, but if the stock rises, this income might mean very little. Let’s useRambus  (RMBS)  once  again  to  show  how  a  covered  put  would  haveworked for this stock when compared to a covered call.
By entering a short put, we have limited risk to the downside all theway to zero. At the same time, we have unlimited risk to the upside and alarge margin requirement for selling the stock short. Let’s assume we didn’talready own Rambus, so we need to sell short 500 shares at $30 and sellﬁve December 30 puts. Remember, RMBS shares were trading right at $30a share, so we would be able to keep the entire premium from the put if thestock  closes  at  or  above  this  point.  However,  as  the  stock  declines,  weproﬁt from being short on Rambus.
The December 30 puts could be sold for 2.10 each and Rambus sharescould  be  sold  short  for  $30  a  share.  Thus,  we  would  receive  a  credit  of$16,050 for entering the covered put. However, the maximum proﬁt wouldbe limited to just $1,050. The best way to see this is by looking at a riskgraph of the trade shown in Figure 4.19. Notice how the risk continues togrow  as  the  stock  moves  higher.  This  is  because  the  amount  of  moneybrought in from selling the put does little to offset the potential loss ob-tained from selling RMBS shares short. However, no matter how low thestock  moves,  our  maximum  proﬁt  is  achieved  because  the  gain  in  theshort stock will offset the loss in the short put.
In our example, shares of RMBS did try several times to break higher,but each time resistance held and the stock ultimately closed at 26.37 onexpiration  (December  19).  This  would  have  resulted  in  the  maximumproﬁt of $1,050. The short put would have had a value of 3.70 to buy backon  expiration.  This  results  in  a  loss  of  1.60  each  (or  $800  for  ﬁve  con-tracts) for the put. However, the 500 shares of RMBS sold short are now
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tiforP
050,1
0
000,1–
000,2–
000,3–
000,4–
000,5–
000,6–
Today: 18 days left 12 days left 6 days leftExpiry:  0 days left
Close= 
30.00
15 
20 
25 
30 
35 
  40  
FIGURE 4.19 Risk Graph of Covered Put on RMBS (Source: Optionetics Platinum © 2004)
showing a proﬁt of 3.63: (30 – 26.37). This means the proﬁt from the shortstock is $1,815: (3.63 × 500). If the option were not bought back, the traderwould be forced to buy shares to cover the short, but the net result wouldstill be a proﬁt.
This might seem like a good way to bring in premium on a stock ex-pected  to  move  lower.  However,  the  margin  required  would  be  largeand  the  risk  is  normally  just  too  high  to  be  a  consistently  proﬁtablestrategy.
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Covered Put Case Study
Strategy: With the stock trading at $30 a share on December 1, sell 5 De-cember 30 puts @ 2.10 each and sell short 500 shares of Rambus stock.
Market  Opportunity: Expect  consolidation  in  shares  after  failure  tobreak out.
Maximum Risk: Unlimited to the upside above the breakeven.
Maximum Proﬁt: Limited to the credit received on the short put option +the price of security sold – put option strike price × 100. In this case, themaximum proﬁt is $1,050: (5 × 210) + (30 – 30) × 100 = $1,050.
Breakeven: Strike price + put option credit. In this case, 32.10: (30 + 2.10).
Margin: Signiﬁcant.
STRATEGY ROAD MAPS
For  your  convenience,  the  following  subsections  provide  step-by-stepanalyses of the basic strategies discussed in this chapter.
Long Call Road Map
In order to place a long call, the following 13 guidelines should be observed:
1. Look for a low-volatility market where a rise in the price of the under-
lying stock is anticipated.
2. Check to see if this stock has liquid options available.3. Review  options  premiums  with  various  expiration  dates  and  strike
prices. Use options with more than 90 days until expiration.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. Look for options with low implied volatility.5. Review  price  and  volume  charts  over  the  past  year  to  explore  price
trends and liquidity.
6. Choose  a  long  call  option  with  the  best  proﬁt-making  probability.
Determine which call option to purchase by calculating:• Limited Risk: Limited to the initial premium required to purchase
the call.
• Unlimited  Reward: Unlimited  to  the  upside  as  the  underlying
stock rises above the breakeven.
• Breakeven: Call strike + call premium.
7. Create a risk proﬁle for the trade to graphically determine the trade’sfeasibility. The long call’s risk proﬁle slants upward from left to right.
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8. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a proﬁt andloss percentage that will trigger an exit of the position. Close out theentire trade by 30 days to expiration.
10. Contact your broker to buy the chosen call option. A margin deposit is
not required.
11. Watch the market closely as it ﬂuctuates. If the market continues torise, hold onto the call option until you have made a satisfactory proﬁtor a reversal seems imminent.
12. If the underlying market gives a dividend to its stockholders, this willhave a negative effect on the price of a call option because a dividendusually results in a slight decline in the price of a stock.
13. Choose an exit strategy based on the price movement of the underly-ing  stock  and  the  effects  of  changes  in  the  implied  volatility  of  thecall option:
• The market rises above the breakeven: Offset the position byselling a call option with the same strike price and expiration at anacceptable proﬁt; or exercise the option to purchase shares of theunderlying  market  at  the  lower  strike.  You  can  then  hold  theseshares as part of your portfolio or sell them at a proﬁt at the currenthigher market price.
• The  market  falls  below  the  breakeven: If  a  reversal  does  notseem likely, contact your broker to offset the long call by selling anidentical call to mitigate your loss. The most you can lose is theinitial premium paid for the option.
Short Call Road Map
In order to place a short call, the following 13 guidelines should be observed:
1. Look for a high-volatility market where a fall in the stock’s price is
anticipated.
2. Check to see if this stock has liquid options available.3. Review  options  premiums  with  various  expiration  dates  and  strike
prices. Options with less than 45 days until expiration are best.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced  or  undervalued.  Look  for  options  with  high  implied  volatilityand, thus, a higher premium.
5. Review  price  and  volume  charts  over  the  past  year  to  explore  price
trends and liquidity.
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6. Choose a short call option with the best proﬁt-making probability.
Determine which call option to sell by calculating:
• Unlimited  Risk: Unlimited  to  the  upside  as  the  underlying  stock
rises above the breakeven.
• Limited Reward: Limited to the initial call premium received as a
credit.
• Breakeven: Call strike + call premium.
7. Create  a  risk  proﬁle  for  the  trade  to  graphically  determine  thetrade’s  feasibility.  A  short  call’s  risk  proﬁle  slants  down  from  left to  right  showing  the  limited  proﬁt  and  unlimited  risk  as  the  stockrises.
8. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
9. Make  an  exit  plan  before  you  place  the  trade.  Determine  a  proﬁtand  loss  percentage  that  will  trigger  an  exit  of  the  position.  For example,  a  50  percent  proﬁt  or  loss  is  an  easy  signal  to  exit  the position.
10. Contact your broker to go short (sell) the chosen call option. Marginis required to place a short call, the amount of which depends on yourbroker’s discretion.
11. Watch the market closely as it ﬂuctuates. If the price of the underlyingstock rises above the strike price of the short call option, it is in dan-ger  of  being  assigned.  If  exercised,  the  option  writer  is  obligated  todeliver 100 shares (per option) of the underlying asset at the short callstrike price to the option holder.
12. If the underlying market gives a dividend to its stockholders, this willusually  cause  the  price  of  the  call  option  to  decline  slightly,  whichworks in favor of the short call strategy.
13. Choose an exit strategy based on the price movement of the under-lying stock and the effects of changes in the implied volatility of thecall option:
• The market falls below the strike price: Wait for the call toexpire worthless and keep the credit received from the premium.• The market reverses and begins to rise above the call strikeprice: Exit the position by offsetting it through the purchase of anidentical  call  option  (same  strike  price  and  expiration  date)  toavoid assignment.
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Covered Call Road Map
In order to place a covered call, the following 13 guidelines should beobserved:
1. A  covered  call  is  a  conservative  income  strategy  designed  to  pro-vide limited protection against decreases in the price of a long un-derlying stock position. Look for a range-bound market or a bullishmarket  where  you  anticipate  a  steady  increase  in  the  price  of  theunderlying stock.
2. Check to see if the stock has liquid options.3. Review  call  option  premiums  and  strike  prices  no  more  than  45
days out.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. Look for expensive options to get the most outof selling the call.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. Choose a higher strike call no more than 45 days out to sell againstlong shares of the underlying stock and then calculate the maximumproﬁt, which is limited to the credit received from the sale of the shortcall plus the proﬁt made from the difference between the stock’s priceat initiation and the call strike price.
7. Determine which spread to place by calculating:
• Limited Risk: Limited to the downside as XYZ can only fall below
the breakeven to zero.
• Limited Reward: Limited to the credit received from the short call
plus the strike price minus the initial stock price.
• Breakeven: Calculated by subtracting the short call premium from
the price of the underlying stock at initiation.
8. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically  determine  the  trade’s  feasibility.  Note  the  unlimited  riskbeyond the breakeven.
9. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
10. Make an exit plan before you place the trade. You must be willing to sellthe long stock at the short call’s strike price in case the call is assigned.
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11. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.12. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy isunlimited—a  loss  occurs  if  the  underlying  stock  closes  at  or  belowthe breakeven points. You can also adjust the position back to a deltaneutral to increase proﬁt potential.
13. Choose an exit strategy depending on the movement of the underlying
stock:
• The price of the stock rises above the short strike: The shortcall  is  assigned  and  exercised  by  the  option  holder.  You  can  thenuse the 100 shares from the original long stock position to satisfyyour obligation to deliver 100 shares of the underlying stock to theoption holder at the short call strike price. This scenario allows youto take in the maximum proﬁt.
• The price of the stock falls below the short call strike price,but stays above the initial stock price: The short call expiresworthless  and  you  get  to  keep  the  premium  received.  No  losseshave occurred on the long stock position and you are ready to sellanother call to offset your risk.
• The stock falls below the initial stock price but stays abovethe breakeven: The long stock position starts to lose money, butthis loss is offset by the credit received from the short call. As longas  the  stock  does  not  fall  below  the  breakeven,  the  position  willbreak even or make a small proﬁt.
• The  stock  falls  below  the  breakeven: Let the short option ex-pire  worthless  and  use  the  credit  received  to  partially  hedge  theloss on the long stock position.
Long Put Road Map
In order to place a long put, the following 13 guidelines should be observed:
1. Look for a low-volatility market where a steady decrease in price is
anticipated.
2. Check to see if this stock has liquid options available.3. Review  options  premiums  with  various  expiration  dates  and  strike
prices. Use options with more than 90 days to expiration.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. Look for options with low implied volatility.
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5. Review  price  and  volume  charts  over  the  past  year  to  explore  past
price trends and liquidity.
6. Choose a long put option with the best proﬁt-making probability. De-
termine which option to buy by calculating:
• Limited Risk: Limited to the initial premium required to purchase
the put option.
• Limited Reward: Limited to the downside as the underlying stock
can only fall to zero.
• Breakeven: Put strike – put premium.
7. Create a risk proﬁle for the trade to graphically determine the trade’s
feasibility. The proﬁt/loss line slopes up from right to left.
8. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a proﬁt andloss percentage that will trigger an exit of the position. Close out theentire trade by 30 days to expiration.
10. Contact your broker to buy the chosen put option. A margin deposit is
not required.
11. Watch the market closely as it ﬂuctuates. If the market continues tofall, hold onto the put option until you have hit your target proﬁt or areversal seems imminent.
12. If the underlying market gives a dividend to its stockholders, this willhave a positive effect on the price of a put option because a dividendusually results in a slight decline in the price of a stock.
13. Choose an exit strategy based on the price movement of the underly-ing  stock  and  the  effects  of  changes  in  the  implied  volatility  of  theput option:
• The  underlying  stock  falls  below  the  breakeven: Either offsetthe long put by selling a put option with the same strike and expira-tion at an acceptable proﬁt or exercise the put option to go short theunderlying market. You can hold this short position or cover the shortby buying the shares back at the current lower price for a proﬁt.
• The  underlying  stock  rises  above  the  breakeven:  You  canwait for a reversal or offset the long put by selling an identical putoption and using the credit received to mitigate the loss. The mostyou can lose is the initial premium paid for the put.
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Short Put Road Map
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In order to place a short put, the following 13 guidelines should be observed:
1. Look for a high-volatility market where an increase or steady rise is
anticipated.
2. Check to see if this stock has liquid options available.3. Review  options  premiums  with  various  expiration  dates  and  strike
prices. Options with less than 45 days to expiration are best.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. Look for options with high implied volatility,and thus a higher premium.
5. Review  price  and  volume  charts  over  the  past  year  to  explore  past
price trends and liquidity.
6. Choose  a  short  put  option  with  the  best  proﬁt-making  probability.
Determine which put option to sell by calculating:
• Limited Risk: Limited to the downside below the breakeven as the
underlying stock can only fall to zero.
• Limited Reward: Limited to the initial put premium received as a
credit.
• Breakeven: Put strike – put premium.
7. Create a risk proﬁle for the trade to graphically determine the trade’sfeasibility.  The  risk  graph  slopes  down  from  right  to  left,  showing  alimited proﬁt.
8. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a proﬁt and
loss percentage that will trigger an exit of the position.
10. Contact  your  broker  to  sell  the  chosen  put  option.  This  strategy requires  a  margin  deposit;  the  amount  depends  on  your  broker’s discretion.
11. Watch the market closely as it ﬂuctuates. If the price of the underly-ing stock falls below the short strike price, it will most likely be as-signed. If exercised, the option writer is obligated to purchase 100shares of the underlying asset at the short strike price (regardlessof the decrease in the price of the underlying stock) from the optionholder.
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12. If the underlying market gives a dividend to its stockholders, this willhave a negative effect on the price of a short put because a dividendusually results in a slight decline in the price of a stock.
13. Choose an exit strategy based on the price movement of the underly-ing stock and the effects of changes in the implied volatility of the putoption:
• The  underlying  stock  continues  to  rise  or  remains  stable:Wait for the option to expire worthless and keep the credit receivedfrom the premium.
• The  underlying  stock  reverses  and  starts  to  fall: Exitthe position by offsetting it through the purchase of an identicalput  option  (same  strike  price  and  expiration  date)  to  avoid assignment.
Covered Put Road Map
In  order  to  place  a  covered  put,  the  following  13  guidelines  should  beobserved:
1. Look for a range-bound market or bearish market where you antici-
pate a slow decrease in the price of the underlying stock.
2. Check to see if this stock has options.3. Review  put  option  premiums  and  strike  prices  no  more  than  45
days out.
4. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
5. Investigate  implied  volatility  values  to  see  if  the  options  are  over-
priced or undervalued.
6. Choose  a  lower  strike  put  no  more  than  45  days  out  to  sell  against
short shares of the underlying stock.
7. Determine which trade to place by calculating:
• Unlimited  Risk: The  maximum  risk  is  unlimited  to  the  upside
above the breakeven. Requires margin to place.
• Limited Reward: The maximum proﬁt is limited to the credit re-ceived  from  the  sale  of  the  short  put  option  plus  the  proﬁt  madefrom the difference between the stock’s price at initiation and theshort put strike price.
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• Breakeven: Calculated  by  adding  the  short  put  premium  to  the
price of the underlying stock at initiation.
8. Risk is unlimited to the upside as the underlying asset rises above thebreakeven. Create a risk proﬁle for the trade to graphically determinethe trade’s feasibility.
9. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
10. Choose your exit strategy in advance. How much money is the maxi-mum amount you are willing to lose? How much proﬁt do you want tomake on the trade?
11. Contact your broker to sell the stock and sell the chosen put optionagainst it. Choose the most appropriate type of order (market order,limit order, etc.). This strategy will require a large margin to place,depending on your brokerage’s requirements.
12. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited.  Keep  in  mind  that  an  unlimited  loss  occurs  if  and  when  theunderlying stock rises above the breakeven point.
13. Choose an exit strategy:
• The price of the stock falls below the short put strike price:The short put is assigned to an option holder. You can then use the100 shares you are obligated to buy at the short put strike price tocover the original short stock position. This scenario allows you totake in the maximum proﬁt.
• The price of the stock rises above the short strike, but staysbelow  the  initial  stock  price: The  short  put  expires  worthlessand you get to keep the premium received. No losses have occurredon  the  short  stock  position  and  you  are  ready  to  place  anothershort  put  position  to  bring  in  additional  proﬁt  on  the  short  stockposition if you wish.
• The price of the stock rises above the initial stock price, butstays  below  the  breakeven: The  short  stock  position  starts  tolose money, but this loss is offset by the credit received from theshort  put.  As  long  as  the  stock  doesn’t  rise  above  the  breakeven,the position will break even or make a small proﬁt.
• The  price  of  the  stock  rises  above  the  breakeven: Let  theshort put expire worthless and use the credit received to partiallyhedge the increasing loss on the short stock position.
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THE OPTIONS COURSE
Having  been  involved  in  teaching  options  strategies  for  more  than  adecade, I’m still amazed by the lack of knowledge pertaining to what I be-lieve  is  the  most  ﬂexible  investment  vehicle  available:  the  option.  Thenumber one question I receive from publications, individual investors, andalmost everyone I meet is: Why should anyone trade options? After all, op-tions are so risky. This line of reasoning makes me cringe. It’s obvious thateducators, brokers, and the overall investment community simply haven’tdone a good enough job informing investors of the beneﬁts of trading op-tions.  Yes,  there  are  risks  if  you  haven’t  taken  the  time  to  learn  how  totrade  options.  But  that  goes  for  stocks,  too!  Knowledge  is  power.  In  myopinion, every trader should attain enough knowledge to be able to makeinformed  decisions  about  whether  to  include  options  as  part  of  their investment arsenals.
The initial eight strategies covered in this chapter—long stock, shortstock, long call, short call, covered call, long put, short put, and coveredput—are  the  fundamental  building  blocks  of  intermediate  and  advancedtrading techniques. It is absolutely essential to your success as an optionstrader  to  develop  a  solid  understanding  of  these  basic  strategies.  Yourknowledge level is what will ultimately determine how successful you willbe. The primary reason that beginning traders do not last is because theydo not educate themselves enough. The more knowledge you have in yourﬁeld, the more conﬁdence you have, and that will inevitably enhance yourtrading results. I am still learning and trying to increase my trading savvyon a daily basis. This is the type of hunger for knowledge that you need tohave—not only to thrive, but also to survive in the volatile markets of thetwenty-ﬁrst century.
Covered  calls  are  the  most  popular  option  strategy  used  in  today’smarkets. If you want to gain additional income on a long stock position,you can sell a slightly OTM call every month. The risk lies in the strategy’slimited  ability  to  protect  the  underlying  stock  from  major  moves  downand the potential loss of future proﬁts on the stock above the strike price.Covered  calls,  however,  can  be  combined  with  a  number  of  bearish  op-tions strategies to create additional downside protection.
While covered calls are a very popular strategy, covered puts enabletraders  to  bring  in  some  extra  premium  on  short  positions,  but  withhigh  risk  involved.  Once  again,  you  can  keep  selling  a  put  against  theshort  shares  every  month  to  increase  your  proﬁt.  However,  shortingstock is a risky trade no matter how you look at it because there is nolimit to how much you can lose if the price of the stock rises above thebreakeven.  There  are  many  other  ways  to  take  advantage  of  a  stock’sbearish movement, using options to limit the trade’s risk and maximize
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the leveraging ability of your trading account. In fact, we will cover 19additional strategies in this book.
Covered writes also enable traders to weather moderate price ﬂuctua-tions  without  accumulating  losses.  This  should  help  reduce  stress;  anytechnique that helps to reduce stress is a worthwhile addition to a trader’sarsenal. To gain added protection, try buying a long put against a coveredcall or a long call against a covered put. The extra outlay of premium actsas an insurance policy, and that could mean the difference between losinga little on the premium versus taking a heavy loss in a volatile market.
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CHAPTER 5
IntroducingVerticalSpreads
S ince all markets have the potential to ﬂuctuate beyond their normal
trend, it is essential to learn how to apply strategies that limit yourlosses to a manageable amount. A variety of options strategies canbe employed to hedge risk and leverage capital. Each strategy has an opti-mal  set  of  circumstances  that  will  trigger  its  application  in  a  particularmarket. Vertical spreads are basic limited risk strategies, and that’s why Itend to introduce them ﬁrst. These relatively simple hedging strategies en-able traders to take advantage of the way option premiums change in rela-tion to movement in the underlying asset.
Vertical spreads offer limited potential proﬁts as well as limited risks by