0011.006.001.000
1.002.504.755.503.00
With the price of XYZ at 86, a January 90 call would have a price (pre-mium) of 3. To be 3 points above the strike price, XYZ has to rise 7 pointsto 93 in order for you to break even. If you were to buy a January 75 calland pay 13.50 for it, XYZ would have to rise to 88.50 in order to break even(75 + 13.50 = 88.50). As you can see, the further out-of-the-money an optionis, the less chance it has of turning a proﬁt.
Theta  (time  value)  correlates  the  change  in  the  price  of  the  optionwith  respect  to  the  time  left  until  expiration.  The  passage  of  time  has  asnowball effect as well. If you’ve ever bought options and sat on them un-til the last couple of weeks before expiration, you might have noticed thatat  a  certain  point  the  market  seems  to  stop  moving  anywhere.  Optionprices are exponential—the closer you get to expiration, the more money
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you’re going to lose if the market doesn’t move. On the expiration day, anoption’s worth is its intrinsic value. It’s either in-the-money or it isn’t.
Early  in  my  options  career,  I  realized  that  as  you  go  deeper  in-the-money with calls or puts, the options have less time value and more intrin-sic  value.  This  means  that  you  are  paying  less  for  time;  therefore,  theoption  moves  more  like  the  underlying  asset.  This  is  referred  to  as  thedelta of an option. The delta is the key to creating delta neutral strategiesand we will delve deeply into its properties and functions as we exploremore  advanced  trading  techniques  throughout  this  book.  Let’s  now  ex-plore various strike price trends.
Call Strike
January
February
Price of XYZ = 50
455055
6.402.30.90
7.503.901.60
May
8.254.752.75
Looking at the expiration months for XYZ, notice that in the Janu-ary  column,  the  price  (premium)  of  a  call  is  higher  for  lower  strikeprices. For example, the price of an XYZ January 45 call (6.40) is higherthan the price of the XYZ January 50 call (2.30). That makes sense sincethe XYZ January 45 call allows you to buy a $50 stock (XYZ) for $45 pershare, while the XYZ January 50 call allows you to buy it for $50. Alsonotice that the price of a call is lower for closer expirations. For exam-ple, the price of the XYZ May 50 call (4.75) is higher than the price ofthe XYZ January 50 call (2.30). This makes sense since the May 50 callallows you to buy XYZ at $50 until close of business prior to the thirdSaturday of May (a period of about four months from January). With theXYZ January 50 call, your right expires at close of business prior to thethird Saturday of January. The only difference between these options isthe amount of time the trader has to make a decision on the option andits  probability  of  closing  in-the-money.  The  same  principle  applies  toputs.  Less  time  to  expiration  means  lower  prices.  The  buyer  has  lesstime for the put to move in-the-money or to decide what to do with theoption.
TIME DECAY
Have  you  ever  heard  the  expression  that  options  are  “wasting  assets”?Since  options  suffer  from  what  is  known  as  time  decay,  the  option  con-tract  loses  value  with  each  passing  day.  Therefore,  if  a  strategist  buys  a
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put or call and holds it in her account, even if the underlying stock orindex makes no price movement at all, the portfolio will lose value. As aresult,  options  strategists  must  carefully  examine  how  time  is  affectingtheir options positions. This section explains how.
Options contracts are agreements between two parties as to the rightto buy (in the case of call) or sell (with respect to puts) an underlying as-set at a predetermined price. Each options contract has a ﬁxed expirationdate. Hence, an XYZ call option gives the owner the right to buy XYZ at aspeciﬁc price (known as a strike price), and the XYZ put option gives theowner the right to sell 100 shares of XYZ stock at a predetermined price,but only until a certain expiration date.
A stock options contract is valid only until the Saturday following thethird  Friday  of  an  expiration  month.  For  example,  the  October  2004  op-tions expire on October 16, 2004. The last day to trade these options is onthe third Friday of October, which falls on October 15, 2004. The time leftuntil the option expires is known as the life of the option. As expirationapproaches, all else being equal, the life and the value of the option willdecline.  Some  traders  use  the  term  time  value  premium.  All  else  beingequal,  the  greater  the  amount  of  time  left  until  the  option  expires,  themore valuable the options contract.
At the same time, the rate of time decay is not linear. As an option ap-proaches expiration, the rate of decay becomes faster. For instance, anoption with only three weeks left until expiration will lose time value pre-mium at a faster rate than an equivalent option with 12 months of life re-maining. Mathematically speaking, the rate of time decay is related to thesquare  root  of  the  life  of  the  option.  For  instance,  an  option  with  threemonths  of  life  left  will  lose  value  twice  as  fast  as  an  option  with  ninemonths  left  (three  being  the  square  root  of  nine).  Similarly,  an  optionwith  16  months  left  will  decay  at  half  the  rate  of  an  option  with  fourmonths left.
The  option’s  amount  of  time  decay  can  be  measured  by  one  of the  Greeks  known  as  theta.  The  theta  of  an  option  is  computed  using an  option  pricing  model.  Alternatively,  it  can  be  found  using  the Optionetics.com Platinum site.
EXITING A TRADE
There are three ways to exit an option trade. An option can be offset orexercised, or it can simply expire. Experience is the best teacher when itcomes  to  choosing  the  best  alternative.  In  most  cases,  traders  close  op-tions through offsetting trades. However, since each alternative has an
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immediate result, learning how to best close out a trade is a vital elementto becoming a successful trader.
Offsetting
Offsetting is a closing transaction that cancels an open position. It is ac-complished  by  doing  the  opposite  of  the  opening  transaction.  There  arefour 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 best time to offset an option is when it is in-the-money and there-fore will realize a proﬁt. Offsetting can also be used to avoid incurring fur-ther losses. An option can be offset at any time—one second after it hasbeen entered or one minute before expiration. Offsetting an option is themost popular technique of closing an option. In fact, 95 percent of all theoptions with value are offset.
Exercising
There are various reasons why a trader might choose to exercise an op-tion versus offset it. Of the 5 percent that are exercised, 95 percent are ex-ercised at expiration. Exercising will close your open call option positionby  taking  ownership  of  the  underlying  stock.  If  you  want  to  exercise  along (bought) stock option:
• Simply notify your broker, who will then notify the Options Clearing
Corporation (OCC).
• By the next day, you will own (if exercising calls) or have sold (if ex-
ercising puts) the corresponding shares of the underlying asset.
• You can exercise an American option at any time; but primarily you
will do it—if you do it at all—just prior to expiration.
• If  the  market  rises,  you  may  choose  to  exercise  a  call  option.  Yourtrading account will then be debited for 100 shares of the underlyingstock (per option) at the call’s strike price.
• If the market declines, you may choose to exercise a put option. Youwill then receive a credit to your account for 100 shares of underlyingstock  at  the  put  strike  price.  This  is  called  shorting  the  market  andcan be a risky endeavor.
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An option seller cannot exercise an option. By selling an option, youare  taking  the  risk  of  having  a  buyer  exercise  the  option  against  youwhen  market  price  movement  makes  it  an  in-the-money  (ITM)  option.The OCC randomly matches or assigns buyers and sellers to one another.If there is an excess of sellers by expiration, all open-position ITM shortoptions are automatically exercised by the OCC. In order to avoid beingautomatically  exercised,  short  option  holders  can  choose  to  offset  orclose their options instead.
Letting It Expire
Letting  an  option  expire  is  used  when  the  option  is  out-of-the-money(OTM)  or  worthless  as  it  approaches  the  expiration  date.  For  short  op-tions,  letting  them  expire  is  the  best  way  to  realize  a  proﬁt.  If  you  let  ashort option expire, you get to keep the credit received from the premium.Since a momentary ﬂuctuation in price can mean the difference betweenopportunity and crisis, traders with open positions need to keep track ofthe price of the underlying asset very carefully. Luckily, computers makethis  process  easier  than  ever  before.  There  are  plenty  of  web  sites  thatprovide  detailed  option  and  stock  listings,  including  our  own  site(www.optionetics.com).
ASSIGNMENT
Assignment is one of the more confusing characteristics of an option. Al-though it occurs infrequently, it is an important part of basic option me-chanics. As an option trader, you’ll need to have a solid understanding ofassignment  in  order  to  maximize  your  chances  for  success.  Let’s  take  acloser look.
Anticipating Assignment
As we have seen, selling puts or calls can involve signiﬁcant risks. How-ever, there are some strategies that carry relatively low risk, but also in-volve selling options. Many of these trades are more complex trades thatwe will explore in later chapters. For now, let’s assume we sell an option,but we want to determine if there is a risk of assignment. Are all optionsassigned? When are the odds of assignment the greatest? While there is noway to know for certain when assignment will occur, there are some rela-tively certain ways to anticipate it before it happens.
Recall that sellers take on an obligation to honor the option contract.
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Therefore, if you sell a call option, you agree to sell the stock at a prede-termined price until the option expires. On the other hand, if you are a putseller, you have the obligation to buy the stock, or have it put to you, at theoption’s strike price until the option expires. When you have to fulﬁll yourobligation  to  buy  or  sell  a  stock,  you  are  “assigned.”  Therefore,  assign-ment is the process of buying or selling a stock in accordance to the termsof the option contract. Once assigned, the option seller has no choice butto honor the contract. In other words, it is too late to try to buy the optioncontract back and close the position.
Although option sellers have an obligation to buy or sell a stock at apredetermined price, assignment will take place only under certain circum-stances. How do you know if you are at risk of being assigned? First, exer-cise generally takes place only with in-the-money options. For example, acall option that has a strike price below the price of the underlying stock isITM. If XYZ stock is currently trading for $55 a share, the March 50 call op-tions will have an intrinsic value of $5 because the option buyer can exer-cise the option, buy the stock for $50, immediately sell it in the market for$55, and realize a $5 proﬁt. A put option, on the other hand, will be ITMwhen  the  stock  price  is  below  the  strike  price.  The  put  is  in-the-moneywhen its strike price is higher than its stock price. It is extremely rare forassignment to take place when options are not ITM. In addition, if an op-tion is in-the-money at expiration, assignment is all but assured. In fact, theOCC automatically exercises any option contract that is one-quarter ofa point ITM at expiration. That is, options that are in-the-money by one-quarter of a point or more are subject to automatic exercise.
The second important factor to consider when assessing the probabil-ity of assignment is the amount of time value left in the option. When anoption  is  exercised  before  expiration,  it  is  known  as  early  or  prematureexercise. In general, if there is time value (1/4 point or more) left in the op-tion, the option will usually not be exercised. Option sellers can expect as-signment when the option has little to no time value remaining. Since thetime value of an option decreases as time passes, the probability of earlyexercise  increases  as  the  expiration  date  approaches.  To  determine  theamount of time value remaining in a call or put option, traders can use thefollowing formulas:
• Call time value = call strike price + call option price – stock price.• Put time value = stock price + put option price – put strike price.
Finally, this discussion of assignment applies to American-style op-tions. American-style options can be exercised at any time prior to expi-ration, while European-style options can be exercised only at expiration.Most  index  options  settle  European-style.  Stock  options,  on  the  other
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hand,  exercise  American-style.  Therefore,  stock  option  sellers  can  beassigned  at  any  time  before  the  option  expires,  and  anticipating  the assignment  is  important  when  using  strategies  that  involve  selling option contracts.
In sum, the probability of assignment increases as:
1. The option moves in-the-money.2. The time value of the option drops below 1/4 point.
There  are  odd  times  when  assignment  will  take  place  with  slightlyout-of-the money options or options with time value remaining. These arethe exception, however, and relatively low-probability events.
CASH OR MARGIN ACCOUNTS
Many options strategies require margin deposited with a broker. Whenwe discuss the strategies in the next few chapters, we will explain whatamount of margin is required for each position. But ﬁrst, what exactly ismargin?
Buying or selling stocks is referred to as a “trade.” For instance, if youdecide to buy 100 shares of XYZ and the stock price is $100, you are trad-ing  your  money  for  the  shares.  In  this  case,  the  trade  is  $10,000  for  100shares of XYZ stock.
The  exact  amount  you  need to  make  your  ﬁrst  trade  depends  on  a
number of factors including:
• Your market selection.• Size of the transaction (number of shares).• Risk on the trade.
Your ﬁrst trade also depends on whether you want to do your trade
using a margin or cash account.
• Cash trades require you to put up 100 percent of the money in cash.All  costs  of  the  trade  need  to  be  in  the  account  before  the  trade  isplaced. For example, to buy 100 shares of IBM at $100 per share, youwould have to pay $10,000 plus commissions up front.
• Margin trades require traders to only put up half the total amount topurchase shares while their brokerage lends them the other half at asmall interest rate. So for the same IBM example you would have topay $5,000 plus commissions up front.
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The term margin refers to the amount of money an investor must payto enter a trade, with the remainder of the cash being borrowed from thebrokerage  ﬁrm.  The  shares  you  have  purchased  secure  the  loan.  Mosttraders prefer a margin account because it allows them to better leverageassets in order to produce higher returns. In addition, a margin account isusually required for short positions and options trading.
Based on Securities and Exchange Commission (SEC) rules, the mar-gin requirement to purchase stock equals 50 percent of the amount of thetrade. At this rate, margin accounts give traders 2-for-1 buying leverage. Ifthe price of the stock rises, then everyone wins. If the price of the stockfalls  below  75  percent  of  the  total  value  of  the  initial  investment,  thetrader receives a margin call from the broker requesting additional fundsto be placed in the margin account.
Brokerages  may  set  their  own  margin  requirements,  but  it  is  neverless  than  75  percent—the  amount  required  by  the  Fed.  Brokerages  areusually willing to lend you 50 percent of a trade’s cost, but often require acertain amount of money be left untouched in your account to secure theloan. This money is referred to as the margin requirement.
Of course, brokers don’t lend money for free. They charge interest onthe loan amount over and above the commission on the trade. The interestand commissions are paid regardless of what happens to the price of thestock.  The  margin’s  interest  rate  is  usually  the  broker  call  rate  plus  theﬁrm’s  add-on  points.  This  rate  is  cheaper  than  most  loans,  as  it  is  a  se-cured  loan—they  have  your  stock,  and  in  most  cases  will  get  their  cashback before you get your stock back.
Ultimately, there are no absolutes when it comes to margin. Combin-ing the buying and selling of options and stocks may create a more com-plex margin calculation. However, these strategies usually have reducedmargin  requirements  in  comparison  to  just  buying  or  shorting  stocksalone.  Since  every  trade  is  unique,  margin  requirements  will  depend  onthe strategy you employ and your broker’s requirements.
Margin calls, which are demands from brokers for more money, area  reality  that  traders  have  to  deal  with  every  day.  Unless  you  have  acrystal ball that forecasts the future, there are no sure bets. Obviously,the larger your capital base becomes, the less you have to worry aboutmargin. But it’s always a good idea to keep margin in mind and not letyourself get overextended, no matter how enticing that “just one more”trade looks.
While stock trades usually require a 50 percent margin deposit fromyour account to place depending on your brokerage, margin requirementson  futures  markets  vary  from  commodity  to  commodity.  Similarly,  theamount of margin in the options market depends on the nature and risk ofthe position as well as your brokerage’s discretion.
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The options market is a fascinating place that continues to grow in popu-larity today. Like any derivative, options can carry high risks when not re-spected  or  when  used  carelessly.  At  the  same  time,  options  on  stocks,futures, and indexes can offer huge rewards to those savvy traders whohave studied them well.
So  far,  we  have  covered  only  the  mechanics  of  options  trading.  Bynow, you should understand the difference between a put and call, the fac-tors that determine and inﬂuence option prices, why options are known aswasting assets, and how to use symbols to retrieve options quotes.
In the next chapter, we move on to the topic that really matters: howoption  strategies  make  money  in  the  markets.  As  we  will  see,  a  profusenumber of different strategies can be used to generate proﬁts whether weexpect  a  stock  to  move  higher,  move  lower,  or  stay  in  a  narrow  pricerange. Some strategies are very simple, and some are more complex. Re-gardless, there are several important factors to be considered when read-ing through various options trading strategies. Which ones make the mostsense  to  you?  Which  ones  feel  right?  Which  trading  strategies  are  youmost comfortable with? Try to identify only one or two, because in the be-ginning you will want to specialize and concentrate your efforts on just afew strategies. It can prove overwhelming if you try to master them all (todo so can take a lifetime), which is one of the major reasons I ﬁnd optionsso fascinating.
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CHAPTER 4
BasicTradingStrategies
T rading is a diverse activity that encompasses a wide variety of analy-
sis techniques and innovative approaches. The optimal approach foryou  requires  an  assessment  of  both  your  time  availability  and  yourrisk tolerance. Once these factors are determined, you’re ready to special-ize in those techniques that ﬁt your parameters. There are three fundamen-tal approaches on which all trading strategies are based: strategic trades,long-term trades, and delta neutral trades. Each has its own set of condi-tions and rules that foster a unique trading style.
Strategic trades are typically short-term trading opportunities gearedespecially for day traders and short-term traders who have the opportunityto monitor the markets very closely each day. Strategic trades are speciﬁcto certain markets and may be driven by economic data or events. Manystrategic traders use the Standard & Poor’s 500 as the key index on whichthey  focus  their  attention  when  trading  market-related  instruments.  TheDow Jones Industrial Average (the Dow) is also watched closely to tip offcertain bond and currency trades. As a trader, you need to develop yourown  personal  trading  style  based  on  the  patterns  you  encounter  in  themarkets.  Consistently  applying  the  use  of  a  strategic  trading  approachfosters success.
Long-term trading methodologies differ greatly from strategic trades.Long-term traders do not look at trades from a second-to-second perspec-tive.  Instead,  they  approach  trades  from  the  perspective  of  a  couple  ofdays to a few months, or even into the next year. These trades are basedmore on market trends and seasonal factors. They take a while to blossom
76
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and bear fruit, which gives the long-term trader more time to develop theart of patience.
Delta  neutral  trades  make  up  the  third  kind  of  trades,  and  probablythe  most  complex.  These  strategies  create  hedged  trades  in  which  theoverall position delta equals zero. As the market rises and falls, the overallposition delta moves away from zero. Adjustments can then be made bypurchasing or selling instruments in such a way as to bring the overall po-sition  delta  back  to  zero.  Each  adjustment  has  proﬁt-making  potential.Most delta neutral trades can be structured in such a way that your totalcost and risk are minimized.
Delta neutral trading strategies and longer-term trading opportunitiesare better suited for traders who are not able to sit in front of their com-puters  all  day  watching  the  markets  move.  Successful  delta  neutraltraders  create  a  trading  system  with  a  time  frame  they  feel  comfortableworking in. You can create trades that are three months out, two monthsout, one month out, or even only one day out. If you are the type of personwho  does  not  want  to  think  about  your  trading  every  single  day,  simplytake a longer-term approach.
Delta neutral strategies can be applied to any market. It can be advan-tageous to learn to trade both stocks and futures. Even if you think youwant  to  trade  just  futures,  you  can  make  just  as  much  money  tradingstocks if you use delta neutral strategies. In either case, the options strate-gies outlined in this book can be applied using stocks or futures. As youread about them, think about the ones that make the most sense to youand then specialize in those strategies.
RISK PROFILES
Before  launching  into  our  discussion  of  speciﬁc  strategies,  let’s  discussone of the most important tools for viewing the proﬁt and loss potential ofany options strategy: the risk proﬁle. Understanding and managing risk isthe critical task of all traders. Very experienced traders and the mathemat-ically  adept  may  be  able  to  intuitively  understand  what  risk  is  being  as-sumed by a given trade, but the rest of us work best with a visual pictureof the risk we are taking. For that reason, the drawing and understandingof risk curves is an essential part of daily trading activities.
A risk proﬁle is a graphic representation of the proﬁt/loss of a positionin relation to price changes in the underlying asset. The horizontal num-bers at the bottom of the graph—from left to right—show the underlyingstock prices. The vertical numbers from top to bottom show a trade’s po-tential  proﬁt  and  loss.  The  sloping  graph  line  indicates  the  theoretical
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proﬁt and loss of the position at expiration as it corresponds to the priceof  the  underlying  shares.  The  zero  line  on  the  chart  shows  the  trade’sbreakeven.  By  looking  at  any  given  market  price,  you  can  determine  itscorresponding proﬁt or loss. Risk proﬁles enable traders to get a feel forthe trade’s probability for making a proﬁt.
In order to get a better handle on what a risk curve is, let’s use a hypo-thetical example. The ﬁrst thing to understand is that the risk graph de-picts the value an option or an options position in relation to changes inthe underlying asset’s price. As an example, let’s consider call options onWal-Mart  Stores  (WMT).  Here,  WMT  is  the  underlying  asset.  Assumeshares of Wal-Mart are trading for $60 each and one January 70 call can bepurchased for $2.50 (or $250 per contract). Therefore, the underlying as-set is Wal-Mart Stores and the option is the WMT January 70 call.
Table  4.1  shows  the  risk  and  reward  of  holding  the  WMT  January  70call. The prices are hypothetical prices that might exist at expiration on thethird  Friday  in  January.  Notice  that  if  the  stock  doesn’t  rise  above  $70  ashare, the position loses $250 because the option expires worthless at or be-low $70 a share and yields no proﬁt. If the stock climbs to $75, the optionsare  worth  $5  and  the  proﬁt  totals  $250:  [(75  –  70)  –  2.50]  × 100.  At  $80  ashare, the proﬁt equals $7.50 ($10 – $2.50). Notice that the position breakseven at $72.50 because $2.50 was the initial cost of the call when purchased.Rather  than  creating  a  table  for  the  risk/reward  proﬁle  of  the  WMTJanuary 70 call, we can create a risk graph. It plots the proﬁt from the op-tion (on the vertical axis) along with the price of the stock (along the hor-izontal axis). Figure 4.1 shows the risk graph of the Long WMT January 70call in its standard form. The potential proﬁt from the call is plotted alongthe vertical axis.
The  classic  view  risk  graph  shown  in  Figure  4.2  was  created  using Optionetics.com  Platinum  software.  The  lowest  of  the  four  lines  on  thegraph considers the potential proﬁt and loss of the WMT January 70 call atexpiration and contains the same information as the table. Just as we saw
TABLE 4.1 Risk/Reward Proﬁle of