to move.Choosing an exit strategy depends on the movement of the underlying stock.If the market falls, you can either sell a put option with the same strike price and
Put Option Premiums for XYX @ 69 3/8Put Strike Prices556065707580Figure 5.12
August
September
October
January
9
3
345/865/89121/4155/8
3
/16/811/8365/8111/83
Put Premiums for XYX @ 693/8
/1611/424 7/8812
1 /1623/837/861/491/8123/4
144
THE VERSATILITY OF OPTIONSLong 1 Sep XYX70 Put @ 4 7/8
Long 1 Oct XYX75 Call @ 91/8
Maximum risk = Put premium
4 7/8 × 100 = $478.50
91/8 × 100 = $912.50
Maximum reward = Unlimited
Unlimited below breakeven
Unlimited below breakeven
Long Put Calculation
7
75 – 91/8 = 657/8
70 – 4 /8 = 65 /8
Breakeven = Strike price –Put premium
Figure 5.13
1
Long Put Results
expiration at an acceptable profit, or exercise the put option and be short the underlying market. You can hold this position or cover the short by buying them back atthe current lower price thereby garnering a profit. If the market rises, you may prefer to sell your option to minimize the loss or wait for a reversal if you have enoughtime until expiration.In this example, let’s say the price of XYX falls to 62 3/4. This results in a rise inthe premium of the October 75 put to 183/4. You now have a decision to make. Toexit a long put, you can offset it, exercise it, or let it expire (see Figure 5.14). To offset this position, you can sell the October 75 put and reap a profit of $962.50 [(183/4– 91/8) × 100 = $962.50]. If you choose to exercise the position, you will end upwith a short position of 100 shares of XYX @ 75. This would bring in an additionalcredit of $7,500 (minus commissions). However, you would then be obligated tocover the short some time in the future by purchasing 100 shares of XYX at the current price. If you covered the short with the shares priced at 623/4, you would make aprofit of $1,225. Although you have the opportunity to make a slightly higher profitby exercising the long put, you would need enough money in your trading accountto post a deposit of at least $11,250 ($7,500 × 11/2 = $11,250; the actual amountwould be determined by your broker).The profit/loss line for a long put strategy slopes upward from right to left. Thissignifies that the profit increases as the market price of the underlying stock falls.The risk profile for this example is shown in Figure 5.15.A long put strategy, just like shorting a stock, makes a profit when the underlyingasset decreases in price. However, these two bearish strategies differ greatly when itcomes to profit potentials, risk, margin requirements, and breakevens. The profit on
Long 1 October XYX 75 Put @ 91/8Exit Method
Procedure3
Profit
Margin
Offset
Sell 1 Oct 75 Put @ 18 /4
$ 962.50
$
Exercise
Exercise put, hold a short stock position,buy 100 shares of XYX @ 623/4
$1,225.00
$11,250
Figure 5.14
Exit Strategy of Long Put Position
0
PUT OPTION BASICS
Figure 5.15
145
Long Put Risk Graph
a long put position is unlimited as the price of the stock falls below the breakeven.The profit on a short stock position is unlimited as the stock price falls below theinitial price where the stock was sold. The risk, however, is significantly different,which leads to different returns on investment (ROIs).In the case of a long put, the risk is limited to the premium paid to purchase theoption. In contrast, the risk of the short stock position is unlimited as the price of theunderlying asset rises. Thus, the ROI for the long put will be much greater than forthe short stock. This risk differential shows up dramatically in the margin requirements for the two positions. The long put requires the payment of the premium, butno additional margin. The maximum potential loss is limited to the premium paid.The short stock position will result in an initial credit to your trading account in theamount of the sale, but will also require a margin availability of 11/2 times thatamount or more upon entering the position (much more with a highly volatile techstock). Also, if the price goes against you and moves up, you would be subject to increasing margin requirements.The one positive benefit of the short stock over the long put is the breakevenpoint. With the short stock, the breakeven point is the price at which the stock wasinitially sold. As the stock moves below that price, the trade becomes profitable.With the long put, the price of the stock must move below the strike price of the putminus the premium paid for the trade to become profitable.Shorting a stock comes with unlimited risk as you can see by reviewing the riskprofile of the short stock strategy in Figure 5.16. An increase in the price of thestock above the breakeven triggers a loss of $1 per point per share. In contrast, thepurchase of a long put is a managed risk strategy that takes advantage of bearishmovement with minimal investment capital.
146
THE VERSATILITY OF OPTIONS
Figure 5.16
Short Stock Risk Graph
Short Put ExampleThe sale of a put option garners a credit into your trading account in the amount ofthe option’s premium. The premium received is the maximum reward for a short putposition. In most cases, you are anticipating that the short put will expire worthlessby expiration. If the price of the underlying stock remains higher than the strikeprice of the put, you will not be in danger of having the put assigned by an optionbuyer. There is no reason for an option buyer to exercise the put option when theperson can sell the underlying stock at a higher current price. If the price of the underlying stock falls below the strike price, a corresponding put buyer may choose toexercise it and your put may be assigned.A short put strategy offers limited profit potential and unlimited risk.It is best placed in a bullish market when you anticipate a rise inthe price of the underlying market beyond the breakeven.
By shorting a put option, you are selling the right to sell the underlying instrumentat the strike price until the expiration date. That means that if you are assigned, youhave an obligation to buy the underlying stock from the assigned option buyer at thestrike price of the short put. This results in a long stock position at a higher price. However, you still get to keep the premium paid for the short call to offset any losses youtake. The maximum loss has limited downside risk as the underlying asset falls to zero.Let’s create an example using the put premium values in Figure 5.12. Since theway to make money on a short put is to let the put expire worthless, it is importantto sell an option with less than 45 days until expiration. Although an option withmore time until expiration will bring in a higher initial credit and a lowerbreakeven, more than 45 days will leave the underlying stock too much time to fall
PUT OPTION BASICS
147
beneath the put’s strike price. Therefore, let’s track the scenario of one short September XYX 70 Put @ 47/8.Upon initiation of the trade, the option writer receives a credit of $487.50, whichis the maximum profit available on this trade (see Figure 5.17). The breakeven iscalculated by subtracting the put premium from the strike price. In this example, thebreakeven is 651/8—as long as XYX remains above $65.13 per share, you will notlose money on this position.A short put strategy offers three distinct exit scenarios. Each scenario depends onthe movement of the underlying stock. The best exit strategy occurs if the underlyingstock rises above the put strike price and the put expires worthless. If this occurs, youget to keep the premium, which is the maximum profit on a short put position. However, if the underlying stock reverses and starts to fall, you may want to offset the position by purchasing a put option with the same strike price and expiration to exit thetrade. If the underlying asset falls below the put strike price, the put may be assigned toa put holder. If your put is assigned, you will be obligated to buy 100 shares of XYX at$70 per share. This gives you a long stock position that you can either sell at a loss orwait for a reversal. The maximum loss occurs if the price of XYX falls to zero. Theshort put writer then loses $7,000 (100 shares × 70 = $7,000) less the $487.50 credit received from the premium or a total of $6,512.50 ($7,000 – $487.50 = $6,512.50).The short put strategy, like a long stock position, makes a profit in a bullish market. There are many differences between these two strategies including profit potentials, margin requirements, and breakevens. The profit on a long stock position isunlimited as the price of the stock rises above the initial price, while the profit on ashort put is limited to the premium received when the trade is placed. Thebreakeven of a long stock position is the price of the stock at initiation. Thebreakeven of the short put is usually lower than that of a long stock because thebreakeven of a short put is offset by the credit received from the put premium. Thisrelationship is exploited by a strategy known as a covered put.Covered put: A short put option position hedged against a short stock position.
The margin on a short put can be as high as $50,000, depending on the brokerage.The margin on a long stock position rarely exceeds 50% of the total cost of the shares.Since a short put comes with high margin rates, limited profit potential, and high risk,we do not recommend selling a naked put option. But it is important to understandhow a short put works, for it is used in many low-risk, combination options strategies.
Short 1 September XYX 70 Put @ 4 7/8Maximum risk = Unlimited as stock falls to zero
Reaches maximum if the stock reaches zero
Maximum reward = Net credit
4 7/8 × 100 = $478.50
Breakeven = Short strike price – Put premium
651/8 (70 – 47/8 = 651/8)
Figure 5.17
Short Put Results
148
THE VERSATILITY OF OPTIONS
A long stock risk profile slants down from right to left (see Figure 5.18). A shortput strategy also creates a risk profile that slants down from right to left (see Figure5.19) but has a horizontal line that represents the limited credit available from thesale. Notice that as the price of the asset falls, the loss of your short put position increases until the price of the underlying stock hits zero. This signifies that the profitincreases as the market price of the underlying stock rises.
COVERED WRITESOptions are effective tools that make an invaluable contribution to your tradingarsenal. They provide high-leverage opportunities that can really make a difference to your trading approach. The secret to making a profit on them, however,lies in your ability to understand how they work and the best ways in which theycan be applied.One conservative income strategy quite popular among traditional buy-and-holdinvestors uses options as protection on long and short stock positions. A coveredwrite is designed to secure additional cash from stock positions and provide limitedprotection against decreases in the price of a long underlying stock position (covered call) or increases in the price of a short underlying stock position (coveredput). The key word to remember here is limited. Unfortunately, investors who arenot well versed in options often employ covered write strategies without a concreteunderstanding of the risks involved. Bottom line: If a market makes a big move,losses can occur. However, covered writes do provide traders with more protectionthan traditional uncovered stock positions.
Figure 5.18
Long Stock Risk Graph
COVERED WRITES
Figure 5.19
149
Short Put Risk Graph
Since writing an option involves the sale of an option, a profit is made on thetime decay of the short option. Your success with this strategy lies in your abilityto skillfully discern the nature of a market’s directional trend.
There are two kinds of covered writes: covered calls and covered puts. A coveredcall is composed of the purchase of stock shares and the sale of call options. A covered put consists of the sale of stock shares and the sale of put options. Profit on theoptions is derived from the credit received from the options premiums at the initiation of the trade. Investors receive a credit for the amount of the option premiumand get to keep that credit if and when the option expires worthless.It is important to note that writing (selling) options comes with an obligation todeliver (call) or purchase (put) the underlying stock at the option’s strike price if theoption is exercised. This obligation increases the risk of a covered write. A limitedprofit, however, can still be made even if the option is assigned and exercised if themove stays within the trade’s profit range. Therefore, it is best to place coveredwrites in stable or sideways markets. A sideways or range-trading market exhibitsprice action between two specified points: resistance and support. Resistance is thepoint at which prices stop rising and tend to drop. Support is the point at whichprices tend to stop dropping and start to rise. When a range-trading stock rises, it hitsa certain price where the sellers rush in, soon outnumbering the buyers. At this point,prices start to fall off. The support level is the price where buyers start to outnumberthe sellers and the price begins to rise again. Stocks exhibiting these characteristicscan be excellent candidates for covered writing. However, you should also note thatrange-bound stocks can begin trending at any time—there are no guarantees. Let theseller beware!
150
THE VERSATILITY OF OPTIONS
Covered CallsA covered call trade combines a long stock position with the sale of call optionsagainst it. This strategy is best implemented in a bullish to neutral market where aslow rise in the market price of the underlying stock is anticipated. This strategy allows traders to handle moderate price declines because the call premium reducesthe position’s breakeven. The success of a covered call relies on the short option expiring worthless. Hence, try to sell options with 45 days or less until expiration.However, since the profit on a covered call is limited to the premium received plusany stock appreciation up to the strike price of the short option, the premium needsto be high enough to balance out the trade’s risk. Figure 5.20 illustrates the advantages a covered call offers in comparison to simply purchasing stock.Let’s create a hypothetical example using XYX currently trading at 711/2. Unlikevertical spreads, there are a limited number of options that can be used successfullywith covered calls. As previously mentioned, the key to a successful covered calllies in finding a stable market with slightly OTM options with less than 45 days tillexpiration with enough premium to make the trade worthwhile. Using the values inFigure 5.21, there are a few winning options that fit the criteria previously mentioned. Although the October 75 option brings in a larger premium than the 80 call,Vertical spreads: Combined options strategies that offer limited potential profitsas well as limited risks by combining long and short options with different strikeprices and like expiration dates. The juxtaposition of long and short options hasa directional bias and results in a net debit or net credit.
Covered Call Strategy versus Long Stock StrategyMarket Scenario
Covered Call
Long Stock
Stock price increases: Callis assigned to an optionbuyer and the underlyingstock shares must be soldat the call’s strike price.
Profits are limited to thepremium received on theshort call plus the profit madefrom the difference betweenthe stock’s price at initiationand the call strike price.
Profits may begarnered if the stockis sold at the higherprice.
Stock price remains stable:Call expires worthless andthe trader still owns thestock shares.
Profits are limited to thepremium received on theshort call.
No profit is made.
Stock price decreases:Call expires worthless andthe trader still owns thestock shares.
The breakeven on the stockis lowered by the premiumreceived on the short call.
Losses accumulate asthe stock pricedeclines.
Figure 5.20
Covered Call versus Long Stock Strategy Comparison
COVERED WRITES
151Price of XYX = 711/2
Call Strike Price
September
October
3
123/48 7/8641/421/2
6570758085Figure 5.21
11 /4731/4115/163/4
XYX Call Option Premiums
it only allows the underlying stock to move 31/2 points before assignment. The September options do not offer high enough premiums to make them worthwhile positions. Instead, let’s create a covered call by selling 1 October XYX 80 Call @ 41/4against 100 shares of XYX stock purchased at 711/2.The maximum profit for this trade is the premium received for the short calloption plus the profit to be gained on the long stock. The maximum reward on theoption side of this position is $425. The maximum reward on the stock side of thisposition is $850. The maximum profit on this example of a covered call strategy is$1,275 (see Figure 5.22). The maximum risk is limited to the downside as XYXfalls below the breakeven to zero. The option side of this trade should not requirea heavy margin deposit to place because the short call option is covered by thelong stock.The breakeven on a covered call is calculated by subtracting the call premiumfrom the price of the underlying stock at initiation. In this example, thebreakeven is 671/4. XYX must drop below 671/4 for the trade to begin to take aloss. If the stock rises to or above 80, the call will be assigned. You can then usethe original XYX shares purchased at 711/2 to fulfill your obligation to deliver100 XYX shares to the option holder at 80, thereby garnering the maximumprofit of $1,275.
Covered Call: Long 100 Shares XYX@ 711/2, Short 1 October XYX80 Call @ 41/4Maximum risk = Limited to the price of theunderlying stock at initiation – short call premium
(711/2 – 41/4 ) × 100 = $6,725
Maximum reward = [Short call premium +(short call strike price – price of long underlyingasset)] × value per point
[41/4 + (80 –711/2)] × 100 = $1,275
Breakeven = Price of the underlying asset atinitiation – short call premium
711/2 – 41/4 = 671/4
Figure 5.22
Covered Call Results
152
THE VERSATILITY OF OPTIONS
The risk graph for this trade is shown in Figure 5.23. The profit line on thistrade slopes up from left to right, conveying the trader’s desire for the market priceof the stock to rise slightly. It also shows the trade’s limited protection. As XYXdeclines beyond the breakeven (671/4), the value of the position plummets as thestock falls to zero.Since a covered call only protects a stock within a specific range, it is vital tomonitor the daily price movement of the underlying stock. Let’s investigate optimalexit strategies in the following four scenarios:1. XYX rises above the short strike (80): The short call is assigned. You can usethe 100 shares from the original long stock position to satisfy your obligationto deliver 100 shares of XYZ to the option holder at $80 a share. This scenario allows you to take in the maximum profit of $1,275.2. XYX falls below the short strike (80), but above initial stock price (711/2):The short call expires worthless and you get to keep the premium received. Nolosses have occurred on the long stock position, and you are ready to place another covered call to offset the risk on the long stock position if you wish.3. XYX falls below the initial stock price (711/2), but stays above the breakeven(671/4): The long stock position starts to lose money, but this loss is offset bythe credit received from the short call. If XYX stays above 671/4, the positionwill break even or make a small profit.4. XYX falls below the breakeven (671/4): Let the short option expire worthlessand use the credit received to partially hedge the loss on the long stock position.Covered calls are the most popular option strategy used in today’s markets. Ifyou want to gain additional income on a long stock position, you can sell a slightlyOTM call every month. The risk lies in the strategy’s limited ability to protect the
Figure 5.23
Covered Call Risk Graph
COVERED WRITES
153
underlying stock from major moves down and the potential loss of future profits onthe stock above the strike price. Covered calls can also be combined with a numberof bearish options strategies to create additional downside protection.
Covered PutsIn a covered put strategy, you are shorting the underlying stock and selling a put option against it. This strategy is best implemented in a bearish to neutral marketwhere a slow fall in the market price of the underlying stock is anticipated. Thisstrategy’s profit-making ability depends on the short option’s ability to expireworthless at expiration. Therefore, although an option with more time yields ahigher premium, never sell puts in a covered put strategy with more than 45 daysuntil expiration. Too much time increases the chance of the market price movinginto a range where the short option is no longer effective at mitigating the loss onthe short stock position. However, if the short put is assigned, you can use the 100shares of the underlying stock you were obligated to buy at the put’s strike pricefrom the option holder to cover the short stock position and make the maximumprofit. This strategy requires a large margin deposit to place.Let’s create an example of a covered put strategy using the values in Figure 5.24with XYX trading at 711/2. Looking at the prices, the October 65 put is probably thebest trade available. To make the maximum profit, XYX needs to fall below $65. If theput option is assigned, you can then use the shares you are obligated to buy from theassigned option holder to cover the short stock position. You get to keep the premiumreceived from the short put plus receive the money accrued from the difference between the initial stock price (711/2) and the put strike price (65). The maximum rewardon the option side of this position is $400. The maximum reward on the stock side ofthis position is $650. This creates a maximum total profit of $1,050 (see Figure 5.25).The breakeven is calculated by adding the price of the underlying asset at initiation to the short put premium. In this example, the breakeven is 751/2. The maximumrisk is unlimited to the upside beyond the breakeven. This is a very important pointto remember. A covered put only offers limited protection on a short stock position.The risk graph of a covered put (see Figure 5.26) shows the profit/loss line slanting upward from right to left to a maximum profit of $1,050. As the underlyingstock rises above the breakeven, the loss on the position is unlimited.
Price of XYX = 711/2Put Strike Price6065707580Figure 5.24
September7/811/223/851/497/16
Put Option Premiums
October19/16461/4811/16101/2
154
THE VERSATILITY OF OPTIONSShort 100 Shares XYX @ 711/2 , Short 1 October XYX 65 Put @ 4
Maximum risk = Unlimited above the breakeven
Unlimited above 751/2
Maximum reward = [Short put premium + (priceof long underlying asset at initiation – short putstrike price)] × value per point
[4 + (711/2 – 65)] × 100 = $1,050
Breakeven = Price of the underlying asset atinitiation + short put premium
711/2 + 4 = 751/2
Figure 5.25
Covered Put Results
Figure 5.26
Covered Put Risk Graph
To make a profit on a covered put position, it is important to monitor the underlying stock to watch for breakouts above the breakeven. Let’s take a look at the exitstrategies in the following four scenarios:1. XYX falls below the short strike (65): The short put is assigned. You can usethe 100 shares you are obligated to buy at the short put strike price to coverthe original short stock position. This scenario allows you to take in the maximum profit of $1,050.2. XYX rises above the short strike (65), but below the initial stock price (711/2):The short put expires worthless and you get to keep the premium received. Nolosses have occurred on the short stock position and you are ready to place another covered put to bring in additional profit on the position if you wish.3. XYX rises above the initial stock price (711/2) but stays below the breakeven(751/2): The short stock position starts to lose money, but this loss is offset bythe credit received from the short put. As long as the stock stays below thebreakeven, the position will break even or make a small profit.4. XYX rises above the breakeven (751/2): Let the short put expire worthless anduse the credit received to partially hedge the loss on the short stock position.
ROADMAP TO SUCCESS
155
Covered puts enable traders to bring in some extra premium on short positions.Once again, you can keep selling a put against the short shares every month to increase your profit. However, shorting stock is a risky trade no matter how you lookat it because there is no limit to how much you can lose if the price of the stock risesabove the breakeven. There are many other ways to take advantage of a stock’sbearish movement using options to limit the trade’s risk and maximize the leveraging ability of your trading account.Options are effective trading tools. In the beginning, options trading will mostlikely be a little confusing. But, hopefully, the terms discussed in this introductorychapter will help you locate and understand specific information that can be used tofind profitable trades. Options are the mainstay of my trading approach, and I havespent the past decade of my life perfecting their implementation. They have becomean indispensable part of my hedge trading operation. I highly encourage you tolearn more about them. I am positive that they will enable you to maximize your returns if you take the time to learn how to use them correctly.
ROADMAP TO SUCCESSObjective
Course of Action
Understand calloption basics.
• Call options give traders the right to buy the underlying stockat the strike price until market close on the third Friday ofthe expiration month.• A call option is in-the-money (ITM) if its strike price is belowthe current price of the underlying stock.• A call option is out-of-the-money (OTM) if its strike price isabove the current price of the underlying stock.• A call option is at-the-money (ATM) if its strike price is thesame as (or close to) the current price of the underlying stock.
Understand theprocess of buyingcalls.
• If bullish—believe the market will rise—buy (go long) calls.• Buyers have rights. A call buyer has the right, but not theobligation, to buy the underlying stock at the strike priceuntil the expiration date.• If you buy a call option, your maximum risk is the moneypaid for the option, the debit.• The maximum profit is unlimited depending on the rise inthe price of the underlying asset.• To offset a long call, you have to sell a call with the same strikeprice and identical expiration date to close out the position.• By exercising a long call, you are choosing to purchase 100shares of the underlying stock at the strike price of the calloption.
Understand theprocess of sellingnaked calls.
• If bearish—believe the market will fall—sell (go short) calls.• Sellers have obligations. If a call is assigned, the call seller hasthe obligation to buy 100 shares of the underlying stock atthe strike price from the person to whom the option was sold.
156
THE VERSATILITY OF OPTIONS• If you sell a call option, your risk is unlimited to the upside.• The profit is limited to the credit received from the sale of thecall.• When selling calls, make sure to choose options with littletime left until expiration. Call sellers want the call to expireworthless so that they can keep the whole premium.• To offset a short call, you have to buy a call with the samestrike price to close out the position.• Selling naked calls is an extremely risky strategy that comeswith unlimited risk.
Understand putoption basics.
• Put options give traders the right, but not the obligation, tosell the underlying stock at the strike price until market closeon the third Friday of the expiration month.• A put option is in-the-money (ITM) if its strike price is abovethe current price of the underlying stock.• A put option is out-of-the-money (OTM) if its strike price isbelow the current price of the underlying stock.• A put option is at-the-money (ATM) if its strike price is thesame as (or close to) the current price of the underlying stock.
Understand theprocess of buyingputs.
• If bearish—believe the market will fall—buy (go long) puts.• Buyers have rights. A put buyer has the right, but not theobligation, to sell the underlying stock at the strike price untilthe expiration date.• If you buy a put option, your risk is the money paid for theoption, the debit.• The profit is unlimited depending on the fall in the price ofthe underlying asset.• To offset a long put, you have to sell a put with the samestrike price and identical expiration date to close out theposition.• By exercising your long put, you are choosing to go short theunderlying stock at the strike price of the put option.
Understand theprocess of sellingnaked puts.
• If bullish—believe the market will rise—sell (go short) puts.• Sellers have obligations. A put seller has the obligation tobuy 100 shares (per option) of the underlying stock at the putstrike price from the option holder if the put is assigned.• If you sell a put option, your risk is unlimited as theunderlying stock falls to zero.• The profit is limited to the credit received from the sale of theput.• When selling puts, make sure to choose options with littletime left until expiration. Put sellers want a put to expireworthless so that they can keep the whole premium.• To offset a short put, you have to buy a put with the samestrike price and expiration to close out the position.• Selling naked puts is an extremely risky strategy that comeswith unlimited risk as the underlying stock falls to zero.
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157
Understand how to • Choose a higher-strike call no more than two months out tocreate a coveredsell against long shares of the underlying stock.call trade.• The maximum potential profit is the credit received from theshort call option,