It occurs if the share price falls below the strike priceof the options and both options expire worthless. Ideally, however, theprice of UTH will begin to trend higher. For instance, if the fund risesto $115 at November option expiration, that option will expire worthless. However, the value of the long call should have increased in valueas well.On November 18 when the short call expired, the fund was actuallytrading near $112 and the market for the long call was a bid of $2.05.Therefore, if the short call was allowed to expire worthless, the strategistgained $1.05 on the sale of the short call. This must be netted against thepaper loss of 0.30 cents per contract on the January 115 call. At that point,the strategist could (1) close the position by selling the long January callsand realize a $0.75 profit per spread on the trade; (2) sell another shortterm option such as the December 115 call; (3) roll the position to a highercalendar; or (4) simply hold the long call position.Figure 5.5 shows the risk and reward of the calendar spread graphically. The maximum profit occurs at expiration when the price reaches$115 a share at November expiration. At that point, the short call expiresworthless, but the long call has appreciated in value and can be sold at a
FIGURE 5.5 UTH January/November Call Calendar Spread Risk Graph (Source:www.Optionetics.com Platinum)
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profit. However, the trade loses money in the event of a strong movehigher or lower in the underlying index. If shares rally above the strikeprice of the short option, it will probably be assigned near expiration andthe strategist will either buy the shares in the market to satisfy the assignment, or exercise the long option to fulfill assignment. If the share pricetumbles, the call calendar spread will result in a loss since both optionswill lose value and may even expire worthless. The strategist then losesthe debit paid for entering into the spread.The exit strategy for the calendar spread determines the success ofthe trade. The outlook for the underlying index will generally dictatethe decision. If the shares remain range-bound and the short call expires worthless, the strategist has three courses of action from which tochoose:1. Exit the position.2. Sell another call.3. Roll up to another strike price.
If the price of the underlying index does indeed remain stable, thebest approach is to sell another shorter-term option. In our example,once the UTH November 115 call expires, the strategist might sell a December 115 call. Or the position can be rolled up by purchasing the February 120 call and selling the December 120 call. Sometimes it isn’tpossible to sell another call. Instead, the share price jumps too high andthe risk profile associated with selling another call is not attractive. Inthat case, the strategist might simply want to close the position by sellingthe long call.If the shares move against the strategist during the life of the shortcall, the best approach is probably to exit the entire position when theshort call has little time value remaining. If the shares jump higher and thelong call has significant time value, it is better to close the position ratherthan face assignment or buy back the short option. If assigned and forcedto exercise the long option to cover the assignment, the strategist will losethe time value still left in the long contract.The strategist can also choose to do nothing when the short call expires and simply hold the long call. This will yield profits if the underlying index moves higher. The strategist simply takes the calendar spreadand turns the trade into a long call. As an alternate bullish approach, ifthe index looks bullish, the strategist can hold the call and sell anothercall at a higher strike price, which creates a strategy known as a bullcall spread.
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Breakevens on Time SpreadsThe breakeven point for calendar spreads is sometimes difﬁcult to calculate since most charting software looks at the breakeven price when theshort-term option expires. However, at that point, the longer-term optionwill probably still have value.It is difﬁcult to know exactly what the breakeven stock price will befor this type of spread because the strategist is evaluating options withdifferent expiration dates. In these situations, it is best to use optionsanalysis software that will incorporate other option pricing factors to get ageneral idea of the breakeven. Keep in mind that even this approach is notperfect because software can’t predict changes in an option’s future implied volatility. The best we can do is to calculate an approximatebreakeven and then plan our exit strategies accordingly.
BULL CALL SPREADSThe covered call and call calendar spread can generate profits in trendingmarkets, but what about when the strategist expects an explosive movehigher? What strategies make sense? The long call has already been discussed. The problem with a straight call is that it is risky. If the underlyingindex moves in the wrong direction, the trader stands to lose 100 percentof the initial investment (the premium of the option). In addition, time decay can be a killer when holding long options, waiting for the index market to move.The bull call spread is a vertical debit spread strategy that can helpmitigate the risk of a long call. The trade is created by purchasing a lowerstrike call and selling a higher strike call with the same expiration dates.The total investment is usually far less than the amount required to buyshares or long calls. In addition, the bull call strategy comes with both limited profit potential and limited downside risk.The maximum risk on a bull call spread is limited to the net debit paidto enter the spread. To calculate the maximum profit, multiply the difference in the strike prices of the two options by 100 and then subtract thenet debit. The maximum profit occurs when the underlying stock risesabove the strike price of the short call, causing it to be assigned. If so, thestrategist can honor assignment by exercising the long call, thereby purchasing the underlying stock at the lower strike price and delivering thoseshares to the option holder at the higher short price. However, the spreadcan also be closed at any time prior to expiration through an offsettingtrade. The breakeven of a bull call spread is calculated by adding the netdebit to the lower strike price.
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Let’s consider an example of the bull call spread using the InternetHOLDRS (HHH). Technology stocks often perform well during the fourthquarter and Internet stocks are no exception. In fact, October is often aturnaround month, and in this example the strategist expects the scenarioto play out again. To capitalize on this move, the strategist sets up a bullcall spread for HHH, which is trading near $60.50 a share. This is accomplished through the purchase of five January 2006 60 calls for $3.75 andthe simultaneous sale of five January 2006 65 calls for $1.25. The cost ofthis spread is $250 [($3.75 – 1.25) × 100]. Since the trader created fivespreads, the net debit is $1,250 (250 × 5). Figure 5.6 shows the risk graphassociated with this spread.The maximum risk of the bull call spread is equal to the debit paidfor the trade and occurs if all the options expire worthless. In that case,the strategist eats the cost of the trade, which is $1,250 in this example.The maximum profit occurs at or above the short call strike price. IfHHH rises to $65, the January 65 call expires worthless while the January 60 call is worth minimally $5 per contract, or $2,500 for five contracts. Therefore, the maximum profit is equal to $2,500 minus the debitof $1,250, regardless of price movement beyond $65. The maximumprofit of a bull call spread is always equal to the difference between thestrike prices minus the debit and occurs at or above this higher strike atexpiration.
FIGURE 5.6 HHH January Bull Call Spread Risk Graph (Source: www.Optionetics.com Platinum)
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The bull call spread is one of the first strategies we teach, and it workswell when the market trends higher over a period of time. However, justas with any strategy, a few guidelines are in order.• Strategists should focus on options with at least 60 days until expiration in order to give the underlying stock enough time to move into aprofitable position. Extremely short-term bull call spreads provide themost leverage, but also provide less time for the trade to work in thestrategist’s favor. Longer-term bull call spreads have more time towork in the trader’s favor.• Keep the net debit as low as possible to make the trade worthwhile.We often look for ratios of one-to-three or more. That is, for every dollar that is at a risk, the trade has the potential of making three. In theHHH example, the ratio was one-to-one (i.e., for every dollar at risk,there is one dollar of profit potential). To increase the ratio, the strategist can look at out-of-the-money options or wider spreads. In sum,the difference in the strikes should be large enough so that the maximum profit is worthwhile.• Finally, when exiting the trade, the strategist will want to consider afew factors. Ideally, the price of the index will move above both strikeprices near expiration and the spread can be closed out at a profit.However, if the short call is assigned, the long call can be used tohonor assignment and bank the profit. If the underlying asset pricerises up toward the strike price of the short call, but does not exceedit, the long call can be closed at a profit and the short call can be allowed to expire worthless. On the other hand, if the market tanks, thestrategist will want to exit both of the positions. If the price of the underlying index falls below the strike price of the long call near expiration, the spread might expire worthless, creating the maximumpossible loss on the trade.
A NOTE ABOUT TRADING LEVELSNow that we are talking strategies, traders will want to keep in mind thatnot all brokerage firms allow clients to trade high-risk strategies such asnaked call writing. In fact, some won’t let traders establish any type ofspread. In order to understand why, traders need to understand how brokerage firms view options trading levels.
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Prior to trading in an option account, brokerage firms require clientsto complete an options approval form. This form is designed to providethe brokerage firm with information about the customer’s experience,knowledge, and financial resources, and is required for compliance withfederal regulations. According to the “know your customer” rule, optiontrading firms must completely minimize the potential for clients to takeinappropriate risks. Therefore, the new account form and the optionsapproval document gather appropriate background information abouteach customer.The compliance department within the firm reviews the information in order to determine whether the client has attained a certain levelof experience in trading before allowing them to open accounts andplace more complex trades. The process is designed to protect inexperienced traders from taking inappropriate risks. For example, if the option approval form reveals that the client has little or no options tradingexperience, and the client then goes on to lose large sums of moneyvia complex, high-risk trades, the brokerage firm could potentially faceregulatory and legal troubles for not knowing its customer. Each andevery brokerage firm is required to understand the client’s backgroundso that new traders are not taking risks outside of certain parameters ofsuitability.Once the firm has considered the customer’s background, the clientis assigned a trading level. For instance, Level 1 strategies include relatively straightforward approaches such as covered calls and protectiveputs. More complicated trades, however, require a higher level of approval. Table 5.1 shows a typical breakdown a brokerage firm might useto group strategies by levels. Traders with a great deal of experienceand significant financial resources can generally receive approval forLevel 5 trading. This would allow them to implement any type of tradingstrategy, including high-risk trades such as naked calls and uncoveredstraddles.Although the options approval levels can vary from one broker to thenext, Level 3 as described here is sufficient for the strategies discussed inthis book. Uncovered selling of options, which requires approval beyondLevel 3, is unnecessary. Nevertheless, in order to avoid the frustration ofopening an account with a firm that will not allow trading in more advanced levels, new traders should review the brokerage firm’s policy regarding options approval before opening an account. The best way to dothis is to contact the firm’s options approval department by phone and askthem if they will allow you to trade strategies such as long calls, calendars, and bull call spreads.
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TABLE 5.1 Typical Brokerage Breakdown of Strategy LevelsOptions Trading LevelStrategy
Level 1
Level 2 Level 3 Level 4
Level 5
Covered call writing (Chapter 5)
√
√
√
√
√
Protective puts (Chapter 6)
√
√
√
√
√
√
√
√
√
Covered put writing (Chapter 6)
√
√
√
Spreads (Chapters 5, 6, 7)
√
√
√
Uncovered writing of equity putsand calls (Chapters 5, 6)
√
√
Uncovered writing of straddlesand strangles (Chapter 7)
√
√
Buying stock or index putsand calls (Chapters 5, 6)
Uncovered writing of index putsand calls (Chapters 5, 6)
√
CONCLUSIONThe stock market moves higher roughly two-thirds of the time. Therefore,more profit opportunities exist trading to the upside rather than to thedownside. In addition, a number of bullish trades can be created using calloptions. When looking for short-term aggressive moves higher, tradersshould focus on buying calls. However, the risks associated with long callscan be significant because a move in the wrong direction can result in a100 percent loss of one’s investment. Time decay can also be a killer.Bull call spreads work better in a bullish market when the trader has alonger-time horizon of 60 days or more. Call calendar spreads can workwell when the strategist expects a modest move higher or even sidewaysaction. If the market is expected to fall, a bear call spread can be employed to make a profit. However, the bear call spread is not the best strategy for a bearish market. Instead, the strategist might want to focus onstrategies that use puts when the market is expected to trade lower; thesestrategies are discussed in Chapter 6.
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Basic StrategiesUsingPut Options
C
hapter 5 introduced a variety of strategies that use only call options.Now let’s flip things around and look at strategies that use only putoptions. Since puts increase in value when the price of the underlying index falls, it makes sense that many of these strategies are simply theopposite of those discussed in Chapter 5. For example, if the strategist expects the market to fall next week, a long put on the SPDRs makes sense.In short, each strategy should be used according to what the situation dictates. A basic understanding of each strategy will help traders by puttingmore tools in their trading arsenals.
THE LONG PUTThe put option gives the owner the right, but not the obligation, to sell theunderlying stock at a specific price until the expiration date. Hence, theowner can “put” the stock to the option writer. The value of the put optioncontract will increase as the price of the underlying asset falls. Therefore,the long put is used when the strategist anticipates a fall in the price of theunderlying security. Similar to a long call, a long put position involves arelatively small capital commitment and is used to get leverage on anunderlying security that is expected to decline in value.The long put strategy also offers high profit potential (limited becausethe underlying can only fall to zero) and limited downside risk. The risk isequal to the cost of the put option or premium. Profits are realized as the93
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put increases in value as the price of the underlying index trades lower.Many traders prefer buying puts over short selling stock because, whileboth are bearish strategies, the put purchase is generally less expensiveand has less risk. The downside is that put options lose value due to timedecay; this is not an issue for short sellers.Let’s consider an example of a long put using the Dow Jones diamonds (DIA). In this case, the strategist is bearish on the market and expects a move to the downside in early 2005. The trading day is December23, 2004 and the DIA is quoted at $108.15 a share. The strategist expects a5 percent market correction during the first month of 2005 and sets up anaggressive long put play by purchasing five February 2005 DIA 105 putsfor $0.80 per contract.Figure 6.1 shows the risk profile for the long DIA position with potential profit and loss values corresponding to underlying share prices. Thecost of the trade is $400, which is calculated by multiplying the put premium per contract by the number of contracts and the multiplier of 100($0.80 × 5 × 100). The cost of the trade is also the maximum potential riskof the trade. Profits increase as the price of the Dow Jones falls. The maximum profit is equal to the strike price of the option minus the premiumdebit, multiplied by the number of contracts and the multiplier (100). Inthis example, the max profit is $52,100 [(105 – $0.80) × 5 × 100]. The maximum profit will occur if the Dow falls to zero, which is not a likely event.
FIGURE 6.1 DIA February Long Put Risk Graph (Source: www.Optionetics.comPlatinum)
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The breakeven is calculated by subtracting the put premium from theput strike price. In this trade, the breakeven is $104.20 (105 – $0.80); if thediamonds fall to $104.20 at expiration in February 2005, the trade breakseven—there is no profit or loss (excluding commissions). If the value ofthe diamonds falls below the breakeven, the trader can bank a profit.Choosing an exit strategy for the long put depends primarily on themovement of the Dow. There are three ways to exit the position. The firstis to let the put expire worthless and lose the premium paid to purchase it,which will happen if the price of the diamonds moves above the strikeprice of the long put at expiration. Obviously, this is not an ideal situationbecause the strategist has lost the entire investment.More often, the strategist will want to offset the trade during the lifeof the option. Offsetting the position involves selling an identical put option with the same strike price and expiration. If the market falls, the result will likely be a profit. If the market rises, the put can be sold tominimize any further losses. We generally recommend exiting a long putposition at least 30 days before expiration because the final weeks of anoption’s life are when it experiences the greatest rate of time decay.In the DIA example, the strategist is expecting a 5 percent correctionduring the first month of 2005. Therefore, the exit will occur sometime inlate January if the market does indeed turn south. At that time, the optionwill still have time premium remaining. For example, by January 23, 2005,the DIA had fallen to $103.75 and the February 105 puts were bid at $2.00a contract. Therefore, the strategist could exit the position (sell the puts)for $2.00 per contract, which is $1.20 more than their initial cost. Thistranslates to a 150 percent profit. Had the DIA rallied during the firstmonth of the year, the puts would probably have little to no value and thetrade would have resulted in a loss.The third exit strategy is to exercise the put option, which creates ashort position in the Dow, assuming the trader did not already have anexisting position in DIA. At that point, the strategist can hold the position or cover the short by purchasing the shares back to close the trade.Exercise makes sense when the time premium of the option has fallentoward zero and the put owner wants to unload shares or set up a shortposition. Most long puts, however, are closed through offsetting trades,which is the most common way to book a profit or a loss with almostany option strategy.In conclusion, the long put is a simple strategy that increases in valuefrom a decline in the underlying security. Unlike selling shares short, thereis no need to use margin. Perhaps the biggest benefit is that by entering along put, the trader has limited risk to the amount of the initial premium.Similar to any long option strategy that results in a debit, the long put willsuffer from time decay as time progresses. To minimize this situation, we
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recommend using options with at least 60 days until expiration. At thesame time, we have large potential rewards as the price of the underlyingfalls, with the maximum profit occurring if the price of the underlying fallsto zero.Bid and AskOptions are quoted using bid prices and ask prices. The bid is the pricethat the market is willing to take for the option. Therefore, if a strategisthas a long put and wants to offset the trade by selling that option, theleast he will get is the bid price.The ask or offering price is the price at which the market is willing tosell the option. If the strategist wants to open a long put or close a shortput, the price he is going to pay is often the bid price.The difference between the bid and the ask is known as the bid-askspread. Sometimes it is possible to get orders executed or ﬁlled within thespread, but this generally occurs only when another investor is attempting to create the opposite order at the same price or if the market makes asudden move and the price quotes change.
THE PROTECTIVE PUTOne of the more basic combination stock and option strategies is the protective put. It is widely used and easy to understand. As the name suggests, the protective put is designed to protect a long position. Let’sassume an investor owns 100 shares of Microsoft (MSFT) and is worriedthat holiday sales of the latest Xbox will not meet expectations. This is ashort-term bearish scenario for the stock. That same investor can buy putoptions on Microsoft as a way of protecting the value of his or her holdings. When establishing a protective put, the strategist generally buys oneput for every 100 shares.Let’s consider an index example of the protective put using the Semiconductor HOLDRS (SMH). It’s October 24, 2005, and the strategist is bullish onchip stocks and wants to take a bullish position on the SemiconductorHOLDRs. However, during the past few months, the sector has been facingselling pressure and the strategist also wants protection in case the bullishprediction proves wrong. As a result, rather than simply buying shares, a protective put is set up by buying 100 shares of the Semiconductor HOLDRs for$35 a share and buying one December 35 put for $1.25. The total cost of thetrade is $3,625 [(35 × 100) + ($1.25 × 100)].The risk graph of the protective put appears in Figure 6.2. Since the
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FIGURE 6.2 SMH December Protective Put Risk Graph (Source: www.Optionetics.com Platinum)
trade generates profits as the stock price climbs, the curve slants upwardand to the right. The breakeven at expiration is equal to the strike price ofthe option plus the premium for the call. In this case, the trade breakseven at $36.25, which is the point where the shares can be sold for a profitof $1.25, off-setting the cost of the put. Above $36.25, the protective putposition begins to make money.While the total cost of the trade is $3,625, the downside risk is cappedby the long put. Since the option holder has the right to sell or “put” thestock for $35 a share, the most that is at risk is the put option premium of$1.25, or $125 per contract. In the protective put, the maximum risk iscomputed as the difference between the put strike price and the cost pershare, plus the premium.It is important to note, however, that the protection is only good untilDecember option expiration. At that point, the put expires worthless andthe strategist can either (1) hold the shares with no protection, (2) buyanother put, or (3) exit the position entirely. The outlook for the underlying asset will determine the best course of action. Generally, the strategist will want to roll forward the put at least 30 days prior to expirationbecause the put will experience significant time decay during its finalmonth. In other words, the put options used in the trade should havemore than one month of life remaining if the strategist is concernedabout time decay.
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Rockin’ and Rollin’Roll is a term used to describe a position adjustment. For example, rollingout an option refers to switching an existing option with a longer-term option for the same underlying. More speciﬁcally, if a strategist owns theSeptember 35 call, the position can be rolled out by closing the September35 call and buying a December 35 call.Rolling up occurs when the strategist substitutes a call option withthe same expiration date for a call with a higher strike price. For instance,the strategist owns the September 35 call and rolls up the position byclosing out the September 35 call and buying a September 40 call.Rolling down involves trading a put option for a put with a lowerstrike price. For example, if one holds the September 50 put, the positioncan be rolled down by closing out the September 50 put and buying a September 45 put.
When does the protective put make sense in the index market? In ouropinion, it doesn’t very often. Why? Because the same risk graph can becreated using a simple call purchase. Let’s consider an example. In fact,we already have, in the previous example of the Semiconductor HOLDRs.Instead of purchasing 100 shares, we purchase one December 35 call option. The risk curve of this strategy, shown in Figure 6.3, is identical to therisk curve of the SMH December 35 protective put shown in Figure 6.2.Since the protective put and the long call have the same risk graph,the strategist can achieve the same results with either strategy. However,purchasing one call option requires much less money when compared tobuying 100 shares and one put. So, while the protective put and the longcall have the same risk graph, the protective put requires a lot more capital—it is an expensive strategy.Yet, despite its drawbacks, some investors do use the protective put.Sometimes the trade is short-term. For example, if an investor holds alarge position in one stock and is worried that shares might fall followingan earnings report, he might decide to buy a protective put ahead of thenews and then sell it the day after.The married put is a term used for a position that is created when theput and the underlying shares for the option are purchased at the sametime. In addition, the strategist must intend to exercise the put in order forthe put and the shares to be “married.” The status can be relevant in thetax treatment of the position, which is a detailed discussion that lies outside the scope of this book. Suffice it to say that the protective put can beestablished either on an existing position or as part of a new position.When it is part of a new position and is designated as a hedge or protection, it is considered a married put.
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FIGURE 6.3 SMH December Long Call Risk Graph (Source: www.Optionetics.comPlatinum)
Cash-Secured PutBy selling a cash-secured put, the investor receives premium while waitingfor the stock to decline to the strike or price at which he is willing to ownthe stock. The position involves selling a put option and depositing themoney for the purchase of stock into the brokerage account. The moneyis often placed in an interest-bearing account such as a money market.The money remains on hand in case the put is assigned and the shares are“put” to the option seller. The buyer of the put will generally exercise theoption should the underlying stock drop below the strike price and thereis little or no time value remaining. If the stock remains above the strikeprice by expiration, the premium is retained by the seller and another putcan be sold.
THE SHORT PUTThe short or naked put strategy is another one that we don’t find compelling. It has limited profit potential but can carry significant risk. Thestrategy is sometimes used in lieu of buying stock. For example, optionwriters might sell out-of-the-money puts on the Dow Jones diamonds if
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they are willing to buy shares at the strike price, which is below the current market price.Naked puts are best used in bullish or trendless markets when thestrategist expects the underlying asset price to remain above the strikeprice of the put option. The strategist receives the option’s premium forselling the option. The premium is the maximum reward for a short putposition. The losses can be significant if the price of the underlying assetdeclines in value and falls below the strike price of the put.Let’s look at an example of a short put on the mini-NASDAQ 100 Index($MNX), or “minx.” The fourth quarter has been a historically strong period for tech stocks and the NASDAQ during the past few years, and thestrategist expects this year to be no different. As a result, the strategist decides to sell at-the-money puts to bring premium into the trading accountduring the final two months of the year. The time is late October and theminx recently printed at 155. The strategist sells ten MNX December 150puts and collects $1.75 per contract, or $1,750 in total.Figure 6.4 shows the risk graph of the naked MN