market’s opinion is, of course, registered in theprice of stock on a day-to-day basis. In this instance, Coke had traded up toa price of 44 several times but had never been able to go higher. Thus, atechnician would have said that while he might believe the fundamental analysts’ prediction of good fortune for the future earnings of the company, hewould not buy the stock until its price could actually go higher than 44.That would have been a good strategy, for it wasn’t until over two yearslater that Coke actually traded higher than 44—after repeatedly trying toexceed that level, but failing. A technician would thus have saved his investment capital until the stock price had some momentum.
Technical analysis is more apropos to short-term trading, since itattempts to give some timing on when to buy and when to sell. Fundamental analysis is a good long-range tool, but on the short run itis often woefully late (or way too early) in predicting the actual movement of stock prices; it is therefore a poor technique for timing. Fundamental analysts attempt to predict whether the tangible businessoperations of a company will make money. However, that information is only vaguely related to the price of a stock in the short term.Most option trading strategies are of a short-term nature, so fundamental analysis is almost useless, and technical analysis is a betterapproach.Fundamental reports, however, can and do have an effect on theshort-term trading of a stock (in Chapter 4, we examine ways to takeadvantage of this phenomenon). This usually happens when a company announces quarterly earnings that are significantly differentfrom what the analysts have been expecting. A worse-than-expectedearnings report will inevitably cause a stock to drop as soon as theinformation is made public, while better-than-expected earnings willnormally cause the stock to rise in price immediately.Don’t confuse the market’s short-term reaction to these fundamental reports with fundamental analysis itself. In fact, had the analysts been able to correctly predict the earnings, there would have
44
OPTION HISTORY, DEFINITIONS, AND TERMS
been no “surprise.” This is particularly true when the earnings arebad. Usually, by the time that Wall Street analysts change their opinions from positive to negative on a stock, it is too late to benefitstockholders. How many times have you seen a company report surprisingly bad earnings, which causes the stock price to immediatelydrop, and then all the brokerage firms downgrade the stock? Or howabout a stock falling from lofty levels—perhaps by as much as 50percent—and then a brokerage firm downgrades it from “buy” to“hold”? Of what use is that to a short- or intermediate-term trader?Thus, fundamental analysis may be more appropriate for thelong-term picture, but it is not useful for short-term decision making.The following story shows the difference between fundamental andtechnical analysis quite clearly.Recently, I read an article that was originally published in 1948, regardingthe price of Coca-Cola. The article stated that the price of Coke—whichhad rallied strongly following the end of World War II—was discounting allof the good fortune in the foreseeable future. Fundamental analysts disagreed, arguing that Coke was on its way to becoming a world leader in softdrinks (at the time, Coke was sold mostly in the United States).In fact, the inflation-induced recession of 1948 did harm the price ofCoke and it dropped 30 percent; but today it is many, many times its 1948price. So, for the long term, fundamental analysts were right; but on theshort term, technicians were correct.
Since many of the strategies presented in this book are of a shortto-intermediate-term nature, we favor technical analysis for that purpose. Technical analysis bases its price projections for the future onpast prices, moving averages, or volume considerations. These arevaluable tools in many cases, and we discuss them in detail as theyarise in the context of the option strategies that we are presenting.This chapter has covered a lot of ground in a short amount ofspace. Definitions, price behavior, and relationships of the variablesaffecting option prices have all been described. This has laid thegroundwork for most of the later discussions in this book. In the nextchapter, we take a look at various option strategies.
2
An Overview ofOption Strategies
Even though the main thrust of this book is modern option tradingapplications, we want to cover the basics in terms of strategies. Thepurpose of this chapter is twofold: (1) it will serve as a foundation ofdefinitions for terms used later in the book and (2) it may serve as alearning or reference section, depending on the reader’s previousknowledge of option strategies. Each of the major strategies is brieflydescribed, with an example and a graph showing the strategy’s profitand loss potential.
PROFIT GRAPHSSome traders prefer to see columns of numbers, and others—myselfincluded—prefer to look at graphs or charts. A “profit graph” is agraph of the potential profits and losses from a position. Withoptions, it is possible to describe most the of major strategies by theshape of their profit graphs. A simple example should be sufficient todemonstrate the concept.
45
46
AN OVERVIEW OF OPTION STRATEGIES
Example: Suppose that XYZ common stock is trading at 50, and the XYZJuly 50 call is selling for 3, or $300. The profit table shown here details thepotential profits and losses at various XYZ prices at July expiration. Thesame information is shown in the profit graph, Figure 2.1, which shows thatthis position has a limited loss on the downside and can make theoreticallyunlimited profits on the upside.At July ExpirationStockNetPrice
CallPrice
Result ($)
40455053556070
000351020
–300–300–3000+200+700+1,700
Figure 2.1CALL PURCHASE
OUTRIGHT OPTION BUYING
47
A quick look at the graph is all that is needed to understand thenature of this strategy. When the graph is labeled with the dollaramounts of risk and profit and with the break-even point, then wehave a specific graph of this particular call option purchase. Thus,the profit graph can be generic or specific, depending on whether ornot the axes are significant profit and loss points.
OUTRIGHT OPTION BUYINGThe outright purchase of an option is the simplest type of optiontrade for most traders to understand, and some prefer to go no further. When we say “outright,” we are referring to an option purchasethat is not hedged by anything else, such as the sale of a similaroption or the sale of stock. In the preceding example, the purchaseof the XYZ July 50 call for 3 has several definable qualities that arefairly easily understood by most traders. First, the cost of one optionis $300, and that is the most that can be lost. Second, the breakeven point at expiration is 53 (plus commissions), for a call option isalways worth at least the difference between the stock price (53) andthe striking price (50). Third, nearly unlimited profits are available,for the option will appreciate in price as long as the underlying stock,XYZ, continues to rise in price.This is typically felt to be an aggressive strategy, because theleverage is so high. You can lose all your money in a fairly shortamount of time if the option expires worthless. In the precedingexample, if the stock drops at all from the price of 50 (where it wastrading when the option was purchased) by expiration, the optionwill expire worthless, and the trader will lose the $300 he paid forthe call. Leverage works both ways, of course, and thus huge percentages are possible as well. For example, if the stock were toadvance by only 20 percent (from 50 to 60), then the option wouldbe worth $1,000. So the stock trader would make 20 percent, whilethe option trader would make 233 percent ($300 becomes $1,000)from the same stock movement.Before discussing option buying in more detail, let’s look at anexample of a put purchase. Since the put gives the holder the rightto sell the underlying strike at the striking price (up until the expiration date), this is a bearishly oriented strategy. The put option will
48
AN OVERVIEW OF OPTION STRATEGIES
appreciate in value if the stock falls and will lose value if the underlying stock rises in price.Example: Suppose that XYZ common stock is trading at 50, and the XYZJuly 50 put is selling for 2, or $200. The profit table and profit graph (Figure 2.2) are shown below.At July ExpirationStockNetPrice
PutPrice
NetResult($)
303540455055
201510500
+1,800+1,300+800+300–200–200
Figure 2.2PUT PURCHASE
OUTRIGHT OPTION BUYING
49
Figure 2.2 shows that this position has a limited loss on the upside andcan make very large profits on the downside.
Many experienced traders prefer option purchases to stock purchases, however, because they feel that if they can pick a reasonablepercentage of trading winners—perhaps only 30 percent or 40 percent—the leverage provided by the winning trades will outweigh themore frequent but limited losses incurred by the losing trades. Thekey in such a strategy is to be able to let profits run when they occur.Buying options is often regarded as one of the most speculativetrading activities. However, there are often differing ways in which toestablish a strategy. These differing ways may change the speculativeto the conservative, or at least moderate things somewhat.Before actually discussing the type of option you should purchase, it must be stated that the outlook for the performance of thestock is of utmost importance. If the underlying stock drops inprice, you are not going to profit from a call option purchase, nomatter which call you buy.The main attraction for buying options—at least to the averageor novice trader—is the leverage that is available. You can put up afairly small amount of money (a couple of thousand dollars) andmake returns in the 200 percent or 300 percent area. Of course,you can lose 100 percent fairly quickly as well.In this regard, many novice traders buy out-of-the-money optionsin order to keep their cost down. They then dream of huge potentialreturns, but these returns are usually attainable only if the stock canmake a rather large percentage move. To make matters worse, thetypical buyer of out-of-the-money options buys options that have tooshort a life span—he does not give the stock enough time to makethe large move that is required.Over the years, I have spoken to numerous stock traders whohave given up on options. They feel that they can make money trading stock but always seem to lose when options are concerned. Theirproblems generally result from one mistake: buying too far out-ofthe-money.Professional stock traders often use options for one purposeonly: to reduce their required investment in a position. They are not
50
AN OVERVIEW OF OPTION STRATEGIES
attempting to capture huge leveraged returns; rather, they are merelyusing the option as a substitute for the stock itself. In order to create anoption position that is virtually the same as a stock position, youshould buy in-the-money options, probably with little time remaining. Moreover, if a professional normally trades 2,000 shares of stock,then he would probably buy 20 in-the-money calls; he does not usuallyattempt to leverage the quantity—the leverage is in the price.By buying in-the-money options, you are minimizing the amountof money spent for time value premium. Time value premium is thepart of an option that wastes away as time passes. Out-of-the-moneyoptions are entirely composed of time value premium. In-the-moneyoptions may have little or sometimes even no time value premium.Also, the in-the-money option will most closely match the performance of the underlying stock on a day-to-day basis. If the stock is upa point, the in-the-money call option will probably rise in price by atleast three-quarters of a point or more. The out-of-the-money optionmay not move much at all. Of course, this fact could work against thecall option holder if the stock moves down in price. That is why weoriginally stated that stock selection is of the utmost importance. Anexample may be helpful.Example: Suppose that you have decided that XYZ is a good stock to buyfor a short-term trade, and the stock is selling for 19 per share. If todaywere the first trading day of the year, which option would you buy?Call Option
Offering Price
Jan 15Jan 171⁄2Jan 20March 171⁄2March 20March 221⁄2
421⁄221⁄211⁄81⁄2
The professional stock trader would buy either the Jan 15 call (whichhas no time value expense at all) or the Jan 171⁄2 call (which has a half pointof time value, but is 11⁄2 points in-the-money and will move upward quicklyif the stock advances).
OUTRIGHT OPTION BUYING
51
The novice would be more inclined to buy the cheapest options (eitherthe Jan 20 or the March 221⁄2, both trading at 1⁄2) or maybe the March 20s.
In the preceding example, suppose the stock makes a quickmove to 21—a 10 percent increase. The professional will make 2points on the purchase of a Jan 15 call or 11⁄2 points on the purchase of a Jan 171⁄2 call—returns of 50 percent or 75 percent,respectively. The novice might have a larger percentage return, buthe might actually make less money because it is unlikely that hewould buy such a large quantity of out-of-the-money options that hewould make more money than the trader who bought, for example,20 in-the-money calls.In order to quantify these concepts, you can judge how aggressive your option purchase is merely by looking at the delta of the callbeing bought. The lower the delta, the more aggressive the optionpurchase. If you think of the delta as being the probability of theoption being in-the-money at expiration—which is an alternative, butstill correct, way of viewing delta—you can see how speculative anout-of-the-money option purchase is.Even if you do correctly predict the direction of the stock andyour option purchase is profitable, you must be prepared to takefollow-up action to lock in your profits where applicable. One of theeasiest ways to lock in some profits while still retaining potential, is tosell out part of your position after gains have been made. This worksfor any type of investment—stock, options, futures, bonds, and soon. The biggest problem with doing that is that if really large gainsoccur, you have reduced the quantity of shares or contracts that youown and you therefore don’t participate as much as you could haveon the upside.However, options actually sometimes provide a fairly easy meansof having your cake and eating it, too—you can nail down some niceprofits, but still preserve your “presence” in the stock. All that isrequired is to so sell the options you already own (and that are profitable) and buy the same number of options at the next strike. This isbest accomplished when the stock has already reached the nextstrike, so that you are selling an in-the-money option and buying anat-the-money one.
52
AN OVERVIEW OF OPTION STRATEGIES
Example: Suppose that you bought 10 XYZ June 20 calls for 2 each whenthe stock was 21. This costs $2,000 before commissions. XYZ subsequently rallies to 25, and your calls are now worth 5 (at least). Upon investigation, you see that the July 25s are selling for 11⁄2. You could therefore dothe following:Sell 10 June 20 calls at 5: $5,000 creditBuy 10 July 25 calls at 11⁄2: $1,500 debitYou therefore take a nice healthy $3,500 credit out of the position, lesscommissions—which more than covers your $2,000 initial cost—and youstill have 10 long calls in case the stock explodes on the upside. The worstthat can now happen is that the July 25s expire worthless, if the stock takesa dive. However, you have locked in a profit already, so that needn’t overlyconcern you.
USING LONG OPTIONSTO PROTECT STOCKAnother advantage of owning options is that they can be combinedwith stock or futures to produce a position that has much less riskthan that of the underlying. Long puts can be bought as a hedgeagainst the downside risk or owning stock, or long calls can bebought as a hedge against the risk of selling stock short.
Buying Puts as an Insurance Policyfor Long StockIf a trader wants to protect against the downside risk of owningstock, he can buy a put against that stock. The ownership of the putwill eliminate much of the downside risk, while still leaving room forplenty of gains on the upside.Example: Suppose XYZ is selling for 51 and the July 50 put is selling for 2.If you buy 100 shares of stock and also buy the July 50 put, your profitpotential at expiration would be the figures depicted in Table 2.1, or shown
USING LONG OPTIONS TO PROTECT STOCK
53
in the profit graph in Figure 2.3. Note that the position has limited risk,equal to the initial cost of the put (2 points) plus the amount by which theput was out-of-the-money (1 point). Moreover, it has unlimited upside profitpotential, which is almost as large as that of owning the stock itself.Table 2.1LONG STOCK/LONG PUT PROFIT POTENTIALStockPrice
Long StockProfit ($)
OptionPrice
Long PutProfit ($)
Net Profit($)
3035404550556070
–2,100–1,600–1,100–600–100+400+900+1,900
20151050000
+1800+1300+800+300–200–200–200–200
–300–300–300–300–300+200+700+1,700
Figure 2.3LONG STOCK/LONG PUT
54
AN OVERVIEW OF OPTION STRATEGIES
One other item is important: note that the shape of the profitgraph of this position is exactly the same as the shape of the profitgraph for owning a call. When two strategies’ profit graphs have thesame shape—as do call buying and this strategy of protecting longstock with a long put—then the two strategies are considered to beequivalent, which means they have the same profit and loss potential. We discuss equivalences repeatedly in this chapter. Note that justbecause two strategies are equivalent doesn’t mean they have thesame rates of return. For example, the cost of buying a call is far lessthan the cost of buying both 100 shares of stock and buying a put.When you consider buying a put to protect a holding in yourstock, you have several things to consider, just as you do withanother form of “insurance.” How much coverage do you want, howlong a time period does the insurance cover, and how much are youwilling to pay? Since options have varying expirations—even goingout to two years or more with LEAPS options—as well as severalstriking prices, usually there are many choices. You might considerthe amount by which the put is out-of-the-money as the “deductible”portion of your insurance policy.A very short-term insurance policy that has a large deductible isnot very expensive. Thus, if XYZ were at 51 in April, then the purchase of a July 45 put would represent a rather short-term, largedeductible insurance policy. However, a two-year LEAPS put with astriking price of 50 would be a much more expensive form of insurance because (1) it is long-term and (2) there isn’t much of adeductible (only one point).This strategy was employed, but rather rarely, back in the days ofover-the-counter options, prior to the 1973 introduction of listedoptions. The first listed options were only calls (puts weren’t listeduntil 1976, and then only on 25 stocks). Thus, in the early days oflisted options, investors were forced to use covered calls as their onlyreal means of lessening the downside risk of stock ownership.The introduction of listed options coincided fairly closely with the 1973–1974 bear market that saw the Dow Jones Industrials decline from 1,000 toabout 580 in a matter of approximately one year. The havoc wreaked onsome of the “high-flying” stocks was even worse than the more than 40percent loss suffered by the averages. The “nifty 50” stocks were supposed
USING LONG OPTIONS TO PROTECT STOCK
55
to be a group that would outperform the regular market, regardless of bullor bear markets. These stocks were very overpriced and eventually sufferedsome of the worst declines of that bear market.One trader owned Polaroid at about 150 a share at the beginning ofthat market and wrote covered calls against it all the way down to its eventual low of 15! He claimed that he was able to protect nearly 75 percent ofthe loss with covered calls, a figure that may be a slight exaggeration—alltrading stories grow in stature as the years pass—but is probably not a grossexaggeration. This shows just how expensive call options were in thoseearly years (recall, there were no listed puts). It also reflects how large thevolatility of that 1973–1974 market became as the months wore on.
In today’s market, of course, option premiums are much smaller,and investors do not view covered call writing as providing muchmore than a modicum of downside protection. Today’s strategy ofinsuring your stock holding by buying puts has become more andmore popular since the crash of 1987. The main problem is that theprotection is static; that is, if the underlying stock were to rally bya substantial amount after the insurance was purchased, the“deductible” portion of the policy becomes huge. For example, withXYZ at 51, if the stockholder initially bought the LEAPS put with astriking price of 50, his deductible was one point. If the stock thenproceeds to rally 20 points to 71 over the next year, his policy is stillin force, except that the deductible is now 21 points since the putstill has a striking price of 50. The only way to “upgrade” the insurance would be to sell the original put and then to buy another putwith a striking price closer to the current stock price.Some money managers and individuals with large holdings havefound that it is easier to buy index puts on a sector or broad-basedindex whose characteristics more or less match those of their stockportfolios. Then, they can buy all of their insurance at once—putsdon’t have to be bought individually for each stock in the portfolio.This subject is covered in more detail in the next chapter.
Buying Calls to Protect Short StockSelling stock short is often considered a somewhat sophisticatedstrategy because theoretically there are unlimited risks involved. The
56
AN OVERVIEW OF OPTION STRATEGIES
stock could soar in price and cause large losses. While it is usually thecase that a trader can limit his risk with stop-loss orders or by payingattention to the market on a constant basis, it is sometimes easier forthe short seller to know for certain that he has a limited loss even ifthe stock soars mightily. He can accomplish the task of limiting hisloss by merely buying a call—probably an out-of-the-money one—against his short stock. Then, even if there were a high-pricedtakeover bid for the company, his loss would be limited on theupside. Thus, a long call acts as insurance against large loss for ashort seller, much in the same way that the stockholder’s loss waslimited by the ownership of a put in the previous section.The profit graph of the long call/short stock position is presentedin Figure 2.4. Note that its shape is the same as that of merely owning a put. Thus, long put is equivalent to long call/short stock. As aresult, the strategy is also known as a synthetic put.In fact, when options were first listed—and for the ensuing threeyears—there were only listed calls. Thus, the only way that you couldhave large downside profit potential with limited risk was to utilizethis long call/short stock strategy. Even when puts first were listed inFigure 2.4LONG CALL/SHORT STOCK
BUYING BOTH A PUT AND A CALL
57
1976, there were only 25 stocks that had listed puts trading. If youwanted a position that was similar to owning a long put in any of theother optionable stocks, you still had to short the stock and buy a call.The strategy was widely used, especially by professionals andarbitrageurs, and its name was shortened merely to “synthetic.” Ifyou were “doing synthetics,” you were setting up a sizable position ofshort stock and long calls, for the purpose of making an arbitrageprofit via the interest earned on the short sale, and/or for the purpose of capitalizing on the collapse of the stock price. Today, sinceall stocks with listed options have both a listed put and a listed call,this strategy is no longer as widely used as it once was.
BUYING BOTH A PUT AND A CALLIn some cases, a trader may feel that there is the potential for explosive movement by an underling instrument, but he is uncertain of thedirection that that movement might take. In such a case, he mightconsider buying both a put and a call with the same strike—a straddle. Then, if there is a large move—either up or down—he will makemoney. The drawback, of course, is that nothing much happens andtime decay eats away at both the put and the call. This strategy hasprofit potential as shown in Figure 2.5; the maximum loss, which isequal to the initial premium paid, would be realized if the stock wereexactly at the striking price at expiration. However, the possiblerewards are large if the stock rises or falls far enough by expiration.As a general rule of thumb, this is a strategy that should only beundertaken if two conditions are met: (1) the options are inexpensiveon a historical basis (we have more to say about how to judge this condition in later chapters) and (2) the underlying has a history of beingable to move distances large enough to make the straddle profitable.Markets have a tendency to trade in small increments most of thetime and then to make most of their ground in a very short period oftime. Studies have been done that show that 90 percent of the gainsare made in only 10 percent of the trading days (other studies showsimilar figures for downside moves as well). It is often the case thatoptions get very cheap just before large moves. This is especially trueif the market has been rather trendless for a while just before a big
58
AN OVERVIEW OF OPTION STRATEGIESFigure 2.5STRADDLE PURCHASE
move occurs; option buyers are losing money to time decay andtherefore are less aggressive in their bids for options, while optionsellers become more aggressive as their profits build up. There havebeen many examples of options getting “cheap” just prior to largemarket explosions. One of the most famous was the cheapness ofindex options just prior to the crash of 1987, but there are manyother instances as well, both in stocks and in futures. In fact, youmight think that buying straddles works best just before big marketdeclines because option prices tend to expand very quickly duringdeclines (in stocks and indices). However, two of the swiftest rallieswe have had since index options were listed were both preceded byvery cheap options—one rally was in August 1983, and the other inthe first half of 1995—and straddle buyers profited handsomely.When the put and the call that are purchased have the samestriking price and expiration month, you are buying a straddle. If theyhave different striking prices, you are buying a strangle, or combination. The straddle purchase usually involves more risk in the worstcase; however, it has better profit potential. The two profit graphs,Figures 2.5 and 2.6, compare the profitability of straddle buying and
SELLING OPTIONS
59
Figure 2.6COMBINATION (STRANGLE) PURCHASE
combination buying. It has been my experience that if you havedetermined that you want to buy options in advance of what you perceive to be a potential price explosion by the underlying, you are better off buying straddles than buying combinations (strangles).
SELLING OPTIONSJust as with any other type of security, the initial, or opening, optiontransaction may be a sale rather than a purchase. When you do thatwith a stock, you must first borrow the shares before you can sellthem “short.” However, with options or futures, that is not necessary.The mere option transaction itself creates a contract, so that the buyerof the option is long the contract and the seller of the option is shortthe contract. The common term to describe the sale of an option asan opening transaction is to say the option has been written. Thisterm comes from the old days when a physical contract was issued bythe seller and delivered to the buyer. In today’s paperless tradingworld, there is no longer any physical contract, but the term remains.
60
AN OVERVIEW OF OPTION STRATEGIES
Covered Call WritingWhen you write a covered call, you own the underlying and havesold a call option against it.Example: Assume that XYZ is trading at 51 and a July 50 call is selling for4. If you bought 100 shares of XYZ and sold one July 50 call, you wouldhave a covered write with the following profit potential at July expiration:
StockPrice
StockProfit($)
OptionPrice
OptionProfit($)
TotalProfit($)
4045505560
–1,100–600–100+400+900
000510
+400+400+400–100–600
–700–200+300+300+300
Figure 2.7 shows the same results as in the example profit table.Covered call writing is considered to be a conservative strategy.There is limited upside profit potential and rather large downsiderisk. The profit potential is limited because the trader has written thecall and therefore has assumed the obligation to sell his stock at thestriking price should he be assigned on the call. The risk of coveredwriting is less than that of owning the common stock, although thatrisk can still be considerable if the stock falls by a great distance. It isthis reduction in risk that has made covered writing a “conservative”option strategy not only in the eyes of institutional money managersbut in the eyes of the courts as well.Covered call writers are usually interested in two numbers: (1) thekind of return that would be made if the underlying stock were calledaway at expiration (called the return if exercised) and (2) the kind ofreturn that would be made if the underlying stock were unchanged atexpiration (called the return if unchanged). Of course, opinions ofwhat is an acceptable return would probably differ depending onwhether the stock were being bought specifically for the purpose of
SELLING OPTIONS
61
Figure 2.7COVERED CALL WRITE
writing calls against it or whether an existing stockholder was writingcalls against his long stock. The former probably represents the operation of the entire position as a strategy, while the latter may justbe looking for a little additional income without really wanting to sellhis stock.There is an inherent attraction in selling options, since an optionis a wasting asset and the writer enjoys the benefit of the time decay.This seems especially true to those who have suffered substantiallosses due to time decay from owning options. As we pointed