.
CONCLUSIONStrategists have two vehicles from which to choose when trading the index market: (1) shares of exchange-traded funds or (2) options on the underlying index or exchange-traded fund. The options contracts are similarto stock options. They come in two types: puts and calls. Finding quotes,creating options chains, and developing risk graphs are the same for bothstocks and indexes.Index options, however, also have unique characteristics that makethem different from stock options. Before developing strategies on the indexmarket, traders want to ask a series of questions including the following:• Does this product settle for cash or shares?• Is the last day to trade the option on a Thursday or a Friday?• Do these options settle American- or European-style?If uncertain, strategists can obtain product specification informationfrom the various web sites where the index options trade. Please seeChapter 15 for a list of index web site addresses.
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large number of options strategies have been covered in detail inour three previously published books: The Stock Market Course,The Options Course, and The Volatility Course. In order to preventtoo much repetition, this book does not provide an overview of all optionsstrategies. Instead, we prefer to focus on identifying profit-making opportunities in the index market using trading strategies such as market timing, sector rotation, and system trading. All of these important issues arediscussed in greater detail in later chapters.For now, we continue the foundational task of building a knowledgebase, beginning with a discussion about basic options strategies. Readerswho already understand strategies such as long calls, covered calls, andvertical spreads are encouraged to skim through this chapter and move onto the next. However, since options are used extensively throughout laterchapters, a thorough understanding of these basic strategies is a must!
LONG CALLWe have already introduced the basics of options trading, including themost fundamental strategy, the long call. The term long is used often andsimply means that the trader is holding a position. For example, if a traderis “long 100 shares of SMH,” he or she has purchased and is holding sharesof the Semiconductor HOLDRs in hope that the price will move higher. Onthe other hand, a short position is one where the trader borrows shares73
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from the brokerage to “short sell,” in the belief that the asset will declinein price. In the strategies used here, traders can be long or short shares,puts, or call options.So, as the term implies, a long call is simply buying and holding a calloption. We saw this trade in our discussion about risk graphs in the previous chapter. Specifically, we analyzed the Semiconductor HOLDRs tradingnear $35 a share and assumed that a trader purchased one December 35call for $1.25 a contract. So the total premium is $125 for one contract,which gives the owner the right to buy (“call”) 100 shares of the SMH for$35 per share.To compute the breakeven, the cost of the option contract (the premium) is added to the strike price of the call . In this case, the breakevenis $36.25 ($35 + $1.25). Traders will often exit the long call strategy beforeexpiration if the underlying asset moves dramatically higher or lower. If itjumps higher, the call can be sold at a profit in most cases (although timedecay and volatility will also affect the premium). If the underlying assetfalls in price, the long call position can be closed at a loss. If it falls belowthe strike price and is not sold, it expires worthless.The Long and Short of ItLong: A term used to describe an ownership position in a stock, option,or other investment. Being long shares and calls is a bullish strategy thatproﬁts when the price of the asset moves higher. Being long puts proﬁts ina bearish market when the price of the underlying asset moves lower.Short: A term used to describe the selling of a stock, option, or other investment. Stocks are best sold short in bearish markets when the shareprice moves lower. Selling a call is a bearish strategy while selling a put isa bullish one. When selling stock, a short seller borrows shares from thebroker and sells them at the current market price. The shares are eventually bought back and returned to the broker. Investors can also short putsand calls. However, options contracts are not borrowed from the broker.Instead, a short put or call can be established at any time, if the broker allows this type of strategy. In some cases, the broker will not allow shortselling of options because of the risks involved.
When do long calls make sense? Since the premium is relatively smallcompared to the price of the underlying asset itself, the trade is relativelyinexpensive. Therefore, call buyers are often speculators betting on amove higher in a stock, index, or exchange-traded fund. Basically, the longcall provides a low-cost way of profiting from a move higher in the underlying asset. In sum, the strategy works well when the strategist expects
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the underlying asset to move higher and wants some leverage. It is anaggressive trade.For example, suppose the strategist expects chip stocks to make a runtoward the end of the year. In 2003 and 2004, the technology sector did wellduring November and December. Consequently, during mid-October, thestrategist makes an aggressive play by purchasing the December 35 callson the Semiconductor HOLDRs. The SMH is trading near $35 a share atthe time. The calls cost $1.25 a contract.The risk graph of the SMH December 35 call was explained in the previous chapter. We see it again in Figure 5.1. The risk graph gives us a visual display of the profit/loss potential of the trade. For example, the costof the trade is the entry debit of $125, which is the premium ($1.25) timesthe multiplier (100). Since the trade was just established, the profit is zero;the option has not increased or decreased in value. The potential profit isunlimited, however, and will rise along with the price of the SMH. For example, if the SMH rises to $70 (unlikely but possible) before expiration,the value of the December 35 call will rise to $35 per contract, or $3,500,plus any remaining time value. Therefore, the long call has relatively lowrisk equal to the premium paid, but high profit potential.The long call can be used to profit from a rise in the underlying ETF orindex. When using this approach, the strategist faces several important
FIGURE 5.1 SMH December Long Call Risk Graph (Source: www.Optionetics.comPlatinum)
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questions. These include which option strike price and expiration datesare best when looking to profit from a move higher in the underlying asset. Out-of-the-money strike prices provide greater leverage (because thepremiums are smaller), but they also have a greater chance of expiringout-of-the-money. Short-term options will see a faster rate of time decayand therefore are better used when the expected holding period is short.Given these considerations, the strategist will use short-term at-themoney or out-of-the-money options when bullish and looking for an aggressive move higher. Longer-term and in-the-money options are betterwhen looking longer-term and expecting a more moderate move higher.The exit strategy is also important. In fact, the success of any trade requires an understanding of not just when to buy but also when to sell. Often overlooked by new traders, the exit is just as important as the entry.The long call strategist may be looking for a percentage gain as large as 50or 100 percent, which is not unusual, but the key, of course, is timing. Thissubject is discussed in greater detail later in the book.Putting the question of timing aside for now, call options with a fewweeks of life remaining will see a relatively fast rate of time decay, particularly for at-the-money options. Given this characteristic, the long callshould generally be closed out well before expiration due to the negativeimpact of time decay. For that reason, we often suggest exiting any longcall position at least 30 days prior to expiration.The worst-case scenario for a long call trade is that the stock pricefalls and the call option expires worthless. Therefore, the strategist willoften establish a maximum loss threshold for exiting the trade. For instance, if the call loses more than 25 percent of its value, close the trade. Asecond approach would be to exit the option position if SMH falls below$34.50 a share. These specific exit points are called stop-losses.On the other hand, if the stock price moves higher, the strategist canexercise the option or close it at a profit. In most cases, the call will beclosed out through an offsetting trade rather than exercised. Exercisegenerally doesn’t make sense unless there is no time value remaining inthe option and the strategist specifically wants to be long the shares.
Opening and Closing TransactionsAn opening transaction occurs when an option strategist initiates a position. For instance, if a trader buys 10 QQQQ calls in anticipation of a movehigher in the Qs, it is an opening transaction.An offsetting or closing transaction cancels an open position. It is accomplished by doing the opposite of the opening transaction. For example,
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Opening and Closing Transactions (Continued)if the trader wants to cancel the long 10 QQQQ calls, 10 QQQQ calls willbe sold to close. There are four ways to offset an option transaction:1. If you bought a call, you have to sell a call.2. If you sold a call, you have to buy a call.3. If you bought a put, you have to sell a put.4. If you sold a put, you have to buy a put.
THE SHORT CALLIn a short call trade, the strategist is selling call options to establish a position. It is a bearish strategy because it works best when the price of theunderlying asset is expected to fall. However, if the strategist sells an outof-the-money call, the trade can yield profits even if the underlying assetprice stays flat or moves higher. As long as the short call expires worthless, the call writer is generally okay.However, the risk to the short call is that the underlying asset movesto the upside. If the price of the underlying asset makes a big move higher,the call writer can run into trouble. In fact, there is no limit to the potential losses from a short call because, theoretically, there is no limit as tohow high the price of an asset can climb.Let’s consider an example. The strategist expects the market totrade flat or modestly lower during the final two months of the year. Tocapitalize on this expectation, a short call is established in early November on the SPDRs (SPY), which is trading near $121 a share. The strategist sells 10 of the SPY 125 December 2005 calls for $0.70 a contract. Thesale brings in premium of $700 ($0.70 × 10 contracts × 100), which thestrategist will keep as long as the SPY stays below $125 by December2005 expiration.Figure 5.2 shows the risk profile of the short call position. Notice howthe profit/loss lines slant upward and to the left. The line furthest to theright represents the risk at expiration. It confirms that if the SPY stays below $125 a share, the strategist can keep the entire credit of $700. However, once the SPDRs climb above $125, the curve begins to slant in.The trade breaks even at $125.70, while the short calls are likely assigned at $125 and higher. To avoid possible assignment the strategist canpurchase the calls back at approximately $0.70 to offset the position priorto expiration. As an alternate approach, the strategist can buy the sharesfor $125.70 to satisfy assignment. However, these shares are then assigned
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FIGURE 5.2 SPY December Short Call Risk Graph (Source: www.Optionetics.comPlatinum)
(sold) for $125 and the transaction realizes a $0.70 per share loss. Sinceselling 10 calls is a commitment to sell 1,000 shares, the assignment results in a $700 loss—the premium received for selling the 10 SPY December 125 calls. In short, the breakeven is equal to the strike price plus thepremium received from the short call. The losses begin to pile up asshares rise above $125.70.The call’s potential loss is unlimited. Losses continue to increase asthe price of the underlying asset rises above the breakeven, and there istheoretically no limit to how high it can go. Therefore, given the risks involved, the short call is not a recommended strategy for private investors. It is generally less risky when applied to the index market thanto stocks because an exchange-traded fund or an index is less likely toexperience a one-day surge that might sometimes take shares of an individual company higher.For instance, imagine selling calls on Google (GOOG) when itstarted trading in August 2004, only to see it double from $100 to $200 ashare in the months that followed. Say a trader sold the October 100calls for $8 a contract, assuming the stock would fall shortly after thecompany’s IPO, and then waited until October expiration to cover. Lessthan two months later, those same calls were trading for $44 a contract.Therefore, the strategist would be buying back the contracts for a $36loss, or $3,600 per contract!
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Obviously, selling naked calls can be a tough way to make a living. Anindex is not likely to make such a dramatic move. Nevertheless, the lossesfrom a naked call gone awry can be significant, especially when dealingwith the large cash-settlement indexes such as the S&P 500 Index or theNASDAQ 100 Index. So instead of using naked calls, strategists who wantto sell premium in a down market might want to focus on an optionsspread strategy, such as the bear call spread.
BEAR CALL SPREADSTraders who sell options receive credits into their trading accounts equalto the premium of the options. In the Google example, the premium forselling the October 100 call was $8, or $800 per contract. Selling optionsmay be used to generate income from a portfolio; however, as we havenoted, the risks can be great. The bear call spread is a vertical creditspread strategy that profits from selling options, but with significantly lessrisk than naked option selling.A bear call spread consists of selling a lower strike call and buying ahigher strike call using the same number of options and identical expiration dates. The trade works when the underlying asset closes below thestrike of the short option. Therefore, a bear call spread works when thestrategist is bearish or neutral on the underlying asset.The bear call spread offers limited profit potential with limited risk.The maximum reward is achieved when the closing price of the underlying security is below the lower strike call. In that case, both calls expireworthless and the strategist can keep the credit from the trade. The maximum risk is equal to the difference between strike prices minus the netcredit, and occurs when the price of the underlying asset closes at orabove the strike price of the long option.To see how the bear call spread works in the real world, let’s consideran example using the AMEX Airline Index ($XAL). It’s late November andthe airline sector has been strong, but the strategist expects the group tohit some turbulence early next year. With the airline index trading near 51,the strategist sells the January 50 call for $4.00 and hedges that bet withthe purchase of a January 60 call for $0.25 a contract. So the bear callspread consists of a short January 50 call and a long January 60 call.Figure 5.3 shows the risk graph of the bear call spread on the AMEX Airline Index. The profit potential is limited and occurs if the airline index losesaltitude before the options expire. The maximum profit is equal to the premium received for selling the XAL January 50 call minus the premium paidfor the long call, or $375 per contract [($4.00 – $0.25) × 100]. The maximumprofit is therefore $375 and occurs if the XAL falls below 50 at expiration.
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FIGURE 5.3 XAL January Bear Call Spread Risk Graph (Source: www.Optionetics.com Platinum)
Losses begin to occur if airlines begin to drift northward. The breakevenis equal to the strike price of the short call plus the net premium received forselling the spread ($50 + $3.75 = $53.75). Beyond that price, the spread willbegin to lose money as expiration approaches. For instance, if the value ofthe XAL is 55 at expiration, the trade will lose $1.25 per spread.However, the long call will cap the losses once the XAL reaches $60.At this point, if the short call is assigned at 50, the long call can be used tosatisfy assignment. In that case, the strategist will be assigned at 50 pershare and can exercise the XAL January 60 call, resulting in a $1,000 lossper spread. However, the strategist also keeps the $375 premium fromselling the spread. Therefore, the maximum loss is $625 ($1,000 – $375)and occurs if XAL is 60 or greater at expiration. Hence, the maximum lossfrom the bear call spread is computed as the difference between the twostrike prices minus the net credit.The example shows that the risk graph of a bear call spread slants upand to the left due to the fact that it loses money as the underlying assetmoves higher in price. It is similar to the short call, but with one importantdifference—the long call caps the potential losses for the trade.However, the farther out-of-the-money the long call is, the greater therisk of the trade. For example, a deep OTM call might be used when thestrategist is looking for disaster insurance, but a more conservative bearcall spread can be established by using two calls with strike prices a bit
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closer together. In the airline example, the strategist could limit the riskeven further by purchasing the XAL January 55 call instead of the January60 call. However, that would also reduce the credit received from the bearcall spread. Finding the right spread is a balancing actThe exit strategy for the bear call spread is straightforward if the index does indeed move lower. If the underlying index falls to the price ofthe short call, the bear call spread reaches its maximum profit potential.At this point, the strategist can’t do anything but simply let the options expire worthless and keep the initial credit.Conversely, if the price of the underlying shares rises to the strikeprice of the long call, the maximum loss occurs. Generally speaking, thestrategist should close out the spread well before expiration if it appearsthat the original forecast and direction of the underlying prove incorrect.Again, establishing stop-loss targets is one way to determine if and whento bail out of a bear call spread. For instance, using the previous example,if the XAL rises above 55, the strategist might choose to exit the spread.If the underlying asset closes in between the two strike prices, theshort call is assigned and the strategist will be forced to deliver cashequal to the difference between the XAL settlement value and the strikeprice of the option. Since the XAL settles European-style, this can onlyhappen at expiration. If it does, the strategist keeps the premium fromselling the spread and the long call will expire worthless. If the loss fromthe assignment of the short call is less than the premium received fromselling the spread, the trade results in a profit. That is, if the XAL settlesbelow the breakeven of 53.75, the strategist banks a profit from the bearcall spread.The Risk of Unexpected AssignmentIt should be noted that signiﬁcant news after the close of trading on thelast day can result in unexpected assignments for nonindex securities.Let’s consider a bear call spread using the Oil Service HOLDRs Trust (OIH),which is trading at $133. Assume the short call strike price is 135 and thelong call strike price is 140. At the end of trading immediately prior to expiration, OIH closes at $134.90. What would happen if some signiﬁcantnews event is expected to push oil to $200 a barrel? Wouldn’t the oil service industry stand to beneﬁt substantially from such a move? A longholder of the expiring 135 call may decide to exercise his or her rights after the close of trading even if the underlying closed below the strikeprice. Although this is an extreme and atypical scenario, it can happen. Beaware of such a possibility and monitor conditions after the close of theunderlying so you can appropriately manage your risk.
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COVERED CALLSCovered calls are used to generate cash from selling options on an existing position such as a stock or exchange-traded fund. This popular technique is referred to as a buy write strategy. In a buy write, the sale of calloptions serves two purposes. First, it can bring income to a portfolio viathe selling premium. Second, the sale of the call provides some downsideprotection by decreasing the effective purchase price of the stock or ETFand thereby decreasing the total capital at risk. To create the position, thestrategist buys shares and sells calls against those shares. One call is soldfor every 100 shares held. The call can be written against an existing position or as part of a new trade.While this strategy is most often used with stocks, we will consider itsuse on exchange-traded funds. Keep in mind that any combination strategy that uses shares and options cannot be applied to indexes such as theS&P 500 Index ($SPX) or NASDAQ 100 ($NDX) because these are cash indexes with no tradable shares. However, they can be applied to ETFs (exchange traded funds). The covered call is also used in one of the enhancedindex strategies discussed later in the book.Let’s consider an example of a covered call using the NASDAQ 100 Index Trust (QQQQ). During the late 1990s, the NASDAQ was a volatileplace and the QQQQ, which holds the top 100 NASDAQ stocks, became amanic-depressive beast. It would see huge rallies and sharp declines.Volatility was high, to say the least. That has since changed, however, andduring the years 2004 and 2005 volatility on the NASDAQ imploded. As ofthis writing, the QQQQ has been trading quietly.Narrow, range-bound trading is what strategists want to see when establishing covered calls. Ideally, the underlying ETF will see modest capital appreciation over time and the strategist can continue to sell callsagainst those appreciating shares. If the underlying shares fall too much inprice, the trade will result in a loss. On the other hand, if the price rallies,the short call will be assigned. While it will probably result in a profit, thestrategist will be taken out of the trade and not be able to fully participatein the bullish move.For example, in March the strategist sets up a buy write with the purchase of 1000 QQQQ shares for $36.50 a share and the sale of 10 QQQQJune 40 calls for $0.50 a contract. The cost of the trade is equal to theprice of the shares minus the premium received for selling the calls, or$36,000 [($36.50 – $0.50) × 1,000], which is also the breakeven.Ideally, once the strategist has established the covered call, shares ofthe QQQQ will begin to trend higher. Figure 5.4 shows the risk graph ofthe trade. It slopes upward and to the right because the profits increase asthe value of the underlying index moves higher. However, at a certain
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FIGURE 5.4 QQQQ June Covered Call Risk Graph (Source: www.Optionetics.comPlatinum)
point, the gains are capped because of the obligation from the short calls.Once the underlying asset reaches the strike price of the short call, assignment becomes more likely. In this example, the gains max out at the strikeprice of 40. At that point, the short calls are assigned at $40 a share andthe strategist will be forced to sell the stock at that price. Nevertheless,the position realizes a $4,000 profit, which is equal to the strike price minusthe net cost of the trade [($40 – $36) × 1000].If the shares decline in price, the covered call begins to lose money.Therefore, the risk of the covered call is similar to the risk of owningshares outright, but somewhat less due to the sale of the call options. Ifthe options are deep out-of-the-money, the premiums will be less, but theupside potential will be greater. Selling options that are at- or near-themoney will yield a greater premium, but less upside potential. In theQQQQ example, the premium was 50 cents per contract for an investment trading for $36.50. Therefore, the downside protection from theshort calls was only 1.4 percent. If the strategist sold the QQQQ June37.50 calls instead, the call premiums are greater—roughly $1.00 a contract, or almost 3 percent. The strategist needs to determine which tradeoff is more important.The exit strategy for the covered call will depend on the movementin the underlying share price. The worst-case scenario is for the price ofthe underlying asset to plummet below the breakeven. In that case, the
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strategist will want some sort of stop-loss or price level to exit the position. If the price of the underlying asset remains stable and below thestrike price of the option, the strategist lets the calls expire worthless. Theshares can then either be exited or be held with the prospect of sellingmore calls. A strong upward move in the underlying that pushes it abovethe option strike price will likely result in assignment. If assignment is notthe desired outcome, the strategist needs to close out the short calls byentering an offsetting trade.
CALL CALENDAR SPREADSJust as with the covered call, the calendar spread is a trade that can beused when the trader expects a gradual trend or sideways move in the underlying index. However, rather than using shares and options, the calendar spread uses only options. It is sometimes called a horizontal spreador time spread because it uses two options with the same strike price butdifferent expiration dates. In most cases, the option strategist creates acalendar spread by purchasing a longer-term option and selling a shortterm option.Calendar spreads can be created when the strategist is neutral or hasa directional bias on the underlying index. Basically, in a neutral calendarspread the trader is taking advantage of the fact that short-term optionslose value due to time decay at a faster rate than long-term options. However, strategists can also create both bullish and bearish calendar spreadsdepending on their outlook for the underlying shares. In this chapter, weconsider the bullish calendar spread with calls; in Chapter 6, we take acloser look at a bearish one using puts.To create a call calendar spread, the strategist buys a longer-term calland sells a short-term call with the same strike price. The number ofmonths remaining in the lives of the options contracts can vary, but ultimately, the strategist wants the longer-term option to retain its value orappreciate and the short-term option to lose value from time decay.Vertical versus Horizontal SpreadsThe names vertical, horizontal, and diagonal relate to the way that newspapers used to publish tables of closing option prices.A vertical spread is a trade that involves the simultaneous purchaseand sale of options on the same stock with the same expiration date. Theonly difference between the options that are purchased and those that are
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Vertical versus Horizontal Spreads (Continued)sold is the strike price. Vertical spreads get their name from the fact thatoption tables list options vertically by strike price. A vertical bull callspread is an example. Vertical spreads can also be created with puts.Jan.
Feb.
Mar.
505560
505560
505560
The horizontal spread will use two options with the same strikeprices and different expiration dates. This type of spread is also known asa calendar or time spread, which can be created with puts or calls. The callcalendar spread is an example.Jan.
Feb.
Mar.
505560
505560
505560
Diagonal spreads are a combination of vertical and horizontalspreads. They can include different expiration dates and different strikeprices. For example, buying a longer-term call option and selling a shorterterm call option with a higher strike price is an example of a diagonalspread.Jan.
Feb.
Mar.
505560
505560
505560
Let’s consider an example using an exchange-traded fund. Shares ofthe Utility HOLDRs (UTH) are trading near $110 per share in October2005 and the strategist expects the shares to grind higher during thenext several months. A bullish calendar spread is created by purchasing10 UTH January 2006 115 calls for $2.35 and selling the same number ofNovember 2005 115 calls for $1.05. The cost of the trade is equal to thepremium paid for the long call minus the premium received for theshort call, multiplied by the number of contracts and the multiplier. Inthis case, the cost of the call calendar spread is $1.30 per contract, or$1,300 total.The debit, or the cost of the trade, is also the maximum risk of the
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calendar spread.