endency to be assigned early more frequently than calls. Weprefer to be a little early in rolling out our short puts rather than toolate.Systematic Option WritingMany investors alternate put writing with covered call writing.They write puts on stocks they would like to add to their portfolio;some puts expire worthless, others are assigned. When assigned,they start writing covered calls against the shares held; when thecalls are assigned, they deliver the stock and resume put writing.With $100,000 an investor could write puts on 10 different equities, and by keeping the total value of the stock that would have tobe purchased if all puts were assigned to $100,000, this investorwould never have to purchase stocks on margin.The appeal of allocating part of a portfolio to an option writingprogram is that this strategy will generally outperform equities inﬂat markets, will still be proﬁtable in bull markets, and be somewhat less painful in bear markets. It’s simply another way to diversify one’s investments.
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BASIC TRADINGSTRATEGIESBuying CallsWhen traders become interested in the options market, the ﬁrststrategy they generally use is purchasing call options. This oftenleads to their ﬁrst frustration with the options market and, too often,their ﬁrst loss.That buying calls is traders’ entry point into the world of optionsshould not be too surprising. Most investors ﬁrst take interest inequities during a bull market: the news is positive, friends are making money, and it all looks so easy. Traders turn to options in thosesame bull markets. They are already making money on their stocks,they’ve heard about options, and buying calls is presented as themost basic bullish option strategy. If a bull market is good for stockowners, it must be great for call holders.
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56
The Options Strategist
Selecting Calls Based on PriceThe call buyer, whether a ﬁrst-time trader or a crusty old vet, is oftenoverwhelmed by the large number of options listed on any onesecurity. A typical stock will have six expiration dates available (fourshort-term options plus two long-term LEAPS) and a minimum ofthree strike prices, more often ﬁve or six strikes, giving a total of 18to 36 different options from which to choose. Confronted with thisselection, many options traders select a series based on the one variable that is immediately apparent to them—price.The April 35 calls at $3.40 look expensive, especially when compared to the April 40 calls at $1.05. The May 40 calls are $2, but the45s can be purchased for only $0.35. And buying the lower-pricedoptions lets the trader purchase a greater number of contracts. Thelast time you owned a stock that went up nicely, you could not helprepeating to yourself, “Should have bought more.” You are notabout to make the same mistake with options. By purchasing thelower-priced options you can buy more with the same trading capital, and it would be foolish not to do so.
Looking Beyond an Option’s PriceUnfortunately, too many options traders are guided by price. Thereare two basic assumptions underlying an option trade, and bothshould be used in the selection process. The ﬁrst assumption is thatfor a given position a trader will be willing to risk a ﬁxed dollaramount. In other words: “I have $2,500 to allocate to this one position and to risk,” not “I am looking to purchase calls on 400 sharesno matter what they cost.” We view traders as allocating blocks oftheir trading capital to each of their positions.The second assumption is that a trader is looking to maximize hisreturn on capital on any one trade. Don’t laugh; this obvious pointis ignored more often than traders are willing to admit. To illustratethe point, look at the following selected options on Minnesota Mining & Manufacturing (MMM):MMM:April 105 call:
$115.50$11.90–$12.30
57
Basic Trading Strategies
April 110 call:April 115 call:April 120 call:April 125 call:
$8.20–8.50$5.10–$5.20$2.70–$2.90$1.20–$1.30
The April options have 60 days until expiration, and a trader whois bullish on MMM is wondering which of these calls to purchase.Traders looking only at option premiums are often drawn to thelower-priced options because they can buy more. For example, atrader who decides to risk $3,000 on his MMM position could purchase only 2 of the 105 calls but would have sufﬁcient funds to buy23 of the 125 calls. At cocktail parties, it sounds better if he can claimto have bought “a 20 lot” rather than just two options. But let’s bemore thorough and analyze this situation from the perspective ofreturn on investment.Let’s start with the purchase of the at-the-money 115 calls. Thereturn on this option at expiration will obviously be a function ofhow MMM performs over the next 60 days. Table 3.1 calculates thereturn on trading capital obtained if the 115 calls are purchased forvarious MMM prices at option expiration.
Table 3.1MMM Priceat OptionExpiration
Value of115 Call atExpiration
Cost of115 Call
Proﬁt/(Loss)
Return onTradingCapital
$112.50
$0
$5.20
($5.20)
(100%)
$115.00
$0
$5.20
($5.20)
(100%)
$117.50
$2.50
$5.20
($2.70)
(52%)
$120.00
$5
$5.20
($0.20)
(4%)
$122.50
$7.50
$5.20
$2.30
44%
$125.00
$10
$5.20
$4.80
92%
$127.50
$12.50
$5.20
$7.30
140%
$130.00
$15
$5.20
$9.80
188%
58
The Options Strategist
Table 3.2MMM Priceat OptionExpiration
Value of105 Call atExpiration
Cost of105 Call
Proﬁt/(Loss)
Return onTradingCapital
$102.50
$0
$12.30
($12.30)
(100%)
$105.00
$0
$12.30
($12.30)
(100%)
$107.50
$2.50
$12.30
($9.80)
(80%)
$110.00
$5
$12.30
($7.30)
(59%)
$112.50
$7.50
$12.30
($4.80)
(39%)
$115.00
$10
$12.30
($2.30)
(19%)
$117.50
$12.50
$12.30
$0.20
2%
$120.00
$15
$12.30
$2.70
22%
$122.50
$17.50
$12.30
$5.20
42%
$125.00
$20
$12.30
$7.70
62%
MMM Priceat OptionExpiration
Value of125 Call atExpiration
Cost of125 Call
Proﬁt/(Loss)
Return onTradingCapital
$122.50
$0
$1.30
($1.30)
(100%)
$125.00
$0
$1.30
($1.30)
(100%)
$127.50
$2.50
$1.30
$1.20
92%
$130.00
$5
$1.30
$3.70
285%
$132.50
$7.50
$1.30
$6.20
477%
$135.00
$10
$1.30
$8.70
669%
$137.50
$12.50
$1.30
$11.20
862%
$140.00
$15
$1.30
$13.70
1054%
Table 3.3
59
Basic Trading Strategies
The same type of analysis can be performed for all call options,but we will limit ourselves to two additional series: the in-themoney 105 call in Table 3.2 and the out-of-the-money 125 call inTable 3.3.Yes, some of those returns on the 125 call are eye-popping, butbefore jumping to conclusions let’s look at this from another angle.Which option offers the better return on trading capital if MMM rallies to $120? $125? $130? By referring back to the three tables you willﬁnd that the answers are the 105 call, the 115 call, and the 125 call.The conclusion is that no one option will offer the best return ontrading capital; there is only one best option for a given price ofMMM at option expiration. Table 3.4 expands on the previous threetables and in the right-hand column identiﬁes the “best” option fora given stock price at expiration.
Table 3.4Return on105 Call
Return on115 Call
Return on125 Call
“Best”Option
$102.50
(100%)
(100%)
(100%)
None
$105.00
(100%)
(100%)
(100%)
None
$107.50
(80%)
(100%)
(100%)
105 C
$110.00
(59%)
(100%)
(100%)
105 C
$112.50
(39%)
(100%)
(100%)
105 C
$115.00
(19%)
(100%)
(100%)
105 C
$117.50
2%
(52%)
(100%)
105 C
$120.00
22%
(4%)
(100%)
105 C
$122.50
42%
44%
(100%)
115 C
$125.00
63%
92%
(100%)
115 C
$127.50
83%
140%
92%
115 C
$130.00
103%
188%
285%
125 C
$132.50
124%
237%
477%
125 C
$135.00
144%
285%
669%
125 C
60
The Options Strategist
Some of the conclusions we can draw from this last table come asno surprise:■
No one option works best under all outcomes.
■
The higher the call’s strike price, the higher its breakeven point,and the higher the price to which the underlying must rise forthis option to be proﬁtable.
■
If the price of the underlying stock goes down by a sufﬁcientamount, all of the options will expire worthless.
The key consideration in selecting which option to purchase turnsout to be not the price of the option, but the trader’s forecast for theprice of the underlying stock. With MMM at $115.50 the 105 call wasthe best option for a rally to slightly above $120; from that point tosomewhere around $128 the 115 call offered the better return ontrading capital; and above $128 the 125 call looks like the betterchoice. The trader who has just decided to purchase some calls onMMM must ask: Where do I expect this stock to be trading in 60days? Is $130 a realistic target? Do I want to err on the side ofcaution?This last question is an important one. Comparing the 115 and the125 calls, we have a breakeven of $120.20 for the ﬁrst option and$126.30 for the second one. It is obviously easier to earn a positivereturn by purchasing the 115 call. But what about those home runsone can hit with the 125 call? What if the stock goes to $130 or $135?At those higher prices the 115 call, even if its returns are signiﬁcantlylower than those of the 125 call, are still quite attractive. Erring onthe side of caution (by purchasing fewer calls with a lower strikeprice instead of a greater number with a higher exercise price) maynot produce as many home runs but will certainly generate moresingles and doubles.The example here was simpliﬁed. We ignored the 110 and 120calls in addition to strikes below 105 and above 125 that were listedfor trading at the time we created this example. But even with amore complete analysis our conclusions would remain the same.The MMM example can be easily replicated for any call buyingsituation because the options’ values at expiration will be equal totheir intrinsic value and the returns on trading capital a cinch to cal-
Basic Trading Strategies
61
culate. But what if our trader is purchasing calls on MMM with theexpectation that the stock will move up over the next two to fourweeks? He will be more interested in how the returns on tradingcapital look sometime before expiration, an exercise that requiresmaking an assumption as to how the options will be priced at thatpoint in time.Using a technique from economics class, we will start by assuming that the options’ volatility estimate will remain constant overthe life of the options. We will relax this assumption a little later. Thequestion now is, which option will provide the higher return ontrading capital if MMM hits its target price prior to option expiration? To ﬁnd the answer we start with Table 3.5 which, based on anunchanged volatility assumption, calculates the value and thereturn for the 115 call for various stock prices and different times toexpiration.Table 3.5 Value of 115 Call/Return on Trading Capital60Days
50Days
40Days
30Days
20Days
10Days
Expiration
$112.50
$3.70/(29%)
$3.27/(37%)
$2.80/(46%)
$2.27/(56%)
$1.65/(68%)
$0.94/(82%)
$0/(100%)
$115.00
$4.85/(7%)
$4.41/(15%)
$3.94/(24%)
$3.40/(35%)
$2.76/(47%)
$1.94/(63%)
$0/(100%)
$117.50
$6.36/22%
$5.92/14%
$5.43/4%
$4.88/(6%)
$4.24/(18%)
$3.50/(33%)
$2.50/(52%)
$120.00
$7.95/53%
$7.55/45%
$7.11/37%
$6.62/27%
$6.04/16%
$5.45/5%
$5/(4%)
$122.50
$9.78/88%
$9.38/80%
$8.96/72%
$8.57/65%
$8.11/56%
$7.69/48%
$7.50/44%
$125.00
$11.72/125%
$11.40/119%
$11.05/113%
$10.69/ $10.36/ $10.10/106%99%94%
$10/92%
$127.50
$13.82/ $13.50/ $13.24/ $12.96/ $12.73/ $12.57/166%160%155%149%145%142%
$12.50/140%
$130.00
$16.02/ $15.78/ $15.52/ $15.33/ $15.16/ $15.06/208%203%198%195%192%190%
$15/188%
62
The Options Strategist
The above exercise can be repeated for the 105 and 125 calls, a process we will spare you. But the results from Table 3.5 can be combined with the equivalent results for these two other calls and the“best” option for each square in the grid selected. This was doneand compiled in Table 3.6.Although it analyzes the returns from only three options, Table3.6 presents all of the potentials and pitfalls of the different optionseries. If your price target on MMM is $120, which option shouldyou purchase? If the stock hits $120 within 10 days of your establishing your position, the 125 calls offer the highest return on trading capital. If reaching this target takes from 20 to 30 days, the 115call is the most efﬁcient vehicle, and any longer makes the 105 callthe trader’s choice. This is a roundabout way of saying that thereare two variables that must be taken into account when selectingwhich option to purchase: the target price of the underlying stockand when it is expected to reach this price.Table 3.6 Highest Return on Trading Capital/Call Option60Days
50Days
40Days
30Days
20Days
10Days
Expiration
$112.50
(23%)/105
(26%)/105
(29%)/105
(32%)/105
(35%)/105
(38%)/105
(39%)/105
$115.00
(6%)/105
(9%)/105
(12%)/105
(14%)/105
(16%)/105
(18%)/105
(19%)/105
$117.50
32%/125
14%/115
7%/105
5%/105
3%/105
2%/105
2%/105
$120.00
94%/125
66%/125
37%/115
27%/115
23%/105
22%/105
22%/105
$122.50
172%/125
141%/125
105%/125
66%/125
56%/115
48%/115
44%/115
$125.00
261%/125
228%/125
192%/125
152%/125
105%/125
94%/115
92%/115
$127.50
377%/125
344%/125
308%/125
267%/125
219%/125
165%/125
140%/115
$130.00
500%/125
471%/125
438%/125
402%/125
359%/125
315%/125
285%/125
63
Basic Trading Strategies
This table also lets us see how different options behave. Start withthe out-of-the-money 125 call. On a quick run-up in the price of thestock, this is the option to own: it has the highest return on a moveto $117.50 on the initial trade date, and to $120 within 10 days. Butas expiration nears, MMM has to rise to higher and higher levels tomake this the option of choice. Conclusion: out-of-the-moneyoptions perform best only if the underlying stock rises soon afterthe trade date or if the stock rises by a substantial amount.As for the in-the-money 105 call, it holds its own if the price ofthe stock remains unchanged or drops slightly. This is easy to understand since most of its premium is intrinsic value that will not decayover time. Of course, should MMM fall below 105 it will perform nobetter than the other two options because it will also expire worthless. This in-the-money option performs best in slowly or moderately rising markets.An Option’s Sweet SpotWe ﬁrst developed the notion of an option’s sweet spot in theLEAPS book we coauthored with Marty Kearney. Look at the areain Table 3.6 where the at-the-money 115 call offers the highest returnon trading capital. This is what we named the option’s sweet spot—that area in the price and time continuum where it outperforms allother options. By reﬁning the numbers and calculating thebreakeven points more precisely we come up with Figure 3.1, whichillustrates the 115 call’s sweet spot.
$130$126$124$122$120$118$116$11460
50
40
30Days to Expiration
Figure 3.1 MMM 115 Call: Sweet Spot
20
10
0
MMM Price
$128
64
The Options Strategist
Calculating multiple options’ sweet spots before every call purchase is bound to drive even the most avid option trader into munibonds. We certainly would not advise trying to re-create this exercise. But at-the-money calls will have sweet spots similar in shapeto this one, which can therefore be used as a template. Rememberthat this sweet spot was created by comparing the 115 at-the-moneycall to both the 105 and 125 calls. If we had used the 110 and 120calls in our analysis the sweet spot would be somewhat narrower.Out-of-the money options will have a sweet spot above the onedepicted in Figure 3.1, and its general shape can be inferred by looking at the numbers in Table 3.6. The sweet spot for in-the-moneyoptions will lie below that of the at-the-money options. Think ofthese as a reality check: you are about to purchase the MMM March125 calls. Is it realistic to expect this stock to trade in this option’ssweet spot some time before or at expiration? If not, choosing anoption with a lower strike price (and therefore a lower sweet spot)may be a more conservative way to take a position in this stock.Relaxing the Volatility AssumptionWe have not yet discussed the full impact of changes in volatility onoption pricing, so you may want to return to this section after reading Chapters 4 and 9. But we want to address the question of whathappens to an option’s sweet spot if the option’s volatility estimatechanges.When a stock rallies, a change in volatility is likely to be onewhere the estimate is reduced (this is discussed in more detail inChapter 9). So the trader is bound to ask, “If the stock goes up as Iexpect, and the option’s volatility estimate declines, how will thischange the call’s sweet spot?” To view the result, make the unrealistic assumption that the option’s volatility estimate drops to zero.What shape would the sweet spot then take? This is an easy question because at expiration the option’s volatility is zero. (Remember,at expiration an option will be trading at its intrinsic value andvolatility will not come into the equation.) So, if volatility drops tozero 30 days before expiration, the option’s sweet spot at that pointin time would be deﬁned by the same boundaries as the ones it hasat expiration. In other words, the sweet spot would shift upwards.Assuming that an option’s volatility estimate will fall to zero is unre-
Basic Trading Strategies
65
alistic, but it helps us visualize the impact of a reduction involatility—an upward shift in the option’s sweet spot. This is a pointof importance to the buyers of out-of-the-money calls, whoseoptions have become somewhat less attractive. Note that an option’ssweet spot cannot shift any higher than its boundaries at expiration,as these represent the sweet spot’s upper limits.An Option’s Proﬁtability BoundaryIt is important to remember that an option’s sweet spot may includean area where losses are realized. Since the sweet spot establishesonly that area where an option outperforms other options (outperform means either a higher return or a lower loss), it may also be ofinterest to look at the option’s proﬁtability boundary. This boundary is better understood through an illustration. Figure 3.2 gives usthe boundaries of the three MMM calls from our example.The boundaries tell us how much the underlying stock has toincrease in value for the option buyer to break even at any givendate. Obviously, options buyers want the price of the stock to beabove the boundary of the call they have purchased. Once again wehave assumed that the options’ volatility will remain constant untilexpiration.It is often said that call buyers are ﬁghting an uphill battle. Ourboundary graph clearly illustrates how steep the slope is for selectedoptions. An option’s proﬁtability boundary should be used as a
$128
$124$122$120$118$116$11460
50
40
30
20
10
Days to Expiration
Figure 3.2 MMM Calls: Proﬁtability Boundaries
0
MMM Price
$126125 C115 C105 C
66
The Options Strategist
quick reality check. How probable is it that this particular stock willbe trading above its boundary prior to expiration? More important,how probable is it that it will be trading above its boundary by anamount sufﬁcient to generate an adequate proﬁt?Note that if the volatility used to price these options increases, theoptions’ boundaries will be pushed down, which is good. Thereverse happens if the volatility estimate is reduced. The only pointin the graph that will not change is the option’s boundary at expiration, since at that point in time an option’s value will not beimpacted by volatility but will be equal to its intrinsic value.Choosing the Option’s Expiration DateThose who are hoping to ﬁnd an analysis as elaborate as the onepresented earlier for strike price selection are bound to be disappointed. The question here is, by which date do you expect thisstock to reach your target price? We would recommend answeringthis question before looking at the stock’s option quotes. It is impossible to ignore the fact that the September options are less expensive than the Octobers, and the August calls even less pricey thanthe Septembers. So even though it may be late July, many tradersopt for the August contracts based on price alone.Selecting options’ expiration dates based on price will always leadto buying the shorter-dated options and will too often lead to atrader running out of time—being right about the stock, being rightabout the direction, but being out of the market when the stockﬁnally moves because the April calls expired two weeks ago.If you expect a stock to move over the next 30 days, it wouldappear that a one-month option ﬁts the bill. But if you purchase atwo-month option you are giving yourself some additional leeway,and there is no need to hang on to your two-month option untilexpiration. If after 30 days the stock has performed as expected, sellit and take your proﬁts.The trade-off in buying more time is best illustrated by an example. Take a look at the 28- and 56-day options on Quick Pop Stock(QPS).QPS:28-day 45 call:56-day 45 call:
$45$1.76$2.51
67
Basic Trading Strategies
Table 3.7
QPS in28 days
ExpiringOption
Return onTradingCapital
Option with28 DaysRemaining
Return onTradingCapital
$45
$0
(100%)
$1.76
(30%)
$47.50
$2.50
42%
$3.37
34%
$50
$5
184%
$5.37
114%
$52.50
$7.50
326%
$7.67
206%
$55
$10
468%
$10.10
302%
Let’s look at what happens to each of these options when QPS isup by various amounts in 28 days. Table 3.7 assumes that the volatility used in pricing these options remains unchanged.By “buying more time,” i.e., purchasing the 56-day option, lossesare reduced if QPS remains unchanged or rises only slightly, butsome upside potential is lost as well because the return on capitalis higher with the shorter-term option when QPS rallies sufﬁciently.And here one sees the major trade-off between shorter- and longerdated options: shorter-term options provide more leverage if theunderlying stock performs as expected but result in relatively largerlosses if the stock remains unchanged or rises only slightly. We generally argue in favor of buying more time, as we prefer to give up alittle if we are correct in our forecast in order to obtain additionalstaying power.When to Sell Long CallsMany investors say, “I know when to buy calls, but I never can ﬁgure out when to sell them.” We offer a two-part answer.The sale of a long call position could be triggered by an optiontarget price. For example, you purchased a call at $3 with a $6 goal.If the option goes to $6, sell it. An alternative to this simple target isto sell the option if it reaches $6 or if it drops to $1. The latterincludes a stop loss mechanism that should be part of disciplinedtrading.The second, and perhaps preferable, method for triggering thesale of long calls is to set target prices for the underlying stock and
68
The Options Strategist
not the option. If you purchase a call when a stock is trading at $44and your forecast is that it will rise to $49, sell your option when thestock reaches this level, even though it may not be trading at theprice you had anticipated. There is no reason to hold on to a callposition once the underlying has reached your forecasted price. Amore complete approach would be to sell your long calls if the stockreached $49, or if