike price] [net debit]
■
Breakeven Down
Depends on the value of the long call option at the timeof the short call expiration
■
Breakeven Up
Depends on the value of the long call option at the timeof the short call expiration
2.10.4 GreeksKey:ExpirationToday – 1 monthTime(t) – 5 daysRisk ProfileMaximum profit isachieved when thestock is at the higherstrike price at thetime of the short callexpiration date.
Risk Profile
Theta
DeltaDelta (speed) is at itsfastest either side ofthe strike price, indicating the increasingspeed of the positionin one direction andthen the other.
Delta
Vega
GammaGamma (acceleration)peaks inverselyaround the higherstrike price, showingwhere the Delta lineis steepest.
Gamma
ThetaTheta is positive,illustrating that timedecay is most helpfulto the positionaround the higherstrike price, wherethe position is mostprofitable.VegaIncreasing volatility ishelpful because it willmean the long call’sresidual value shouldbe higher.
Rho
RhoHigher interest ratesbecome more helpfulas the underlyingasset price rises.
Income Strategies
2.10.5 Advantages and DisadvantagesAdvantages■
Generate monthly income.
■
Can profit 8from rangebound stocks and make a higher yield than with aCovered Call.
Disadvantages■
Capped upside if the stock rises.
■
Can lose on the upside if the stock rises significantly.
■
High yield does not necessarily mean a profitable or high probability profitabletrade.
2.10.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the callsyou sold and selling the calls you bought in the first place.
■
Advanced traders may leg up and down as the underlying asset fluctuates upand down. In this way, you can take incremental profits before the expirationof the trade.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-leg.In this way, they will leave one leg of the spread exposed in order to attempt toprofit from it.
2.10.7 ExampleABCD is trading at $26.00 on March 19, 2003, with Historical Volatility at 40%.■
Buy January 2005 25 calls at $6.60
■
Sell April 2003 27.50 calls at $0.55
At April Expiration1. Scenario: stock falls to $23.00Long calls worth approximately 4.28; loss so far  2.32Short calls expire worthless; profit 0.55No exerciseTotal position  6.60  0.55  2.32  4.83  loss of 1.77
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2. Scenario: stock falls to $25.00Long calls worth approximately 5.46; loss so far  1.16Short calls expire worthless; profit 0.55No exerciseTotal position  6.60  0.55  1.16  5.99  loss of 0.613. Scenario: stock stays at $26.00Long calls worth approximately 7.09; loss so far  0.49Short calls expire worthless; profit 0.55No exerciseTotal position  6.60  0.55  0.49  6.64  profit of 0.044. Scenario: stock rises to $27.50Long calls worth approximately 7.09; profit so far  0.49Short calls expire worthless; profit 0.55No exerciseTotal position  6.60  0.55  0.49  7.64  profit of 1.045. Scenario: stock rises to $30.00Long calls worth approximately 8.82; profit so far  2.22Short calls expire $2.50 ITMProcedure: sell bought calls; buy stock at current price and sell at strike priceExercised at $27.50Buy stock at 30.00Sell stock at 27.50Loss  2.50Sell long call for a profit  2.22Keep short call premium  0.55Loss on Exercise  2.50Total position  0.27 profitIf you tried to exercise the bought call:Procedure: exercise bought calls at $25.00; deliver stock at $27.50 for exercisedsold callBuy