WMT January 70 Call
Potential Proﬁt and Loss from WMT January 70 Call Purchase
WMT at Expiration
January 70 Call at Expiration
Proﬁt/Loss
$60.00$65.00$70.00$72.50$75.00$80.00
$  0.00$  0.00$  0.00$  2.50$  5.00$10.00
–$250.00–$250.00–$250.00$    0.00$250.00$750.00
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FIGURE 4.1 Standard Risk Graph for 1 Long WMT January 70 Call @ 2.50
on  the  table,  the  proﬁts  begin  to  accrue  when  WMT  hits  $72.50  a  share.The breakeven point (at expiration) occurs where the straight black diag-onal  line  intersects  with  the  zero  proﬁt  line.  The  other  lines  reﬂect  therisk/reward  with  a  speciﬁc  number  of  days  (as  shown  in  the  upper  left-hand corner) remaining before expiration. The position of the proﬁt/losslines at various time intervals is based on the model’s assumption that im-plied volatility remains constant. While this assumption doesn’t reﬂect re-ality, it must still be made in order to produce the chart.
In addition to using Optionetics.com Platinum, you can also use otheroptions pricing software or compute the graph manually. To actually drawthe risk curve, your tools can be anything from a pencil and piece of graphpaper  to  a  computerized  spreadsheet  program  such  as  Lotus  123  or  Mi-crosoft  Excel.  The  steps  will  be  the  same.  Drawing  a  risk  curve  for  anytrade, regardless of its complexity, consists of ﬁve basic steps:
1. Determine the stock prices for which you will have to calculate values
of your trade at expiration.
2. Calculate  the  proﬁt  (or  loss)  at  each  of  those  points,  and  determine
the breakeven level.
3. Sketch the two axes of your risk curve—the vertical axis will delin-eate the proﬁt (or loss) of the trade, while the horizontal axis will de-pict  the  price  of  the  underlying  for  which  you  have  determined  aproﬁt or loss.
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4. Actually plot the points that you calculated in step 2 onto the graph
set up in step 3.
5. Draw lines connecting each point plotted in step 4.
This simple ﬁve-step process will permit you to calculate a risk curve(even without a computer), detailing the actual proﬁt or loss that can beexpected at any stock price upon expiration. Granted, you cannot estimatepotential proﬁt or loss prior to expiration, but a basic rule of thumb is thatthe proﬁts will not be as high, nor the losses as great, at any time prior toexpiration. If you don’t have a sophisticated risk-graphing program avail-able,  this  process  will  give  you  the  basic  outline  of  what  your  trade  willlook like. As you gain experience and your trading becomes more reﬁned,
Today: 329 days left 219 days left109 days leftExpiration
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FIGURE 4.2 Wal-Mart January 70 Call Risk Curve (Source: Optionetics Platinum © 2004)
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FIGURE 4.3 Risk Graph Framework for 1 Long WMT 70 Call @ 2.50
you will ﬁnd yourself needing the power of the packaged programs. How-ever, for the beginning trader, a simple risk curve at expiration like this onewill help explain where proﬁts can be made or lost. If you graph out therisk curve on every trade you are contemplating, the visual recognition ofthe risk will soon improve your trading in countless ways.
Skill Builder
Now it’s your turn. Follow the ﬁve steps to see if you can manually createa risk graph (using the framework in Figure 4.3) for 1 Long WMT 70 Call @2.50.  The  complete  risk  graph  can  be  found  in  Figure  4.1  if  you  want  tocheck your work.
BreakevenMaximum lossPrice at maximum lossProﬁt @ 75Proﬁt @ 80
72.50
–$25070$250$750
LONG STOCK
While the term going long might have you envisioning a football playergoing deep for a pass, in the ﬁnancial markets going long is one of the
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most common investing techniques. It consists of buying stock, futures,or options in anticipation of a rise in the market price (or, in the case ofa long put, a drop in the price). An increase in the price of the stock ob-viously  adds  value  to  a  stock  holding.  To  close  this  long  position,  atrader would sell the stock at the current price. A proﬁt is derived fromthe  difference  between  the  initial  investment  and  the  closing  price.  Along  stock  position  is  completely  at  the  mercy  of  market  direction  tomake a proﬁt.
Long Stock Mechanics
In this example, the trader is long 100 shares of XYZ (currently trading at$50).  Remember,  shares  of  stock  do  not  have  premium  or  time  decay.Long stock has a one-to-one risk/reward ratio. This means that for everypoint higher the shares move, you will make $100. Conversely, for everypoint the shares fall below the purchase price, you will lose $100.
Figure 4.4 shows the risk proﬁle of this long stock example. As youcan see, when the share price rises, you make money; when it falls, youlose money. Notice how the proﬁt/loss line for the stock position shows a1-to-1  movement  in  price  versus  risk  and  reward.  This  means  that  thestock trade has an unlimited proﬁt potential and limited risk as the priceof the stock can fall only as far as zero.
FIGURE 4.4 Long 100 Shares XYZ @ 50
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When you purchase a stock, the only way to exit the position (without ex-ercising options) is to simply sell the shares at the current market price. Ifthe  price  of  the  stock  rises,  the  trader  makes  a  proﬁt;  if  the  price  falls,then  a  loss  is  incurred.  Thus,  if  XYZ  rises  to  60,  100  shares  will  yield  aproﬁt of $1,000: (60 – 50) × 100 = $1,000. If XYZ declines to 40, 100 sharescreate a loss of $1,000: (50 – 40) × 100 = $1,000.
Long Stock Case Study
Buying, or going long, stock is the easiest and most straightforward trad-ing strategy available. However, this doesn’t mean it is the best strategy touse. Going long stock consists of buying shares of a company outright andholding onto them as they (hopefully) gain in value. The positives to thisstrategy are that it is easy and ﬁguring your proﬁts and losses is straight-forward. The stock can also be held forever, as long as the company re-mains a valid corporation and does not declare bankruptcy. However, thecosts can be expensive, making it difﬁcult to diversify.
There are many different ideas on how to pick a good stock, depend-ing  on  your  time  frame.  Technical  analysis  is  often  used  for  short-termtrading  decisions,  while  fundamental  analysis  is  the  main  discipline  forbuying stocks over the long term. As with any trading strategy, it still is agood idea to have exit points set up in advance so that you aren’t swayedby emotion.
A  risk  graph  for  a  long  stock  trade  is  very  easy  to  create,  even  byhand.  It  is  a  straight  line,  which  shows  that  for  every  dollar  gained  inthe  security,  you  proﬁt  a  dollar  per  share.  The  same  holds  true  to  thedownside. It shows the dollar-for-dollar proﬁt/loss that comes with thisbasic strategy.
Long Stock
Strategy: Buy shares of stock.
Market Opportunity: Look for a bullish market where a rise in the priceof the stock is anticipated.
Maximum Risk: Limited to the price of the stock as it falls to zero.
Maximum Proﬁt: Unlimited as the stock price rises above the initial entryprice.
Breakeven: Price of the stock at initiation (not including commissions).
Margin: Usually 50 percent of the total cost of the shares.
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Let’s say we saw the Nasdaq 100 Trust (QQQ) break above resistanceon May 1, 2004, and decided to buy 100 shares at $27.69. The risk graph ofthis trade is shown in Figure 4.5.
This trade proved to be a good investment decision, with the Qs mov-ing higher right into 2004. We might have held onto this trade until the Qsstarted a downtrend in early 2004. Let’s assume we got out at 36, when theQs made a lower high and a lower low. By getting out at 36, we would havemade $8.31 per share, or $831 overall. Not bad, but we had to invest $2,769(or  half  this  amount  if  we  used  margin)—a  30  percent  return  on  invest-ment. Of course, if the Qs had lost ground, we would have lost a dollar pershare for each point the Qs fell.
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FIGURE 4.5 Risk Graph of Long 100 Shares of Stock on QQQ (Source: Optionetics Platinum © 2004)
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Long Stock Case Study
Strategy: With  the  security  trading  at  $27.69  a  share  on  May  1,  2004,buy 100 shares of the Nasdaq 100 Trust (QQQ).
Market Opportunity: Expect advance in shares on break of resistance.
Maximum Risk: Limited to initial debit of $2,769.
Maximum Proﬁt: Unlimited to the upside. In this case, exiting at $36 ashare garnered an $831 proﬁt.
Breakeven: Initial  entry  price  (not  including  commissions).  In  this  case,$27.69.
Margin: None needed, but can be used to cover half the cost of initial entry.
SHORT STOCK
Traders  can  take  advantage  of  a  falling  market  by  selling,  or  shorting,shares  of  stock.  Initially,  this  process  can  be  quite  confusing.  After  all,most investors want to buy a stock at a lower price and sell it for a proﬁtat a higher price. Short selling reverses this process. With short sales, thetrader actually sells the stock ﬁrst and hopes that it will decline in value,so that it can be bought back at a lower price. The difference between theselling price and the purchase price represents the proﬁt or loss.
In  order  to  sell  a  stock  short,  traders  must  ﬁrst  borrow  the  sharesfrom their broker. This is not always going to be possible and will dependon the speciﬁc stock and the brokerage ﬁrm. In some cases, it might notbe possible to ﬁnd the stock. This is especially true of less liquid or activelytraded shares.
Generally,  a  broker  will  look  in  one  of  four  places  for  the  shares  tolend to the short seller. The most common source is from other customerswho  are  long  the  stock  in  their  margin  accounts.  Alternatively,  the  ﬁrmmight look to one of three other places:
1. Its own inventory.2. Securities borrowed from another brokerage ﬁrm.3. Securities borrowed from institutional investors.
If the ﬁrm has exhausted these options and come up empty, the short
seller will not be able to borrow and short that particular stock.
Once the stock is sold, the trader will proﬁt if the stock moves lower.Keep in mind, however, that if any dividends are paid by the stock, thenthe lender, not the short seller, is entitled to them. The person holding anopen short position must pay the amount of the dividend to the lender. In
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addition, the margin requirements call for a 150 percent deposit of the netproceeds  from  the  short  sale.  Also,  importantly,  the  lender  generally  re-tains the right to demand that the stock be returned to him or her at anytime. So, one risk to short selling is that the lender may demand that theshares be returned before the stock has made a move lower. Undoubtedly,short selling stock comes with a variety of risks.
Short Stock Mechanics
An  investor  believes  that  the  price  of  XYZ  is  too  high  and  expects  thestock to move southward. It is currently trading for $20 share. So, she in-structs her broker to sell short 1,000 shares of XYZ at $20. The brokerageﬁrm then lends the investor the securities and they are sold in the marketfor $20. The total credit received from the short sale equals $20,000. Nowthe money is in the account, but the customer owes the brokerage ﬁrm the1,000 shares. The risk graph for this trade is shown in Figure 4.6.
If XYZ falls, the trader can book a proﬁt. For example, let’s say XYZdrops to $10 a share and the short seller instructs the broker to buy back1,000 shares to close the position. The stock is purchased for $10 a shareand the cost of the trade is $10,000 (plus commissions). She then returnsthe borrowed shares and closes the trade. The proﬁt is equal to the differ-ence between the purchase price and the selling price, or $10,000 (minuscommissions). Suppose, though, XYZ appreciates to $30 a share and thetrader decides that it’s time to cut her losses. In this case, she must buy
FIGURE 4.6 Short Stock Risk Graph
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XYZ back for $30 per share, or $30,000, and return the borrowed stock toher  brokerage.  The  loss  is  equal  to  the  purchase  price  minus  the  saleprice, or $10,000 (plus commissions).
Exiting the Position
When you sell shares short, the only way to exit the position (without ap-plying options) is to buy back the shares at the current market price. Inorder to do so, you must instruct your broker to close the trade or to “buyto  cover.”  Then,  once  the  stock  is  purchased,  the  borrowed  shares  aremoved out of the account and returned to the original owner.
Short Stock Case Study
Outside of trading options, there is only one method a trader has to makea  proﬁt  during  a  downtrend  in  stocks:  short  selling  stock.  As  previouslydiscussed, going short is the process of borrowing shares from your bro-ker and then replacing these shares at a future date when the stock haslost  ground.  If  this  occurs,  a  trader  can  proﬁt  on  the  decrease  in  price.However, shorting stock is extremely dangerous and cannot be done onall stocks and at all times.
It’s vital to keep in mind that shorting stock requires a large amount ofmargin. This is because the risk is unlimited to the upside. If you borrow astock  from  your  broker  at  $50,  expecting  it  to  decline,  but  it  insteadmoves higher, you are at risk the whole way up. If the stock hits $75, youhave lost $25 for each share you are short. This means that a margin callwould  have  occurred  several  times  on  this  move  up.  A  margin  call  is  aFederal Reserve requirement that a customer deposit a speciﬁed amountof  money  or  securities  to  keep  a  trade  open  when  a  sale  or  purchase  ismade in a margin account; the amount is expressed as a percentage of the
Short Stock
Strategy: Sell shares of stock.
Market  Opportunity: Look  for  a  bearish  market  where  the  stock  is expected to fall sharply.
Maximum Risk: Unlimited as the stock moves higher.
Maximum Proﬁt: Limited to the full stock price as it can only fall to zero.
Breakeven: Price of the stock at initiation (not including commissions).
Margin: Yes—usually 150 percent of short sale proceeds.
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market value of the securities at the time of purchase. The deposit mustbe made within one payment period.
Another  negative  to  shorting  stock  is  that  it  can  only  be  done  onstocks  that  have  large  volume.  Also,  a  stock  can  not  be  shorted  on  adowntick.  This  means  that  if  the  market  is  falling  hard  and  you  want  toshort a stock, it can’t be done until the stock has traded at the same priceor higher.
Let’s take a look at the risk graph in Figure 4.7, which depicts goingshort 100 shares of the Nasdaq 100 Trust (QQQ) at $82.44 on November 6,2000. The short sale of 100 shares produces a credit of $8,244. As you cansee, the risk graph for a short stock is the exact opposite of a risk graph
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FIGURE 4.7 Risk Graph of Short 100 Shares of Nasdaq 100 Trust (QQQ) @ 82.44(Source: Optionetics Platinum © 2004)
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Short Stock Case Study
Strategy: With  the  security  trading  at  $82.44  a  share  on  November  6,2000, sell 100 shares of the Nasdaq 100 Trust (QQQ).
Market Opportunity: Expect continued decline in shares.
Maximum Risk: Unlimited to the upside.
Maximum Proﬁt: Unlimited down to zero. In this case, an exit at $40 ashare would create a $4,244 proﬁt.
Breakeven: Initial  entry  price  (not  including  commissions).  In  this  case,$82.44 (not including commissions).
Margin: Extensive; depends on broker requirements and SEC requirements.
for a long stock. Although the trade proﬁts dollar-for-dollar as the stockmoves lower, it is also at risk dollar-for-dollar if the stock price increases.Keep in mind that your broker will require a rather large sum of capital tocover the margin requirement with the ﬁrm—usually 150 percent.
Luckily, this trade proved to be a good investment decision, with the Qsmoving lower and then sharply lower. If a trader had stayed short until the200-day moving average was broken near 40, he or she would have made asigniﬁcant proﬁt. The Qs fell that year from 82.44 to 40 in about a 12-monthperiod, which would have created a healthy proﬁt for the savvy short seller!
LONG CALL
In the long call strategy, you are purchasing the right, but not the obliga-tion, to buy the underlying shares at a speciﬁc price until the expirationdate. This strategy is used when you anticipate an increase in the price ofthe underlying stock. A long call strategy offers unlimited proﬁt potentialwith limited downside risk. It is often used to get high leverage on anunderlying security that you expect to increase in price.
If you want to go long a call, your risk curve would look like the graphin Figure 4.8. When the underlying security price rises, you make money;when it falls, you lose money. This strategy provides unlimited proﬁt po-tential with limited risk. It is often used to get high leverage on an underly-ing security that you expect to increase in price. Zero margin borrowing isallowed. That means that you don’t have to hold any margin in your ac-count to place the trade. You pay a premium (cost of the call), and thisexpenditure is your maximum risk.
Perhaps  the  only  drawback  is  that  options  have  deadlines,  afterwhich  you  cannot  recoup  the  premium  it  cost  to  buy  them.  Thus,  youneed  to  buy  calls  with  enough  time  till  expiration  for  the  underlying  to
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FIGURE 4.8 Long Call Risk Graph
move into the proﬁt zone—at least 90 days—or simply purchase LEAPSwith a year or two until expiration. In addition, it’s best to buy calls withlow implied volatility to lower the breakeven and minimize the debit toyour account.
Long Call Mechanics
In this example, let’s buy 1 March XYZ 50 Call @ 5.00, with XYZ trading at$50. This trade costs a total of $500 (5 × 100 = $500) plus commissions.The maximum risk is equal to the cost of the call premium or $500. Themaximum  reward  is  unlimited  to  the  upside  as  underlying  shares  riseabove the breakeven. The breakeven is calculated by adding the call pre-mium to the strike price. In this example, the breakeven is 55 (50 + 5 =55), which means the underlying shares have to rise above 55 for the tradeto start making a proﬁt.
In Figure 4.8, note how the numbers that run from top to bottom indi-cate the proﬁt and loss of this trade. The numbers that run left to right in-dicate  the  price  of  the  underlying  asset.  The  sloping  line  indicates  thetheoretical proﬁt or loss of the call option at trade expiration according tothe price of the underlying asset. Note how the loss is limited to the pre-mium paid to purchase the call option.
The risk graph of the long call shows unlimited proﬁt potential and a
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limited risk capped at $500 (see Figure 4.8). The breakeven is calculatedby adding the call premium to the strike price. The long call breakeven isslightly higher than the breakeven on the stock, but this is the trade-off atrader takes for opting for a position with less risk and a higher returnon investment.
Exiting the Position
A long call strategy offers two distinct exit scenarios. Each scenario pri-marily  depends  on  the  movement  of  the  underlying  shares,  althoughvolatility can have a major impact as well.
• XYZ rises above the breakeven (55): Offset the position by sellinga call option with the same strike price and expiration at an accept-able proﬁt; or exercise the option to purchase shares of the underly-ing market at the lower strike. You can then hold these shares as partof your portfolio or sell them at a proﬁt at the current higher marketprice.
• XYZ falls below the breakeven (55): If a reversal does not seemlikely, contact your broker to offset the long call by selling an identi-cal call to mitigate your loss. The most you can lose is the initial pre-mium paid for the option.
In this example, let’s say XYZ rises 10 points to 60. There are two waysto take advantage of it: exercise or offset it. By exercising the March 50call, you will become the owner of 100 shares of XYZ at the lower price of$50 per share. You can then sell the shares for the current price of $60 ashare and pocket the difference of $1,000. But since you paid $500 for theoption, this process reaps only a $500 proﬁt ($1,000 – $500 = $500) minuscommissions.  The  more  proﬁtable  technique  is  to  sell  the  March  50  callfor the new premium of 14.75, an increase of 9.75 points. By offsetting theMarch 50 call, you can make a proﬁt of $975 ($1,475 – $500 = $975)—a 195percent return!
Conversely, if you had bought 100 shares of XYZ at $50 per share, youwould have made a proﬁt of $1,000 (not including commissions) when theshares reached $60 per share—an increase of 10 points. The proﬁt on thelong stock position is slightly higher than the proﬁt on the long call—a big$25. However, the return on investment is much higher for the long callposition  because  the  initial  investment  was  signiﬁcantly  lower  than  theinitial capital needed to buy the stock shares. While both trades offeredproﬁt-making  opportunities,  the  long  call  position  offered  a  signiﬁcantlylower risk approach and the power to use the rest of the available tradingcapital in other trades. For an initial investment of $5,000, you could have
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THE OPTIONS COURSE
Strategy: Buy a call option.
Market Opportunity: Look for a bullish market where a rise above thebreakeven is anticipated.
Maximum Risk: Limited to the amount paid for the call.
Maximum  Proﬁt: Unlimited  as  the  price  of  the  underlying  instrumentrises above the breakeven.
Breakeven: Call strike price + call option premium.
Margin: None.
purchased 10 call options and made a total proﬁt of $9,750—now, that’s ahealthy return.
The ability of a call option to be in-the-money by expiration is primar-ily determined by the movement of the underlying stock. It is therefore es-sential to know how to analyze stock markets so that you can accuratelyforecast future price action in order to pick the call with the best chanceof making a proﬁt. Understanding market movement is not an easy task.Although  it  takes  time  to  accumulate  market  experience,  you  can  learnhow various strategies work without risking hard-earned cash by explor-ing paper trading techniques.
Long Call Case Study
In order to illustrate how the long call works in the real world, let’s consideran example using a familiar name—Intel (INTC). Suppose you were study-ing some research notes on Intel and it seemed to you that the stock pricehad fallen too far given the outlook for the company’s semiconductor sales.The chart pattern also seemed to suggest that the stock was due to movehigher. With shares trading near $15.75, you expect it to move above $20 byyear-end. So, you decide to establish a bullish trade on the chipmaker.
Instead of buying shares, you decide to buy the INTC January 17.50call. That is, you will buy the call option on Intel that has the strike priceof 17.50 and has an expiration month of January. The current premium is$2.55 per contract and you buy 10 contracts. The total cost of the trade istherefore $2,550: (2.55 × 10) × 100 = 2,550. Since Intel is trading near $16 ashare at the time, this call is out-of-the-money. Many call buyers prefer touse out-of-the-money calls because they provide the most leverage. It is avery aggressive way to trade the market.
To