call at 6.60Sell call at 0.55Net cost  6.05
Income Strategies
Buy stock at 25.00Sell stock at 27.50Net profit at 2.50Total  2.50  6.05  loss of 3.55Lesson: Never exercise a long-term option because you’ll miss out on Time Value!
Risk Profile
Profit / (Loss)2.01.51.00.5-0.5
Stock Price18
20
22
24
26
28
30
32
34
-1.0-1.5-2.0-2.5-3.0-3.5-4.0
Before we wrap up this chapter, we’re going to introduce two additional strategies.They’re variations of the Calendar Call and Diagonal Call. They’re simply the equivalent strategies using puts; hence they’re called a Calendar Put and Diagonal Put.We put them at the end of this section in order to be thorough.
2.11 Calendar PutProficiency
Direction
VolatilityN/A
Advanced
Bullish
Asset Legs■ Long Put
Max Risk
Max Reward
Strategy Type
Capped
Income
!
Capped
■ Short Put
2.11.1 DescriptionCalendar spreads are known as horizontal spreads, and the Calendar Put is a variationof a Calendar Call where you substitute the calls with puts. Ultimately the strategy
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is virtually identical. The question lies in whether you can achieve a better yieldusing the puts versus the calls.Like the Calendar Call, the problem with a Calendar Put is in the very essence ofthe shape of the risk profile (see the following). What we’d like to do is create something similar to a Covered Call, but with a better yield and without the expense.The Calendar Put certainly requires less investment; however, the shape is different. If the stock rises too far too soon, then the Calendar Put can become lossmaking. So even though you got the direction of the trade right, you could still losemoney!Both options share the same strike, so if the stock rises above the strike, your shortput will expire worthless, whereas your long put will be less valuable because it’snow further OTM. If the stock falls, the short put will be exercised, and you’ll thenhave to sell the long put (hopefully for a profit), use the proceeds to sell the stock atthe market price, and then buy it back at the strike price. Therefore, the best thingthat can happen is that the stock is at the strike price at the first expiration. This willenable you to write another put for the following month if you like.
Buy put
Sell put
Calendar Put
Steps to Trading a Calendar Put1. Buy a long-term expiration put with a near the money strike price.2. Sell a short-term put (say monthly) with the same strike price.Steps In■
Try to ensure that the trend is upward or rangebound and identify clearareas of support and resistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock closes below the strike at expiration, you will be exercised. Youwill sell your long put, buy the stock at the strike price, and sell it at themarket price, having profited from both the short option premium youreceived and the uplift in the long option premium. Exercise of the shortoption is automatic. Do not exercise the long option or you will forfeit itstime value.
■
If the stock rises above the strike but above your lower stop loss, let theshort put expire worthless and keep the entire premium. You can then writeanother put for the following month.
■
If the stock rises above your higher stop loss, then either sell the long option(if you’re approved for Naked Put writing) or reverse the entire position.
Income Strategies
2.11.2 ContextOutlook■
With a Calendar Put, your outlook is neutral to bullish. You expect a steady rise.
Rationale■
To generate income against your longer term long position by selling puts andreceiving the premium.
Net Position■
This is a net debit transaction because your bought puts will be more expensive than your sold puts, which have less time value.
■
Your maximum risk on the trade itself is limited to the net debit of the boughtputs less the sold puts. Your maximum reward is limited to the residual putvalue when the stock is at the strike price at the first expiration, less the net debit.
Effect of Time Decay■
Time decay affects your Calendar Put trade in a mixed fashion. It erodes thevalue of the long put but helps you with your income strategy by eroding thevalue faster on the short put.
Appropriate Time Period to Trade■
You will be safest to choose a long time to expiration with the long put and ashort time (one month) for the short put.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward or rangebound and identify clear areasof support and resistance.
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—Look for either the ATM or just ITM (higher) strike above the currentstock. If you’re bullish, then choose a higher strike; if neutral, choose the ATMstrike.
■
Expiration—Look at either of the next two expirations for the short option andcompare monthly yields. Look for over six months for the long option.
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2.11.3 Risk Profile■
Maximum Risk
[Put strike] – [maximum value of long put at the firstexpiration]  [net debit]
■
Maximum Reward
[Long put value at strike price at first expiration] [net debit]
■
Breakeven Down
Depends on the value of the long put option at the timeof the short put expiration
■
Breakeven Up
Depends on the value of the long put option at the timeof the short put expiration
2.11.4 GreeksKey:ExpirationToday – 1 monthTime(t) – 5 daysRisk ProfileMaximum profit isachieved when thestock is at the strikeprice at the time ofthe short put expiration date. Any substantial move up ordown is dangerousfor the position.
Risk Profile
Theta
Delta
Vega
DeltaDelta (speed) is at itsfastest either side ofthe strike price, indicating the increasingspeed of the positionin one direction andthen the other.
ThetaTheta is positive,illustrating that timedecay is helpful tothe position aroundthe strike price,where the position isprofitable. Timedecay is not so helpful when the positionis unprofitable.VegaIncreasing volatility ishelpful because it willmean the long put’sresidual value shouldbe higher.
GammaGammaGamma (acceleration)peaks inverselyaround the strikeprice, showing wherethe Delta line issteepest.
RhoRhoHigher interest ratesbecome more helpfulas the underlyingasset price rises.
2.11.5 Advantages and DisadvantagesAdvantages■
Generate monthly income.
■
Can profit from rangebound stocks and make a higher yield than with aCovered Call or Naked Put.
Income Strategies
Disadvantages■
Capped upside if the stock rises.
■
Uncapped downside—you can lose more than your net debit with thisstrategy.
■
Can lose on the upside if the stock rises significantly.
■
High yield does not necessarily mean a profitable or high probability profitabletrade.
2.11.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the putsyou sold and selling the puts you bought in the first place.
■
Advanced traders may leg up and down as the underlying asset fluctuates upand down. In this way, you can take incremental profits before the expirationof the trade.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-leg.In this way, they will leave one leg of the spread exposed in order to attempt toprofit from it.
2.11.7 ExampleABCD is trading at $65.00 on May 5, 2004, with Historical Volatility at 33%.■
Buy January 2006 65 puts at $9.00
■
Sell June 2004 65 puts at $3.00
At June Expiration1. Scenario: stock falls to $60.00Long puts worth approximately 10.76; profit so far  1.76Short puts expire $5.00 ITMProcedure: sell bought puts; sell stock at current price and buy at strike priceExercised at $65.00Sell stock at 60.00Buy stock at 65.00Loss  5.00
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Sell long put for a profit  1.76Keep short put premium  3.00Loss on Exercise  5.00Total position  0.24 lossIf you tried to exercise the bought put:Procedure: exercise bought puts at $65.00; buy stock at $65.00 for exercised sold putBuy put at 9.00Sell put at 3.00Net cost  6.00Sell stock at 65.00Buy stock at 65.00Net profit at 0.00Total  6.00  0.00  loss of 6.00Lesson: Think twice about exercising a long-term option because you’ll miss outon Time Value!2. Scenario: stock falls to $62.50Long puts worth approximately 9.71; profit so far  0.71Short puts expire $2.50 ITMProcedure: sell bought puts; sell stock at current price and buy at strike priceExercised at $65.00Sell stock at 62.50Buy stock at 65.00Loss  2.50Sell long put for a profit  0.71Keep short put premium  3.00Loss on Exercise  2.50Total position  1.21 profitIf you tried to exercise the bought put:Procedure: exercise bought puts at $65.00; buy stock at $65.00 for exercisedsold putBuy put at 9.00Sell put at 3.00Net cost  6.00Sell stock at 65.00Buy stock at 65.00Net profit at 0.00Total  6.00  0.00  loss of 6.00
Income Strategies
Lesson: Think twice about exercising a long-term option because you’ll miss outon Time Value!3. Scenario: stock stays at $65.00Long puts worth approximately 8.75; loss so far  0.25Short puts expire worthless; profit 3.00No exerciseTotal position  9.00  3.00  0.25  11.75  profit of 2.754. Scenario: stock rises to $70.00Long puts worth approximately 7.08; loss so far  1.92Short puts expire worthless; profit 3.00.No exerciseTotal position  9.00  3.00  1.92  10.08  profit of 1.085. Scenario: stock rises to $75.00Long puts worth approximately 5.70; loss so far  3.30Short puts expire worthless; profit 3.00.No exerciseTotal position  9.00  3.00  3.30  8.70  loss of 0.30
Risk Profile
Profit / (Loss)42
Stock Price30-2-4-6-8-10
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100
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2.12 Diagonal PutProficiency
Direction
Volatility
Asset Legs
N/AAdvanced
Bullish
■ Long Put
Max Risk
Max Reward
Strategy Type
Capped
Income
!
Capped
■ Short Put
2.12.1 DescriptionThe Diagonal Put is a variation of a Diagonal Call where you substitute the calls withputs. Ultimately the strategy is virtually identical. The question lies in whether youcan achieve a better yield using the puts versus the calls.The Diagonal Put solves the problems experienced with the Calendar Put, in thatthe shape of the risk profile (see the following) is more akin to the Covered Call,which is what we want. Yet the Diagonal Put is going to be a far cheaper investment,particularly because the long put element is OTM! If the stock rises explosively, thenunlike the Calendar Put, the Diagonal Put done correctly won’t become loss-making.The key is not to get too greedy!The bought option is long-term and OTM, and the short option is short-term andITM. If the stock rises above the higher (short) strike, your short put will expireworthless, and the long put will decrease in value. The long put will reduce in valuebecause it is further OTM and there will have been some time decay, too.
Buy put
Sell put
Diagonal Put
Steps to Trading a Diagonal Put1. Buy a lower strike long-term expiration put.2. Sell a higher strike shorter term put (say monthly).Steps In■
Try to ensure that the trend is upward or rangebound and identify a cleararea of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Reverse the position if the stock trades outside your lower or higher stoploss areas.
■
If the stock rests between the two strike prices, you’ll be exercised, whereupon you must sell the long put and use the proceeds to buy the stock atthe higher strike price (and then sell it at the market price).
Income Strategies■
If the stock rises above the higher strike but is still below your higher stoploss, then the short put will expire worthless, and you’ll have the chance towrite another put for the following month, though your long put will havereduced in value significantly.
2.12.2 ContextOutlook■
With a Diagonal Put, your outlook is bullish.
Rationale■
To create a net credit trade by buying the longer term OTM put options andselling the ITM put options while creating the same risk profile as a DiagonalCall Spread.
Net Position■
This is a net credit trade because your bought puts are OTM and thereforecheaper than your short ITM puts. This of course can depend on the strikesthat you choose and the different expiration dates that you choose (i.e., you cancreate a net debit if your long put is far enough away from expiration, yourshort put has a very short time to expiration, and the strike prices are quiteclose together).
Effect of Time Decay■
Time decay affects your Diagonal Put trade in a mixed fashion. It erodes thevalue of the long put but can help you with your income strategy by erodingthe value faster on the short put, depending on how far ITM it is.
Appropriate Time Period to Trade■
You will be safest to choose a long time to expiration with the long put and ashorter time for the short put.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward or rangebound and identify a clear areaof support.
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
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■
Lower Strike—Look for a deep OTM (ideally around 1020% lower) strikebelow the current stock price.
■
Higher Strike—Look for ITM (higher) by more than one strike to raise enoughincome on the trade.
■
Expirations—Look at either of the next two expirations for the short optionand compare monthly yields. Look for over six months for the long option.
2.12.3 Risk Profile■
Maximum Risk
[Higher strike]  [maximum long put value at the firstexpiration]  [net credit]
■
Maximum Reward
Depends on the value of the long put option at the timeof the short put expiration
■
Breakeven Down
Depends on the value of the long put option at the timeof the short put expiration
■
Breakeven Up
Depends on the value of the long put option at the timeof the short put expiration
2.12.4 GreeksKey:ExpirationToday – 1 monthTime(t) – 5 daysRisk ProfileMaximum profit isachieved when thestock is at the higherstrike price at thetime of the short putexpiration date.
Risk Profile
Theta
DeltaDelta (speed) is at itsfastest either side ofthe strike price, indicating the increasingspeed of the positionin one direction andthen the other.
Delta
Vega
GammaGamma (acceleration)peaks inverselyaround the higherstrike price, showingwhere the Delta lineis steepest.
Gamma
Rho
ThetaTheta is positive,illustrating that timedecay is most helpfulto the positionaround the higherstrike price, wherethe position is mostprofitable.VegaIncreasing volatility ishelpful because it willmean the long call’sresidual value shouldbe higher.
RhoLower interest ratesbecome moreunhelpful as theunderlying assetprice falls.
Income Strategies
2.12.5 Advantages and DisadvantagesAdvantages■
Generate (monthly) income.
■
Can profit from rangebound stocks and make a higher yield than with aCovered Call or Naked Put.
Disadvantages■
Capped upside if the stock rises.
■
Uncapped downside—you can lose more than your net debit with this strategy.
■
Can lose on the upside if the stock rises significantly.
■
High yield does not necessarily mean a profitable or high probability profitabletrade.
2.12.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the putsyou sold and selling the puts you bought in the first place.
■
Advanced traders may leg up and down as the underlying asset fluctuates upand down. In this way, you can take incremental profits before the expirationof the trade.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-leg.In this way, they will leave one leg of the spread exposed in order to attempt toprofit from it.
2.12.7 ExampleABCD is trading at $26.00 on May 11, 2004, with Historical Volatility at 40%.■
Buy January 2006 25 puts at $4.00
■
Sell June 2004 27.50 puts at $2.20
At June Expiration1. Scenario: stock falls to $23.00Long puts worth approximately 5.00; profit so far  1.00Short puts expire $4.50 ITM
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Procedure: sell bought puts; buy stock at higher strike price and sell atcurrent priceExercised at $27.50Buy stock at 27.50Sell stock at 23.00Loss  4.50Sell long put for a profit  1.00Keep short put premium  2.20Loss on Exercise  4.50Total position  1.30 lossIf you tried to exercise the bought put:Procedure: exercise bought puts at $25.00; buy stock at $27.50 for exercisedsold putBuy put at 4.00Sell put at 2.20Net cost  1.80Buy stock at 27.50Sell stock at 25.00Net loss at 2.50Total  1.80  2.50  loss of 4.30Lesson: Never exercise a long-term option because you’ll miss out on TimeValue!2. Scenario: stock falls to $25.00Long puts worth approximately 4.20; profit so far  0.20Short puts expire 2.50 ITMProcedure: sell bought puts; buy stock at higher strike price and sell at currentpriceExercised at $27.50Buy stock at 27.50Sell stock at 25.00Loss  2.50Sell long put for a profit  0.20Keep short put premium  2.20Loss on Exercise  2.50Total position  0.10 loss
Income Strategies
If you tried to exercise the bought put:Procedure: exercise bought puts at $25.00; buy stock at $27.50 for exercisedsold putBuy put at 4.00Sell put at 2.20Net cost  1.80Buy stock at 27.50Sell stock at 25.00Net loss at 2.50Total  1.80  2.50  loss of 4.30Lesson: Never exercise a long-term option because you’ll miss out on Time Value!3. Scenario: stock stays at $26.00Long puts worth approximately 3.90; loss so far  0.10Short puts expire $1.50 ITMProcedure: sell bought puts; buy stock at higher strike price and sell at currentpriceExercised at $27.50Buy stock at 27.50Sell stock at 26.00Loss  1.50Sell long put for a loss  0.10Keep short put premium  2.20Loss on Exercise  1.50Total position  0.60 profitIf you tried to exercise the bought put:Procedure: exercise bought puts at $25.00; buy stock at $27.50 for exercised sold putBuy put at 4.00Sell put at 2.20Net cost  1.80Buy stock at 27.50Sell stock at 25.00Net loss at 2.50Total  $1.80  $2.50  loss of $4.30Lesson: Don’t exercise a long-term option because you’ll miss out on Time Value!
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4. Scenario: stock rises to $27.50Long puts worth approximately 3.40; loss so far  0.60Short puts expire worthless; profit 2.20No exerciseTotal position  4.00  2.20  0.60  5.60  profit of 1.605. Scenario: stock rises to $30.00Long puts worth approximately 2.75; loss so far  1.25Short puts expire worthless; profit 2.20No exerciseTotal position  4.00  2.20  1.25  4.95  profit of 0.95
Risk Profile
Profit / (Loss)2.01.51.00.5-0.5
Stock Price18
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30
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2.13 Covered Put (Also Known as a Married Put)Proficiency
Direction
VolatilityN/A
Advanced
Bearish
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capped
Income
■ Short Stock■ Short Put
Income Strategies
2.13.1 DescriptionThe Covered Put is the opposite process to a Covered Call, and it achieves the opposite risk profile. Whereas the Covered Call is bullish, the Covered Put is a bearishincome strategy, where you receive a substantial net credit for shorting both the putand the stock simultaneously to create the spread.The concept is that in shorting the stock, you then sell an Out of the Money putoption on a monthly basis as a means of collecting rent (or a dividend) while you areshort the stock.The trade-off is that an OTM Covered Put will give a higher potential yield butless cushion, whereas an ITM Covered Put will give a lower yield but much morecushion. This is not a recommended strategy (partly because it’s a little confusing!),but “you pays your money, you takes your chances” on this one!If the stock falls below the put strike, you’ll be exercised and will have to buy thestock at the strike price . . . but you make a profit because you’ve already shorted it,so the purchase simply closes your stock position, and you retain the premium forthe sold put. (You’re covered because you shorted the stock in the first place.) If thestock remains static, then you simply collect the put premium. If the stock rises, youhave the cushion of the put premium you collected.
Short stock
Sell OTM put
Covered Put
Steps to Trading a Covered Put1. Short sell the stock.2. Sell puts one strike price out of the money [OTM] (i.e., puts with a strike pricelower than the stock).■
If the stock is purchased simultaneously with writing the call contract, thestrategy is commonly referred to as a “buy-write.”
■
Generally, only sell the puts on a monthly basis. In this way you will capture more in premiums over several months, provided you are not exercised. Selling premium every month will net you more over a period oftime than selling premium a long way out. Remember that whenever youare selling options premium, time decay works in your favor. Time decay isat its fastest rate in the last 20 trading days (i.e., the last month), so whenyou sell option premiums, it is best to sell it with a month left, and do itagain the following month.
■
Remember that your maximum gain is capped when the stock falls to thelevel of the put strike price.
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If trading U.S. stocks and options, you will be required to sell (or be shortin) 100 shares for every put contract that you sell.
Steps In■
Try to ensure that the trend is downward or rangebound and identify aclear area of resistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock closes below the strike at expiration, you will be exercised. Youwill have to buy back the stock at the strike price, having profited fromboth the option premium you received and the fall in stock price to reachthe lower strike price.
■
If the stock remains above the strike but below your stop loss, let the putexpire worthless and keep the entire premium. If you like, you can thenwrite another put for the following month.
■
If the stock rises above your stop loss, then either buy back the stock (ifyou’re approved for naked put writing) or reverse the entire position (theput will be cheap to buy back).
2.13.2 ContextOutlook■
With a Covered Put, your outlook is neutral to bearish. You expect a steadydecline.
Rationale■
To sell (short) a stock for the medium or long term with the aim of capturingmonthly income by selling puts every month. This is like collecting rent afterselling the stock.
■
If the stock rises, you will lose money because you have shorted the stock.
■
If the stock falls, you will make money because of your short position on thestock; however, you will only make limited profit because if the stock declinesdown to the sold put strike price, you will be exercised at that strike price. Thismeans that you will have to buy the stock at the sold put strike price if thestock declines to that level at expiration.
Income Strategies
Net Position■
This is a net credit transaction because you are selling the stock and taking in apremium for the sold put options.
■
Your maximum risk is unlimited if the stock price rises.
Effect of Time Decay■
Time decay is helpful to your trade here because it should erode the valueof the put you sold. Provided that the stock does not hit the strike priceat expiration, you will be able to retain the entire option premium for thetrade.
Appropriate Time Period to Trade■
Sell the puts on a monthly basis.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is downward or rangebound and identify a cleararea of resistance.
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—Look for either the ATM or just OTM (lower) strike below the currentstock. If you’re confident of the stock falling, then choose a lower strike; ifneutral, choose the ATM strike.
■
Expiration—Look at either of the next two expirations and compare monthlyyields.
2.13.3 Risk Profile■
Maximum Risk
■
Maximum Reward [Shorted stock price  strike price]  put premium
■
Breakeven
Uncapped
[Shorted stock price  put premium]
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2.13.4 GreeksKey:ExpirationToday – 2 monthsTime(t) – 10 daysRisk ProfileAs the stock pricefalls, the covered putmoves into profit butslows down as itapproaches the strikeprice and maximumprofit.
Risk Profile
Theta
ThetaTheta is positive,illustrating that timedecay is helpful tothe position.
DeltaDelta (speed) is negative and rises to zeroas the asset price fallsbelow the strike priceand the maximumprofit is achieved.
Delta
Vega
VegaVega is negative,illustrating thatvolatility is harmful tothe position.
GammaGamma (acceleration)is always negativewith this positionbecause you are anet seller of puts.
Gamma
Rho
RhoRho is positive, illustrating that higherinterest rates wouldbe helpful to theposition.
2.13.5 Advantages and DisadvantagesAdvantages■
Generate monthly income.
■
Can profit from rangebound or bearish stocks with no capital outlay.
Disadvantages■
Capped upside if the stock falls.
■
Uncapped downside if the stock rises.
2.13.6 Exiting the TradeExiting the Position■
If the share falls below the strike price, you will be exercised and thereforemake a limited profit.
Income Strategies■
If the share rises above the strike price (plus premium you received), you willbe losing money.
■
If the share rises in this way, then your exit depends on what type of accountyou have:■
If your account permits you to sell naked options, then you will be able tobuy back the share and let the sold put option expire worthless. Because theput option will have declined in value so much, you may consider buyingit back to avoid any contingent losses that could occur if the share suddenlybounced back down after you sold it!
■
If your account does not permit you to sell naked options, then you shouldbuy back the options you sold and consider buying back the stock, too.This is the safest way to exit a losing covered put trade.
Mitigating a Loss■
Either buy back the share or buy back both the share and the put option yousold.
2.13.